Stat 334

Lecture 1 1st May 2012 Dina Dawoud M3 3126

Course Outline
Lectures: MWF 10:00-11:20 MC 4045 Tutorial: M 4:30-5:20 MC 4045 Notes: Stat 334 course notes available at Campus Copy MC 2018 Supplementary lecture slides

 Final Grade: 20% Assignments + 30% Test + 50% Final Exam 1 Test: 23rd June 2012 4 Assignments: Dates can be found on course outline on LEARN HELP: During tutorials and Office Hours: M 3-4 and Tuesdays 12-1 Held in M3 3126 TA office Hours: TBA

 Motivation and Review

Multivariate distributions (discrete and continuous random variables, moment generating functions.) Conditional Probability and Random Variables

Markov Chain:
Named after Andrey Markov, a Russian Mathematician. It is a random process that possess what is known as the memoryless property. Describes the evolution of a discrete process over time, when time is discrete. The process randomly jumps from state to state at each step. A step usually refers to time, but could also represent physical distance e.t.c

 As state changes (transitions) occur randomly, probabilities are associated with each possible state change and these are called transition probabilities. Example: Suppose that on class days you wake up and only then decide whether to come to class. If you attended class the day before, you are 70% likely to go to class today, and if you skipped the class the day before, you are 80% likely to go today.

 Modeling this as a Markov Chain we can then find the probabilities that: 1. If you go to class on Monday, how likely are you to go to class on Friday? 2. Assuming the class in infinitely long (Disaster!!!) approximately what portion of class will you attend?

Poisson Process
Named after the French Mathematician Simeon-Denis Poisson.

His name can be found on the South-East side of the Eiffel Tower in recognition of his contributions along with another 71 other names!!

 A Poisson Process is a Stochastic process where events occur continuously and independently (Continuous time, Discrete state space). Examples: Birth-death process: Is a special case of the continuous Markov process. States: Current population size and the transitions are birth and death. The number of goals in a soccer match. The arrival of customers in a queue.

Brownian Motion

The Wiener process is a continuous time stochastic process named in honour of Norbert Wiener. It is often called standard Brownian motion, after Robert Brown, who was a Botanist. The model appeared after Robert Brown observed the random movement of particles suspended in a fluid (a liquid/ a gas). The movement is described using a mathematical model. This model is used in several different fields and one application is stock market fluctuations.

 It is prominent in Mathematical theory of Finance, in particular the Black-Scholes option pricing formula. This formula was first introduced by Fischer Black and Myron Scholes in 1973. However, Robert Merton was the 1st to publish the model. Robert Merton and Myron Scholes received the 1997 Nobel prize in Economics. Fischer Black was mentioned for his contributions as he had passed in 1995.

Chapter 1: Motivation and Review

Probability is a mathematical tool that is used to quantify uncertainty and variability. (We cant eliminate uncertainty) We use mathematical models to try and predict future values and make decisions. We cannot know if our model is correct. Model is usually based on some prior knowledge.

 Example 1: You wish to purchase an insurance policy that pays you $1 if a particular event A occurs before the years end. What is a fair premium? Suppose the probability an event occurs is p and X represents your return policy. X is called a random variable: A quantity that takes on numerical values with specified probabilities.

 In the example the Expected Value is the Fair Premium.

We can also talk about Risk. To model risk, we model the return on an uncertain investment as a random variable, Y.

 Example 2: Bond Ratings: Bonds are rated every 3 months. Rating agencies rate bonds based on how likely an issuer is to default. Suppose the possible ratings are: (AAA, AA, A, BBB, BB, B, CCC, D)
Consider the following ratings migration model given in T. Schuermann et al., Credit Migration Matrices,
Encyclopaedia of Quantitative Risk Assessment, 2008, Wiley and Sons.

 We can use the rules of conditional probabilities to solve for questions such as: What is the probability that the bond remains rated at BBB after 6 months?