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Probability Concepts

1. The probability that a stock is dividend paying, given that it is a telecom stock that meets selection criteria, is 1%. 2. If criteria are independent, the number of companies that will pass the screen is 120. 3. The probability that a stock meets both valuation and financial strength criteria is 0.1.

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262 views

Probability Concepts

1. The probability that a stock is dividend paying, given that it is a telecom stock that meets selection criteria, is 1%. 2. If criteria are independent, the number of companies that will pass the screen is 120. 3. The probability that a stock meets both valuation and financial strength criteria is 0.1.

Uploaded by

Aslam Hossain
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as DOCX, PDF, TXT or read online on Scribd
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Probability Concepts

1 Suppose that 5 percent of the stocks meeting your stock- selection criteria are in the
telecommunications (telecom) industry. Also, dividend- paying telecom stocks are 1 percent
of the total number of stocks meeting your selection criteria. What is the probability that a
stock is dividend paying, given that it is a telecom stock that has met your stock selection
criteria?
2 You are using the following three criteria to screen potential acquisition targets from a list of
500 companies:
Fraction of the 500
Companies
Meeting the
Criterion Criterion
Product lines compatible 0.20
Company will increase combined sales 0.45
growth rate
Balance sheet impact manageable 0.78
If the criteria are independent, how many companies will pass the screen?
3 You apply both valuation criteria and financial strength criteria in choosing stocks. The
probability that a randomly selected stock (from your investment universe) meets your
valuation criteria is 0.25. Given that a stock meets your valuation criteria, the probability
that the stock meets your financial strength criteria is 0.40. What is the probability that a
stock meets both your valuation and financial strength criteria?
4 Suppose the prospects for recovering principal for a defaulted bond issue depend on which
of two economic scenarios prevails. Scenario 1 has probability 0.75 and will result in
recovery of $0.90 per $1 principal value with probability 0.45, or in recovery of $0.80 per $1
principal value with probability 0.55. Scenario 2 has probability 0.25 and will result in
recovery of $0.50 per $1 principal value with probability 0.85, or in recovery of $0.40 per $1
principal value with probability 0.15.
A Compute the probability of each of the four possible recovery amounts: $0.90, $0.80,
$0.50, and $0.40.
B Compute the expected recovery, given the first scenario.
C Compute the expected recovery, given the second scenario.
D Compute the expected recovery.
E Graph the information in a tree diagram.
5 You have developed a set of criteria for evaluating distressed credits. Companies that do not
receive a passing score are classed as likely to go bankrupt within 12 months. You gathered
the following information when validating the criteria:
●■
Forty percent of the companies to which the test is administered will go bankrupt within
12 months: P(nonsurvivor) = 0.40.
●■
Fifty-five p ercent of the companies to which the test is administered pass it: P(pass
test) = 0.55.
●■
The probability that a company will pass the test given that it will subsequently survive
12 months, is 0.85: P(pass test | survivor) = 0.85.
A What is P(pass test | nonsurvivor)?

B ing Bayes’ formula, calculate the probability that a company is a survivor, given that it
passes the test; that is, calculate P(survivor | pass test).
C What is the probability that a company is a nonsurvivor, given that it fails the test?
D Is the test effective?
6 In probability theory, exhaustive events are best described as events:
A with a probability of zero.
B that are mutually exclusive.
C that include all potential outcomes.

7 Which probability estimate most likely varies greatly between people?


A An a priori probability
B An empirical probability
C A subjective probability
8 If the probability that Zolaf Company sales exceed last year’s sales is 0.167, the odds for
exceeding sales are closest to:
A 1 to 5.
B 1 to 6.
C 5 to 1.
9 The probability of an event given that another event has occurred is a:
A joint probability.
B marginal probability.
C conditional probability.
10 After estimating the probability that an investment manager will exceed his benchmark
return in each of the next two quarters, an analyst wants to forecast the probability that the
investment manager will exceed his benchmark return over the two-qu arter period in
total. Assuming that each quarter’s performance is independent of the other, which
probability rule should the analyst select?
A Addition rule
B Multiplication rule
C Total probability rule
11 Which of the following is a property of two dependent events?
A The two events must occur simultaneously.
B The probability of one event influences the probability of the other event.
C The probability of the two events occurring is the product of each event’s probability.
12 Which of the following best describes how an analyst would estimate the expected value of
a firm under the scenarios of bankruptcy and survivorship? The analyst would use:
Probabilit Amount Probabilit A the addition rule.
y of Recovered ($) y of B conditional
Scenario Amount expected values.
Scenario (%) (%) C the total probability
1 40 50,000 60 rule for expected
30,000 40 value.
132 60 80,000 90 An analyst developed two
60,000 10 scenarios with respect to
the recovery of $100,000
principal from defaulted loans:

The amount of the expected recovery is closest to:


A $36,400. B $63,600. C $81,600.
14 US and Spanish bonds have return standard deviations of 0.64 and 0.56, respectively. If the
correlation between the two bonds is 0.24, the covariance of returns is closest to:
A 0.086. B 0.670. C 0.781.
15 The covariance of returns is positive when the returns on two assets tend to:
A have the same expected values.
B be above their expected value at different times.
C be on the same side of their expected value at the same time.
16 Which of the following correlation coefficients indicates the weakest linear relationship
between two variables?
A –0.67
B –0.24
C 0.33
17 An analyst develops the following covariance matrix of returns:
Hedge Fund Market Index
Hedge fund 256 110
Market index 110 81
The correlation of returns between the hedge fund and the market index is closest to:
A 0.005. B 0.073. C 0.764.
18 All else being equal, as the correlation between two assets approaches +1.0, the
diversification benefits:
A decrease.
B stay the same.
C increase.
19 Given a portfolio of five stocks, how many unique covariance terms, excluding variances, are
required to calculate the portfolio return variance?
A 10 B 20 C 25
20 The probability distribution for a company’s sales is:
Probability Sales ($
millions)
0.05 70
0.70 40
0.25 25
The standard deviation of sales is closest to:
A $9.81 million.
B $12.20 million.
C $32.40 million.
21 Which of the following statements is most accurate? If the covariance of returns between
two assets is 0.0023, then:
A the assets’ risk is near zero.
B the asset returns are unrelated.
C the asset returns have a positive relationship.
22 An analyst produces the following joint probability function for a foreign index (FI) and a

domestic index (DI).


RDI = 30% RDI = 25% RDI = 15%
RFI = 25% 0.25
RFI = 15% 0.50
RFI = 10% 0.25
The covariance of returns on the foreign index and the returns on the domestic index is
closest to:
A 26.39.
B B 26.56.
C C 28.12.

23 A manager will select 20 bonds out of his universe of 100 bonds to construct a portfolio.
Which formula provides the number of possible portfolios?
A Permutation formula
B Multinomial formula
C Combination formula
24 A firm will select two of four vice presidents to be added to the investment committee. How
many different groups of two are possible?
A 6
B 12
C 24
25 From an approved list of 25 funds, a portfolio manager wants to rank 4 mutual funds from
most recommended to least recommended. Which formula is most appropriate to calculate
the number of possible ways the funds could be ranked?
A Permutation formula
B Multinomial formula
C Combination formula

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