Basic Probability

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Objectives

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Objectives
• Risk managers are
concerned about the
chances for default
among a large number of
customers, not just one or
two

• The bank may exhaust its

cash reserves if too many
borrowers default

• What are the chances

that more than 30 of the
100 borrowers who were
approved this week do
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 Subjective probability

 Subjective probability may differ from person to person

 A media development team assigns a 60%

probability of success to its new ad campaign.

 The chief media officer of the company is less

optimistic and assigns a 40% of success to the same

campaign.
 The assignment of a subjective probability is based on a
person’s experiences, opinions, and analysis of a
particular situation.
 Subjective probability is useful in situations when an
empirical or a priori probability cannot be computed.

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 Basic Probability Concepts
 Probability – the numerical value representing the
chance, likelihood, or possibility that a certain
event will occur (always between 0 and 1).

 Impossible Event – an event that has no chance

of occurring (probability = 0).

 Certain Event – an event that is sure to occur

(probability = 1).

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 Random Experiment

https://arnab-chakraborty.shinyapps.io/shny/

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 Sample Space
The Sample Space is the collection of all
possible events.
e.g. All 6 faces of a die:

e.g. All 52 cards of a bridge deck:

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Sample Space
• A loan made to a borrower results in one of three
possible outcomes: default, late, or on-time.
S = {default, late, on-time}

• The sample space for the status of a single

loan at the bank has 3 elements; the sample
space for 2 loans has
3 X 3 = 9 outcomes:
S={(default, default), (default, late),
(default, on-time)
(late, default), (late, late), (late, on-
time),
(on-time, default), (on-time, late), (on-
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What is Special in Random Sequences?

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 Events
Each possible outcome of a random experiment is an elementary
event.

 Simple event:

An event described by a single characteristic.

e.g., A day in January from all days in 2016.
 Joint event:

An event described by two or more characteristics.

e.g. A day in January that is also a Wednesday from all days in 2016.
 Complement of an event A (denoted A’):

All events that are not part of event A.

e.g., All days from 2016 that are not in January.

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 Defining Probability

Assessing the probability of an uncertain

event:
1. Classical definition

probability of occurrence  number of ways in which the event occurs

Assuming total number of possible outcomes
all
outcomes 2. Relative frequency definition
are
equally
probability of occurrence = no. of occurrence of the event / no. of trials
likely

3. Modified definition (Axiomatic definition)

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Classical definition of probability

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 Example: classical definition of
probability

When randomly selecting a day from the year 2016

what is the probability the day is in January?

X number of days in January

Probability of Day In January  
T total number of days in 2016

X 31 days in January 31
 
T 366 days in 2015 366
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Relative frequency definition of
probability

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Relative frequency definition of
probability

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Statistical Regularity

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Modified definition of probability

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Example: Modified definition of probability

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Organizing & Visualizing Events
 Contingency Tables -- For All Days in 2016.
Jan. Not Jan. Total

Wed. 4 48 52
Not Wed. 27 287 314

Total 31 335 366

 Decision Trees. Total

Sample
W e d. 4 Number
Of
J a n.
Space Sample
All Days Not Wed. 27
Space
In 2016 Wed. 48
Outcomes.
N o t Ja
n.
Not W
ed . 287
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 Definition: Simple Probability
 Simple Probability refers to the probability of a
simple event.
 ex. P(Jan.).
 ex. P(Wed.).
Jan. Not Jan. Total
P(Wed.) = 52 / 366
Wed. 4 48 52
Not Wed. 27 287 314

Total 31 335 366

P(Jan.) = 31 / 366
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 Venn diagram

• A Venn diagram is a graphical method for

depicting the relationship among sets
• Events are sets, Venn diagrams are
helpful for seeing the rules of probability
• Area of a set represents its probability;
events with larger probabilities have
larger area
• Venn diagrams display the sample space
as a shaded rectangle
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Mutually Exclusive Events

 Mutually exclusive events:

Events that cannot occur simultaneously.


Example: Randomly choosing a day from 2016

A = day in January; B = day in February

 Events A and B are mutually exclusive.

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 Exhaustive Events
 Collectively exhaustive events:

One of the events must occur.

The set of events covers the entire sample space.
Example: Randomly choose a day from 2016.

A = Weekday; B = Weekend;
C = January; D = Spring;

Events A, B, C and D are collectively exhaustive
(but not mutually exclusive – a weekday can be in
January or in Spring).

