Math/Stats Review

The following is a quick tour of the basic mathematical/statistical principles and algebra
needed in FNCE 370. 1 Many students will find it redundant. However, if you feel uncertain,
study this review material carefully.

Basic Principles
Tables and Graphs
Keep the following in mind when studying tables and graphs.
1. It is a good habit to look for the units. Are the units in $US, $CAN, Sterling, or in kg,
%, or numbers of people? Are units clearly stated and easily understood and compared?
Cereal boxes are, for example, notoriously ambiguous. (Did you get your daily allowance
of vitamins at breakfast?) How can you tell?
2. Look for the source of data and consider its possible reliability/unreliability.
3. In the case of Tables 1.3 and 1.4 (textbook, pp. 1819) there is a problem. Can you
identify the problem?
Answer
Table 1.3 is in units of billions of US dollars. Table 1.4 is in $billions. Does Table 1.4
specify US or Canadian dollars? If we assume it is Canadian dollars, then Table 1.3 is
difficult or impossible to compare with Table 1.4. Moreover, currency values change with
inflation. What year are the tables for? Furthermore, Table 1.4 does not specify what
month (or in the beginning or end of the year) the data was collected.
Calculations with Brackets
Suppose you are doing the following calculation for Net Working Capital Turnover.
NWC Turnover = SALES/NWC= $2,311/($708 - $540)
From experience, you should know that the first thing to do in order to get NWC Turnover is
to perform the operation within the brackets ($708 $540) = $168.
The second operation is to simplify the ratio $2,311/$168 = $13.756.
The following sections contain some common algebraic principles that will get you on your
way to solving equations in this course.
Commutative Axioms
For Addition
a+b=b+a
For Multiplication
n.m=m.n
These two axioms state that changing the order in which two numbers are added or
multiplied will not alter the result.
For example
2+3=3+2
and
2 . 4 = 4 . 2 (a dot or period may be used in place of x as a multiplication sign)
Division is not commutative; order matters in division.
2/3 does not equal 3/2
1

Based on Auvil, D. L, & Poluga, C. (1984). Elementary algebra (2nd ed.). Don Mills, ON: Addison-Wesley Publishing.

Associative Axioms
For Addition
a + (b + c) = (a + b) + c
For Multiplication
n . (m . p) = (n . m) . p
For example
3 + (2+ 4) = (3 + 2) + 4 = 9
3 . (2 . 4) = (3 . 2) . 4 = 24
Addition Axiom for Equality
If a = b, then a + c = b + c.
Multiplication Axiom for Equality
If a = b, then a . c = b . c
Distributive Axiom
a(b + c) = ab + ac
Compute 2 (10 + 5) in two ways
2(10 + 5) = 2 . 15 = 30
or, using the distributive axiom,
2 (10 + 5) = 2 . 10 + 2 . 5 = 20 + 10 = 30
Since multiplication is commutative,
(b + c)a = ba + ca
Distributive Axiom
Multiplication can be distributed over any finite number of terms.
a(b + c + d) = ab + ac + ad
The distributive axiom comes in handy when we must remove parentheses, such as the
example problem from Calculations with Brackets above.
Remove parenthesis from the expression 6(x + 4)
6(x + 4) = 6 . x + 6 . 4
= 6x + 24
The distributive axiom enables us to combine like terms
3(x2 + 3x2) = 3(4x2) = 12x2

Math Review: Lessons 1 and 2

Adding/Multiplying Signed Numbers
For each real number a there is a unique real number called the negative of a written
a, such that
a + (-a) = (-a) + a = 0
For each real number a (except zero) there is a unique real number called the
reciprocal of a written 1/a, such that
a . (1/a) = (1/a) . a = 1
Rule for adding signed numbers
To add two numbers having like signsadd the absolute values of the numbers and then
prefix the common sign.
To add two numbers having unlike signssubtract the smaller absolute value from the
larger absolute value and prefix the sign of the number having the larger absolute value.
Rule for multiplying signed numbers
To find the product of two numbers, multiply their absolute values. If the numbers have
like signs, the product is positive; if they have unlike signs, the product is negative.
Dividing Signed Numbers
The rules just developed for multiplying signed numbers can now be used to formulate
rules for dividing signed numbers
Rule for dividing signed numbers

