Practical application of probability in finance

edupristine (CFA FRM PRM FM training institute)   (325 Points)

06 October 2012  

 

Practical application of Probability in Finance in broad sense is term used to indicate vague possibility that something might happen. It is also used synonymously with chance.

 

Deterministic phenomena – If the result of experiment is certain, then experiment is said to be of deterministic nature.

Probabilistic Phenomena If the result is not unique and can be any one of the several possible outcomes, such an experiment is called a random experiment. Random experiment is of probabilistic nature.
e.g when we throw a dice we may get the outcome any integer from 1 to 6. Hence it is called random experiment

Biased and UnBiased Experiments
When we throw a die, if there is any reason to beleive that one of the numbers will turn up more frequently we say it is a biased die. If all the six numbers are equallly likely we call it unbiased die. Similarly a coin also can be termed as an unbiased or biased depending on whether the head or tail are equally likely or not. Mostly questions asked in exams like CFA, FRM are based on unbiased experiments.

Occurences The basic outcomes of an experiment are termed as occurences. Hence, if we throw a die there are 6 occurences. If we toss a coin there are 2 occurences.

Events are those that can be defined by us and each event may have one or more occurences. e.g if we throw a dice we can define following events
getting a 1, getting a 2, getting a 3, getting a 4, getting a 5, getting a 6.

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