Events A and B are collectively exhaustive and
also mutually exclusive.
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Mutually Exclusive & Exhaustive Events

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Essential Rules

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Essential Rules

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Essential Rules

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 Probability Summary So Far
 Probability is the numerical measure
of the likelihood that an event will 1 Certain

occur.
 The probability of any event must be
between 0 and 1, inclusively.
0 ≤ P(A) ≤ 1 For any event A 0.5
 The sum of the probabilities of all
mutually exclusive and collectively
exhaustive events is 1.
P(A)  P(B)  P(C) 1
0 Impossible
If A, B, and C are mutually exclusive and
collectively exhaustive

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Additional Rules

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Additional Rules

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 Addition Rule Example

P(Jan. or Wed.) = P(Jan.) + P(Wed.) - P(Jan. and Wed.)

= 31/366 + 52/366 - 4/366 = 79/366
Don’t count
the four
Wednesdays
in January
Jan. Not Jan. Total twice!
Wed. 4 48 52
Not Wed. 27 287 314

Total 31 335 366

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Addition Rule Example

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Addition Rule Example

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Boole’s Inequality

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Example

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Boole’s Inequality Example

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 Computing Joint and
Marginal Probabilities

 The probability of a joint event, A and B:

number of outcomes satisfying A and B
P( A and B) 
total number of elementary outcomes

 Computing a marginal probability:

P(A) P(A and B1 )  P(A and B 2 )    P(A and Bk )


Where B1, B2, …, Bk are k mutually exclusive and collectively
exhaustive events.

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 Definition: Joint Probability
 Joint Probability refers to the probability of an
occurrence of two or more events (joint event).
 ex. P(Jan. and Wed.).
 ex. P(Not Jan. and Not Wed.).

Jan. Not Jan. Total

P(Not Jan. and Not Wed.)
Wed. 4 48 52
= 287 / 366
Not Wed. 27 287 314

Total 31 335 366

P(Jan. and Wed.) = 4 / 366

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Marginal Probability Example

P(Wed.)
4 48 52
P(Jan. and Wed.)  P(Not Jan. and Wed.)   
366 366 366

Jan. Not Jan. Total

Wed. 4 48 52
Not Wed. 27 287 314

Total 31 335 366

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 Marginal & Joint Probabilities In A
Contingency Table

Event
Event B1 B2 Total
A1 P(A1 and B1) P(A1 and B2) P(A1)

A2 P(A2 and B1) P(A2 and B2) P(A2)

Total P(B1) P(B2) 1

Joint Probabilities Marginal (Simple) Probabilities

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Marginal Probability Example

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 Computing Conditional
Probabilities
 A conditional probability is the probability of one
event, given that another event has occurred:
P(A and B) The conditional
P(A | B)  probability of A given
P(B) that B has occurred.

P(A and B) The conditional

P(B | A)  probability of B given
P(A) that A has occurred.

Where P(A and B) = joint probability of A and B

P(A) = marginal or simple probability of A
P(B) = marginal or simple probability of B
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Conditional Probability Example

• To find the proportion of visitors

from Comcast who make
purchases, we condition on the first
column of the table

• This restriction makes the rest of

the sample space irrelevant

• Within this new sample space,

what’s the probability of {Yes and
Comcast}?

• Among visitors from Comcast, the

chance of a purchase is
0.001/0.010 = 0.1
Copyright © 2017, 2014, 2011 Pearson Education, Inc. Chapter 4 - 43
 Conditional Probability Example

 Of the cars on a used car lot, 70% have air

conditioning (AC) and 40% have a GPS. 20%
of the cars have both.

 What is the probability that a car has a GPS,

given that it has AC ?

i.e., we want to find P(GPS | AC).

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 Conditional Probability Example
(continued)
 Of the cars on a used car lot, 70% have air conditioning
(AC) and 40% have a GPS and
20% of the cars have both.
GPS No GPS Total
AC 0.2 0.5 0.7
No AC 0.2 0.1 0.3
Total 0.4 0.6 1.0

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 Conditional Probability Example
(continued)
 Given AC, we only consider the top row (70% of the cars). Of these,
20% have a GPS. 20% of 70% is about 28.57%.