A B A
=
B
C C
Recall
To find the quotient of two numbers, find the quotient of their absolute values. If the
numbers have like signs, the quotient is positive; if they have unlike signs, the quotient is
negative.
Removing the Parentheses
In order to solve equations, it will often be necessary to remove parentheses that contain a
sum or a difference
Example 1
Remove parentheses in 3(2x + 5)
3(2x + 5) = 6x + 15
A negative sign in front of an expression has exactly the same effect as multiplying that
expression by 1. This is
-5 = (-1)5
-x = (-1)x
and
-(x + 2) = (-1) (x + 2)
Remove parentheses in (x + 2). Answer: -x - 2

Example 2
Remove parentheses in
(3x + 5) (3x + 5) = 3x - 5
Example 3
Remove parentheses in
2(x + ) -2(x + ) = 2x 1
Example 4
Remove parentheses in 4(-3x + 1)
-4(-3x + 1) = 12x 4
Example 5
Remove parentheses in (x 5)
-(x-5) = (-1) . (x 5)
= (-1) . [x + (-5)]
= (-1 . x + (-1) . (-5)
= -x + 5
Example 6 Combine the like terms 6a + 7a
6a + 7a = (6 + 7) a
= 13a
Recall that the addition axiom for equality allows us to add equal quantities to both sides of
an equation and the multiplication axiom for equality allows us to multiply both sides of an
equation by equal quantities. Using these two properties, as well as the other axioms, we
shall change the form of an equation without changing its solution.
To solve the equation x +2 = 6, we shall isolate the variable on one side of the equation.
In order to isolate x on one side of the equation, we must remove the 2 from the lefthand side. This is done by adding the negative of 2, namely 2, to both sides.
x
x
x
x

+
+
+
=

2=6
2 +(-2) = 6 + (-2)
0=4
4

In the example above, the number 2 was removed from the left-hand side by adding the
negative of 2 (i.e., 2) to each side.
Example 7
Solve 5x = 10
Again we wish to isolate the variable x on one side of the equation. Therefore, we must
remove the coefficient 5. To do this we multiply both sides of the equation by the
reciprocal of 5, namely 1/5.
5x = 10
1/5 . 5x = 1/5 . 10
1 . x = 10/5
x=2
In this last example, the number 5 was removed from the left-hand side by multiplying
each side by the reciprocal of 5, namely 1/5. The same result could have been achieved by
dividing each side of the equation by 5.

Math Review: Lessons 3 to 6

Exponential Functions

Start by noting that

F(x) = 2x
and
g(x) = x2
are not the same function.
Whether a variable appears as an exponent with a constant base or as a base with a
constant exponent makes a big difference. The function g is a quadratic function. The
function f is called an exponential function. In general, the equation
f(x) = bx

b>0, b

defines an exponential function for each different constant b, called the base. The domain of
f is the set of all positive real numbers.
Exponential Function Properties
For a and b positive, a 1 , b 1 and x and y real:
1. Exponent laws
x

ax
a
xy
ax ay
ax + y=
a=
ax y =
ax b x=
(ax )y
(ab)x
=
b
y

a

ax
bx

424
24 54
Example:=
4=
434
454
2. ax = ay if and only if x = y
Example: If 7

5t+1

=7

3t3

, 5t + 1 = 3t 3 and t = -2

3. For x 0, ax = bx if and only if a = b.

Example: if a4 = 24 then a = 2
Exponential functions are useful in many disciplines, not just in finance and economics. For
example, cholera, an intestinal disease, is caused by a cholera bacterium that multiplies
exponentially by cell division as given approximately by
N = N0e 1.386t
where N is the number of bacteria present after t hours and N0 is the number of bacteria
present at the start (t = 0).

This section draws extensively from Barnett, R. A., Ziegler, M. R., & Byleen, K. E. (2002). Finite mathematics for business,
economics, life sciences, and social sciences (9th ed.). Upper Saddle River, NJ: Prentice Hall.

First Law of Exponents 3

am an = am+n
Example 1
Find the product of x27 and x33
x27 x23 = x27+33 = x60
Now suppose we wanted to find the quotient of a5 divided by a2
a5 / a2

a2 .a3
=
Cancel a2 in numerator and denominator a3
2
a

This quotient could have been obtained by simply subtracting exponents. That is,
5 2
a5 =
/ a2 a=
a3

Second Law of Exponents

/ an am n where m > n and a 0

am=
Example 2
Find the quotient (bp + 2)/b
+2
p + 2 1
= b p=
/ b b=
b p +1
2 2 2
(a2 )3 a=
.a .a
a6
=

Third Law of Exponents

(am)n = am.n
Example 3
Remove parentheses in (x4)3
(x4)3 = x4 . 3 = x12
Remove parentheses in (ar-1)2
(ar - 1)2 = a 2(r - 1) = a 2r - 2
The next law of exponents concerns raising a product to a power.
For example, consider (ab)3. We can write
(ab)3 = (ab) . (ab) . (ab)
= (a . a . a.) . (b . b . b)
= a3b3

Based on Auvil, D. L, & Poluga, C. (1984). Elementary algebra (2nd ed.). Don Mills, ON: Addison-Wesley Publishing.

Fourth Law of Exponents

(ab)n = anbn
Example 4
Remove parentheses in (xy)5
(xy)5 = x5y5
Example 5
Remove parentheses in (3x)3 and simplify
(3x)3 = 33x3 = 27x3
Example 6
Remove parentheses in (ab) 3r
(ab)3r = a3rb3r
Finally, let us consider raising the quotient a/b to the third power
a a a a3
. .
=
b b b b3

(=
a / b)3

Fifth Law of Exponents

n

an
a
,b0
=
b
bn

Example 7
Remove parentheses in (x/y)10
10

x
y

x10
y10

Example 8
Remove parentheses in (u/v)n+1

u
v

n +1

u n +1
v n +1

It will often be necessary to use a combination of the laws of exponents in the same
problem.

Example 9
Remove parentheses and simplify (4x/y2)3.
3

4x
=
2

43 x 3
43 x 3 64 x 3
=
=
3
y6
y6
y2

( )

52
2
0
52 =
5=
1
=
2
5
Definitions
Let a be any real number except zero. Then a0 = 1
Let a be any real number except zero and n any natural number.
Then

a n =

1
an

Therefore,
a1 =

1
a1

2
0
52 = 52 =
5=
1
52

We can observe certain patterns that occur with negative exponents. For example
n

1
1
bn b
a
=
=
=
b =
n
an / bn
an a

a
b

Hence the rule

n

a
b
b=

a where a 0 and b 0


In other words, a negative exponent on a fraction may be replaced by the corresponding
positive exponent simply by inverting the fraction.
Also

1
1
=
=
an
n
a
1 / an
Hence the rule

1
=
an where a 0
a n

Adding and Subtracting Expressions

Recall that to add two rational numbers we use the rule
a/c + b/c = (a + b)/c where c 0
That is, to add two rational numbers having the same denominator we add their numerators
and place that sum over the common denominator.
Example 1
4/15 + 7/15 = 11/15.
On the other hand, to subtract two rational numbers we use the rule
a/c - b/c = (a - b)/c where c 0
These same two rules are used to add and subtract rational expressions.
Example 2
Find the sum 1/7x + 5/7x
Since the denominators are the same, we simply add the numerators
1/7x + 5/7x = 6/7x
Example 3
Find the sum