GPS No GPS Total

AC 0.2 0.5 0.7
No AC 0.2 0.1 0.3
Total 0.4 0.6 1.0

P(GPS and AC) 0.2

P(GPS | AC)   0.2857
P(AC) 0.7

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 Using Decision Trees
.2
Given AC or G P S .7 P(AC and GPS) = 0.2
H as
no AC: 0 .7
C )= D oe
P( A h av e
s no
t P(AC and GPS’) = 0.5
G PS .5
s AC
H a .7
All Conditional
Probabilities
Cars
Do .2
e
hav s not .3
eA
C P(A G P S P(AC’ and GPS) = 0.2
C ’) Has
=0
.3
D oe
s
have not
G PS .1 P(AC’ and GPS’) = 0.1
.3
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 Using Decision Trees (continued)
.2
.4 P(GPS and AC) = 0.2
Given GPS a s AC
H
or no GPS: 0 .4
S )=
( G P D oe
P s
have not .2 P(GPS and AC’) = 0.2
P S AC
s G
Ha .4
All Conditional
Probabilities
Cars
Do .5
e
hav s not
eG
PS P(G C
.6 P(GPS’ and AC) = 0.5
A
PS
’) = Has
0.6
D oe
s
have not .1 P(GPS’ and AC’) = 0.1
AC
.6
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 Independence
 Two events are independent if and only
if:

P(A | B) P(A)
 Events A and B are independent when the probability
of one event is not affected by the fact that the other
event has occurred.

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Independence

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Independence

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 Multiplication Rules

 Multiplication rule for two events A and B:

P(A and B) P(A | B) P(B)

Note: If A and B are independent, then P(A | B) P(A)

and the multiplication rule simplifies to:

P(A and B) P(A) P(B)

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Venn Diagram of Independent Events

• P(A) =1/4 , P(B)=1/2

• P(B|A)=1/2=P(B)

• P(A and B)=1/8=P(A)P(B)

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Disjoint Events & Independence

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Example: Dependence & Independence

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Example: Dependence & Independence

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Problem

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Solution

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 Marginal Probability

 Marginal probability for event A:

P(A) P(A | B1 ) P(B1 )  P(A | B 2 ) P(B 2 )    P(A | Bk ) P(Bk )


Where B1, B2, …, Bk are k mutually exclusive and
collectively exhaustive events.

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 Bayes’ Theorem

 Bayes’ Theorem is used to revise previously

calculated probabilities based on new
information.

 Developed by Thomas Bayes in the 18th

Century.

 It is an extension of conditional probability.

Copyright © 2017, 2014, 2011 Pearson Education, Inc. Chapter 4 - 60

 Bayes’ Theorem

P(A | B i )P(B i )
P(B i | A) 
P(A | B 1 )P(B 1 )  P(A | B 2 )P(B 2 )   P(A | B k )P(B k )

 where:
Bi = ith event of k mutually exclusive and collectively
exhaustive events
A = new event that might impact P(Bi)

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Example

 A drilling company has estimated a 40%

chance of striking oil for their new well.
 A detailed test has been scheduled for more
information. Historically, 60% of successful
wells have had detailed tests, and 20% of
unsuccessful wells have had detailed tests.
 Given that this well has been scheduled for a
detailed test, what is the probability
that the well will be successful?

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 Bayes’ Theorem Example

 Let S = successful well

U = unsuccessful well
 P(S) = 0.4 , P(U) = 0.6 (prior probabilities).
 Define the detailed test event as D.
 Conditional probabilities:
P(D|S) = 0.6 P(D|U) = 0.2
 Goal is to find P(S|D).

Copyright © 2017, 2014, 2011 Pearson Education, Inc. Chapter 4 - 63

 Bayes’ Theorem Example

Apply Bayes’ Theorem:

P(D | S)P(S)
P(S | D) 
P(D | S)P(S)  P(D | U)P(U)
(0.6)(0.4)

(0.6)(0.4)  (0.2)(0.6)
0.24
 0.667
0.24  0.12

So the revised probability of success, given that this well

has been scheduled for a detailed test, is 0.667.
Copyright © 2017, 2014, 2011 Pearson Education, Inc. Chapter 4 - 64
 Bayes’ Theorem Example

 Given the detailed test, the revised probability

of a successful well has risen to 0.667 from
the original estimate of 0.4.

Prior Conditional Joint Revised

Event Prob.
Prob. Prob. Prob.
S (successful) 0.4 0.6 (0.4)(0.6) = 0.24 0.24/0.36 = 0.667
U (unsuccessful) 0.6 0.2 (0.6)(0.2) = 0.12 0.12/0.36 = 0.333

Sum = 0.36

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Bayes’ Theorem Example

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Bayes’ Theorem Example

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Bayes’ Theorem Example

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Problem

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Solution

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Problem

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Problem

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Solution

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Problem

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Solution

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