3x
6
3x
6
3x + 6 3 ( x + 2 )
+
=
+
=
=
=3
x +2
( x + 2) x + 2 x + 2 x + 2 x + 2
Least Common Denominator
The least common denominator (LCD) of a collection of rational expressions is the simplest
polynomial that is a polynomial multiple of each denominator in the collection. LCD can
often be determined simply by inspection.
Example 4
Determine the LCD of 1/8x and 1/12x
The simplest polynomial that is a multiple of both 8x and 12x is 24x. Note that
24x = 3 x 8x and
24x = 2 x12x
Therefore, the LCD is 24x.
Example 5
Determine the LCD of 5/x2y and 4/xy2. The LCD is x2y2 since
x2y2 = yx2y, and
x2y2 = xxy2, and
x2y2 is the simplest multiple of both x2y and xy2.

Complex Fractions
A complex fraction is a fraction that contains other fractions in its numerator or denominator
(or both). A fraction that is not a complex fraction is called a simple fraction.
Because of numerous fractional parts, complex fractions may be difficult to read and
interpret. They may be simplified, however, using either of two basic methods. Both of
these methods are illustrated in Example 1.
Example 1
Simplify the complex fraction

40
1 +1
3
2
Method 1: Simplify numerator and denominator separately, and then divide.

40
40 / 1
40 / 1
= =
1/3 +1/2 2 /6 + 3 /6
5/6
= 48
Method 2: Multiply numerator and denominator by the LCD of the fractions in the
denominator.

Since the LCD of

40
6
=
1 +1
6
3
2

1
1
and
is 6, we have
3
2

40 6 240
=
= 48
2+3
5

The Quadratic Formula

Common Factors
Suppose we wished to solve the quadratic equation x2 5x + 6 = 0.
If we were able to recognize that x2 - 5x + 6 is actually the product of (x 2) and (x 3),
we could write this equation as
(x 2) (x 3) = 0.
When the equation is in this form we can see that both 2 and 3 satisfy the equation, since 2
causes the first factor to be 0 and 3 causes the second factor to be 0.
The key to solving this equation lies in recognizing the fact that
x2 - 5x + 6 = (x 2) (x 3)
When a polynomial is expressed as a product we say that the polynomial has been factored.

Completing the Square

Factoring provides us with an easy method for solving many quadratic equations.
Unfortunately, as we have already seen, not all polynomials are factorable using integers
only. For example, the left-hand side of the following quadratic equation cannot be factored
using integers only.
x2 6x + 4 = 0
We can solve the equation above, however, using a method called completing the square.
The basic idea of this method is to put one side of the equation in the form (x + d)2. This
side of the equation is then said to be in perfect square.
In order to put the equation in this form, we first observe that
(x + d)2 = x2 + 2dx + d2 .
Now, note that the term d2 is the square of one-half the coefficient of x. That is, the
coefficient of x is 2d, and one-half of 2d squared is (2d/2)2 = d2.
We shall now return to the original equation and solve it by completing the square.
x2 6x + 4 = 0
We begin by subtracting 4 from each side.
x2 6x = -4.
We then complete the square on the left-hand side by adding the square of one-half the
coefficient of x to the left-hand side. That is, we add (-6/2)2 = 9 to the left-hand side. Of
course, if we add 9 to the left-hand side we must also add 9 to the right-hand side. After
doing that, our equation becomes
x2 6x + 9 = -4 + 9 .
The left-hand side is now the perfect square (x 3)2. The equation can therefore be written
as
(x 3)2 = 5.
Solving this last equation by extraction of roots, we have

x 3 = 5
x= 3 5
Therefore the solutions are 3 + 5 and 3 5
Example 1
Solve x2 + 4x 7 = 0
We begin by adding 7 to each side.
x2 + 4x 7 = 0
x2 + 4x = 7.
2

4
2 = 4
We now complete the square by adding
to each side.
x2 + 4x + 4 = 7 + 4
The left-hand side is now the perfect square (x + 2)2.
(x + 2)2 = 11.
The solutions are -2 + 11 and -2 11

Algebraic Solutions to the Quadratic Formula

Consider the general quadratic equation as

0
ax 2 + bx + c =
x2 +

b
c
0
x+ =
a
a

x2 +

b
c
x =

a
a

Since the coefficient of x is b/a, the square of one-half the coefficient of x is (b/2a)2. Thus,
we complete the square by adding (b/2a)2 to each side.

x2 +

b
c b
b
= +
x+

a
a 2a
2a
2

4ac
b
b2

+
=

+
x

2a
4a2 4a2

b
b2 4ac

+
=
x

2a
4a2

x+

b
b2 4ac
=

2a
4a2

x+

b
b2 4ac
=

2a
2a

x =
2a

x =

b2 4ac
2a

b b2 4ac
2a

We now have a formula for solving any quadratic equation.

The solutions of the quadratic equation

ax 2 + bx + =
c 0 (a 0)
are given by

x =

b b2 4ac
2a

Example 1
2
1 using the quadratic formula. We first put the equation in standard form
Solve 3x 4 x =
in order to identify a, b, and c.

3x 2 4 x =
1
3x 2 4 x + 1 =
0
a = 3, b = -4, c = 1
Substituting these values for a, b, and c into quadratic formula, we have

x =
x =

( 4 )

( 4 )2 4 (3) (1)
2 (3)

4 16 12
6

4 4
6
42
x =
6
x =

Therefore,
=
x

4+2
42 1
= 1=
=
or x
6
6
3

Math Review: Lessons 7 and 8

Problems in Lessons 7 and 8 may involve solving two equations in two unknowns. (Where
do the 2 lines cross?) Generally, one can substitute logic and an understanding of what one
is trying to do for mathematical savvy. But sometimes the mathematical sophistication
makes things much easier.
Systems of Equations
For a graphical example of solving two equations in two unknowns in finance, see Figure 9.7
on page 253 in the textbook.
Example 1
A paperboy has $11 extra in Christmas tips to divide between his two helpers, Mary and
Ray. Since Mary has helped more often than Ray, he decides that Mary should receive $3
more than Ray. How much should each helper receive?
This particular problem is easy to do simply by trial and error. Many problems of this type,
however, are too difficult to be solved using a trial-and-error approach. Our intent here is to
develop a systematic approach to solving problems of this type. Once developed, this
method will prove useful in many different situations in mathematics.
We shall let x represent the number of dollars Mary is to receive and y the number of
dollars Ray is to receive. We can then write the two equations
x + y = 11
and
xy=3
These two equations taken together are called a system of equations 4. To solve the system
means to find a pair of values x and y that satisfies the conditions of both equations. For
example, the ordered pair (8,3) is a solution to the first equation, since 8 + 3 = 11; but it is
not a solution to the second equation, since 8 3 3.
We know that all solutions to the first equation (x + y = 11) lie on a straight line. Also, all
solutions to the second (x y = 3) lie on some other straight line. If the two equations are
graphed using the same coordinate axes, we obtain two intersecting lines.
14

y=x-3

12
10
8
6
4
2
0
-2 0
-4
-6

10

12

14

16

18

y = -x + 11

Since the two equations are to be true at the same time, they are also referred to as simultaneous equations.

From a graph, the intersection point of the two lines appears to be (7,4). Since the point
(7,4) is the only point that lies on both lines, it is the only point that is a solution to both
equations. The point (7,4) is therefore called the solution of the system. 5
x + y = 11 or 7 + 4 = 11
x y = 3 or 7 4 = 3
Another way of writing the solution of the system above is to say that x = 7 and y = 4.
This method of solving a system of equations is called the graphical method.
If two linear equations that form a system represent two distinct lines, then the system is
said to be independent. If the system has at least one solution, it is said to be consistent.
Therefore, the system of Example 1 is independent and consistent, which we usually
shorten to just independent.
Example 2
Solve the system below using the graphical method.
x+y=2
x+y=4
Graphing both equations, we see that the two lines are parallel.
Since the lines do not intersect, there is no solution to the system.
When the two lines of a system are parallel, the system is said to be independent and
inconsistent, which we usually shorten to just inconsistent.
Given a system of two linear equations in two variables, exactly one of three situations must
occur. Either the system has one solution, no solution, or infinitely many solutions. (The two
lines lie on top of one another.)
Substitution Method
While solving the problems in the Systems of Equations section above, you probably
discovered that the graphical method for solving a system is not always an accurate
method.
The graphical method gives us a clear picture of what is happening in the solving process,
but in order to be assured of obtaining an exact solution to a system, we must use an
algebraic method.
The substitution method involves solving one of the equations for one of its variables (we
usually choose the easiest variable to solve for) and then substituting that expression into
the other equation. The resulting equation then contains only one variable.

Auvil & Poluga (1984, p. 332).

Example 1
Solve the system below using the substitution method.
i. x 2y = 6
ii. x + 2y = 10
We decide to solve the first equation for x. Adding 2y to both sides gives
x = 6 + 2y
Substituting the expression x = 6+ 2y into equation #2 we obtain a first-degree equation in
one variable, and it is easily solved.
6 + 2y + 2y = 10
6 + 4y = 10
4y = 4
y=1
Finally, we substitute 1 for y in the equation x = 6 + 2y (actually this substitution could also
be made in either of the original equations).
x = 6 + (2 x 1)
x=8
Therefore the solution is (8,1).
Addition Method
The same quantity, when added to equals, produces equals. This axiom can be extended to
state
If a = b and c = d, then a + c = b + d.
In other words, equal quantities when added to equals produce equals. Using this property,
we can add the corresponding sides of two given equations in two variables to produce one
equation in one variable. This method for solving a system of equations is called the
addition method.
Example 2
Solve the system below using the addition method.
x+y=6
xy=4
Adding the corresponding sides of the two equations, we see that the variable y drops out.
x+y=6
xy=4
2x = 10
Solving this last equation, we have
2x = 10
x=5
Finally, we substitute 5 for x in either of the original equations and solve for y. For example,
using the first equation we have
5+y=6
y=1

Example 3
Solve the system below using the addition methods.
4x + 5y = 3
3x - 2y = 8
In this case, both equations must be multiplied by a suitable number in order to force either
the variable x or the variable y to drop out.
Notice that we could have eliminated the variable x in Example 3 by multiplying the first
equation by 3 and the second equation by 4, and then adding. There are generally a
variety of ways in which the variable of our choice may be eliminated.
In all of the examples thus far, the terms involving like variables have been lined up on the
left-hand side of the equation, and the constants have been lined up on the right-hand side.
When a system of equations is so arranged, it is said to be in standard form.
System in Standard Form
2x + 3 y = 2
4x + 9y = 9
System not in Standard Form
2x = 2 3y
4x + 9y 9 = 0
When solving a system using the addition method, it is generally convenient to write the
system in standard form before proceeding with the solution.

Statistics Review: Lessons 10 and 11

Standard Deviation
Standard deviation (SD) is important in finance since it directly measures risk. With SD one
can determine the

likelihood of a given level of return in a particular portfolio of investments

probability of returns on a given portfolio falling below a specified level

probability of one portfolio having higher returns than another.

From a students perspective, SD is important because it occurs on many if not most final
examinations and because many students have difficulty answering questions related to
SD. The textbook does not provide an elaborate treatment of SD, presumably because the
subject is assumed to have been covered in prerequisite courses.
Most descriptions of standard deviation start with the calculation. Here we will start with the
interpretation.
First, about 99.7% of all observations are found within 3 standard deviations of the mean.
In other words, only about 3 observations per 1000 are farther from the mean than 3
standard deviations. Thus, 3 standard deviations above plus 3 standard deviations below
(that is, 6 in all) encompass about 997 observations in 1000. This 6 sigma criterion
underlies some quality control systems. If its quality is 3 sigma or more from the mean it
is not good enough.
Then, given 1000 observations of most biological and economic phenomena (e.g., weight of
mice, yield of crops, profitability of investments) the two extreme values (heaviest and
lightest weight, largest and smallest yield) are likely to be about 6 standard deviations
apart. This leads to an estimate of standard deviation.
Take 1000 observations and calculate:
(Largest value smallest value)/6.
This is an estimate of Standard Deviation.
For weights of hockey players in pounds this might be
(260 165)/6 = 15.83 pounds.
(Note: There are about 800 players in the NHL. Their weights are published. A scanning of
this data at time of writing indicates: George Laroque (at 260 pounds) is the heaviest while
Paul St. Denis (at 165 pounds) is the lightest.
Some data sets are not normally distributed or bell shaped. Some, such as street addresses
(every number is equally likely) tend to be rectangular. But the Central Limit Theorem tells
us that means from sampling such distributions (indeed almost any distribution) will be
normally distributed or bell shaped . More importantly, and this is why the normal
distribution is so ubiquitousany data (observation) such as weight of hockey players that
is a consequence of many small and unrelated influences (e.g., heredity, childhood
nutrition, amount of exercise) is likely to be normally distributed.
This has been called the Fuzzy Central Limit Theorem. It turns out to be a boon to
researchers who can use statistical tests on many populations. Even when the population is
not normally distributed, Chebyshevs Theorem 6 tells us that standard deviation can still be
used. For example, according to Chebyshev, at least 75% of a population will lie within the
interval x + /- 2 . (That is, two standard deviations above, plus two below the mean.)

See Triola, M. F., Goodman, W. M., & Law, R. (2002). Elementary statistics (2nd Canadian ed.). Toronto, ON: Addison Wesley
Longman. The text uses (range)/4 instead of (range)/6 (see p. 75).

The standard score (or z-score) enables us to determine if an observation is unusual, and if
so, how unusual it is. It is independent of units used so that z-score for prices is a measure
of how unlikely is a particular price, while the z-score for weight provides a measure of how
unusual is that weight. The standard score (or z) is not tabulated in the textbook nor is it
described there, so analysis of z will be brief.
For any sample

=
z

(x x) s
i

where xi is an observation

x is the sample means of observations and

s is an estimate of standard deviation.
For example, a stock price on the TSX may have a mean of $30 and an s (estimated
standard deviation) of 20. A particular stock (e.g., Royal Bank) may have a price of $60.
The questionis Royal Banks price unusually high?
Answer z = ($60 - 30)/20 = 30/20 = 1.5.
Since most observations (95%) fall within two standard deviations of the mean, 1.5 would
not be considered particularly unusual. Royal Banks price is not unusually high. If we look
up the 1.5 in the z table, we find a coefficient of 0.43 (out of 0.50). So Royal Banks price is
higher than about 43 firms out of 50higher than average, but not remarkable.
Highest observationlowest observation
To this point has been estimated as (range)/6. That is rough and ready. Moreover it is
not efficient since it discards the information contained in all but the highest and lowest
observations. Instead the general method involves the following steps.
1. Take a sample of the subject phenomena and measure the interesting characteristic.
2. Find the mean or average of the sample characteristics.
3. Take the deviations of each characteristic from the sample mean characteristic.
4. Square each deviation, add them, and divide by N - 1. This is the variance.
5. Take the square root of the variance. This is the standard deviation.
2
The notation used in our text is = standard deviation, and = variance.

But since we are doing this on a sample and not on the whole population, the notation s is
frequently useds is an estimate of .
Suppose sample observations are 1, 2, and 3.

The mean is (1 + 2 + 3)/3 = 2

What is the standard deviation?
s2 = {(1 - 2)2 + (2 - 2)2 + (3 - 2)2}/(3 - 1) = 2/(3 - 1) = 2/2 = 1
s = (2/2)1/2 = 1
So our estimated standard deviation is 1. Are these numbers reasonable?

While there are difficulties associated with such very small numbers of observations, it certainly simplifies the math.

The mean (2) plus and minus 2 standard deviations (2 + 2 to 2 - 2) = 4 to 0 should contain
about 95% of observations.
The range 0 to 4 contains all our observations, thus this seems reasonable.
Suppose we have observations 2, 4, and 6.
x = 4; deviations are 2, 0, +2, deviations squared are 4, 0, 4.

s2 = 8/2 = 4
s = (4)1/2 = 2
Is this realistic? Are 95% of observations between 4 + 2s and 4 - 2s, in other words,
between +8 and 0?
The answer is yes.
Now suppose both of these sets of observations arise in one sample which contains (1, 2,
3,) (2, 4, 6).
In that case x = 18/6 = 3 and
s2 = {(1 - 3)2 + (2 - 3)2 + (3 - 3)2 + (2 - 3)2 + (4 - 3)2 + (6 - 3)2}/(6 - 1) = 16/5
And s is (16/5)1/2 = 1.788.
Consider a sample 1, 2, 3, 1, 2, 3, 2, 4, 6. Since several observations occur more than
once, is there a way to simplify the calculations of standard deviation?
Yes, there is. Examine the table below.
Relative Frequency Method 8
Observed x
1
2
3
4
6
Sum

Frequency f
2
3
2
1
1
9

f.x
2
6
6
4
6
24

fx2
2
12
18
16
36
84

Using the formula

n x 2 ( x )
=
n(n 1)
2

nfx 2 (fx )2
n(n 1)

=
where x the
=
sum of all x, x2 the sum of all x2
We can calculate the standard deviations of the sample data set {1, 2, 3, 1, 2, 3, 2, 4, 6}
as follows.

=
s

9(84) (24)2
= 1.58113883
9(9 1)

Adapted from pages 74 and 75 in Triola, M. F., Goodman, W. M., & Law, R. (2002). Elementary statistics (2nd Canadian ed.).
Toronto, ON: Addison Wesley Longman.

Traditional Method

Sample data

Mean

Deviation
from Mean

Deviation
Squared

2.666667

-1.666667

2.7777778

2.666667

-0.666667

0.4444444

2.666667

0.3333333

0.1111111

2.666667

-1.666667

2.7777778

2.666667

-0.666667

0.4444444

2.666667

0.3333333

0.1111111

2.666667

-0.666667

0.4444444

2.666667

1.3333333

1.7777778

2.666667

3.3333333

11.111111

Sum =

24

Mean =

24/9 = 2.6667

Sum of Squared Deviations =

20

Estimated variance =

20/(9-1) = 2.5

Estimated standard deviation

=

2.5 = 1.5811388

Note that the relative frequency method provides the same result as the traditional method.
More on Standard Deviation
On page 378 of the textbook, the standard deviation of the return on a portfolio consisting
of two stocks is given as
= correlation coefficient.

=
p

=
p2

( )
2
p

1/2

. In the equation below, xi is weight and CORR

p2 = x1212 + x2 22 + 2 x1 x2 CORR x1 x2 1 2
This is getting awkward. The correlation coefficient (CORR) is illustrated but not defined.
The correlation coefficient is calculated using the formula

CORR =

n R1R 2 R1 R 2
R 2 ( R )2 R 2 ( R )2
1
1
2
2

Where
R1 = the series of return on stock 1
R2 = the series of return on stock 2, and
n = the number of data points in the series.