Advanced stochastic models risk assessment and portfolio optimization rachev stoyanov and frank j fabozzi

Advanced
Stochastic Models,
Risk Assessment,
and Portfolio
Optimization
The Ideal Risk, Uncertainty,
and Performance Measures

SVETLOZAR T. RACHEV
STOYAN V. STOYANOV
FRANK J. FABOZZI

John Wiley & Sons, Inc.



Advanced
Stochastic Models,
Risk Assessment,
and Portfolio
Optimization


THE FRANK J. FABOZZI SERIES
Fixed Income Securities, Second Edition by Frank J. Fabozzi
Focus on Value: A Corporate and Investor Guide to Wealth Creation by James L. Grand and James
A. Abater
Handbook of Global Fixed Income Calculations by Dragomir Krgin
Managing a Corporate Bond Portfolio by Leland E. Crabbe and Frank J. Fabozzi
Real Options and Option-Embedded Securities by William T. Moore

Capital Budgeting: Theory and Practice by Pamela P. Peterson and Frank J. Fabozzi
The Exchange-Traded Funds Manual by Gary L. Gastineau
Professional Perspectives on Fixed Income Portfolio Management, Volume 3 edited by Frank J. Fabozzi
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Collateralized Debt Obligations: Structures and Analysis by Laurie S. Goodman and Frank J. Fabozzi
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Foundations of Economics Value Added: Second Edition by James L. Grant
Financial Management and Analysis: Second Edition by Frank J. Fabozzi and Pamela P. Peterson
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V. Mann, and Moorad Choudhry
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Short Selling: Strategies, Risk and Rewards edited by Frank J. Fabozzi
The Real Estate Investment Handbook by G. Timothy Haight and Daniel Singer
Market Neutral: Strategies edited by Bruce I. Jacobs and Kenneth N. Levy
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V. Mann
Fat-Tailed and Skewed Asset Return Distributions by Svetlozar T. Rachev, Christian Menn, and Frank
J. Fabozzi

Financial Modeling of the Equity Market: From CAPM to Cointegration by Frank J. Fabozzi, Sergio
M. Focardi, and Petter N. Kolm
Advanced Bond Portfolio management: Best Practices in Modeling and Strategies edited by Frank
J. Fabozzi, Lionel Martellini, and Philippe Priaulet
Analysis of Financial Statements, Second Edition by Pamela P. Peterson and Frank J. Fabozzi
Collateralized Debt Obligations: Structures and Analysis, Second Edition by Douglas J. Lucas, Laurie
S. Goodman, and Frank J. Fabozzi
Handbook of Alternative Assets, Second Edition by Mark J. P. Anson
Introduction to Structured Finance by Frank J. Fabozzi, Henry A. Davis, and Moorad Choudhry
Financial Econometrics by Svetlozar T. Rachev, Stefan Mittnik, Frank J. Fabozzi, Sergio M. Focardi, and
Teo Jasic
Developments in Collateralized Debt Obligations: New Products and Insights by Douglas J. Lucas, Laurie
S. Goodman, Frank J. Fabozzi, and Rebecca J. Manning
Robust Portfolio Optimization and Management by Frank J. Fabozzi, Peter N. Kolm, Dessislava
A. Pachamanova, and Sergio M. Focardi
Advanced Stochastic Models, Risk Assessment, and Portfolio Optimization by Svetlozar T. Rachev, Stoyan
V. Stoyanov, and Frank J. Fabozzi
How to Select Investment Managers and Evalute Performance by G. Timothy Haight, Stephen O. Morrell,
and Glenn E. Ross
Bayesian Methods in Finance by Svetlozar T. Rachev, John S. J. Hsu, Biliana S. Bagasheva, and Frank
J. Fabozzi


Advanced
Stochastic Models,
Risk Assessment,
and Portfolio
Optimization
The Ideal Risk, Uncertainty,
and Performance Measures

SVETLOZAR T. RACHEV
STOYAN V. STOYANOV
FRANK J. FABOZZI

John Wiley & Sons, Inc.


Copyright c 2008 by John Wiley & Sons, Inc. All rights reserved.
Published by John Wiley & Sons, Inc., Hoboken, New Jersey.
Published simultaneously in Canada.
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ISBN: 978-0-470-05316-4
Printed in the United States of America.
10

9 8

7

6 5

4

3

2 1


STR
To my children, Boryana and Vladimir
SVS
To my parents, Veselin and Evgeniya Kolevi, and my
brother, Pavel Stoyanov
FJF
To the memory of my parents,
Josephine and Alfonso Fabozzi

Contents
Preface

xiii

Acknowledgments

xv

About the Authors

xvii

CHAPTER 1
Concepts of Probability
1.1
1.2
1.3

1.4

1.5

1.6

Introduction
Basic Concepts
Discrete Probability Distributions

1.3.1 Bernoulli Distribution
1.3.2 Binomial Distribution
1.3.3 Poisson Distribution
Continuous Probability Distributions
1.4.1 Probability Distribution Function, Probability
Density Function, and Cumulative Distribution
Function
1.4.2 The Normal Distribution
1.4.3 Exponential Distribution
1.4.4 Student’s t-distribution
1.4.5 Extreme Value Distribution
1.4.6 Generalized Extreme Value Distribution
Statistical Moments and Quantiles
1.5.1 Location
1.5.2 Dispersion
1.5.3 Asymmetry
1.5.4 Concentration in Tails
1.5.5 Statistical Moments
1.5.6 Quantiles
1.5.7 Sample Moments
Joint Probability Distributions
1.6.1 Conditional Probability
1.6.2 Definition of Joint Probability Distributions

1
1
2
2
3
3

4
5

5
8
10
11
12
12
13
13
13
13
14
14
16
16
17
18
19

vii


viii

CONTENTS

1.6.3 Marginal Distributions
1.6.4 Dependence of Random Variables

1.6.5 Covariance and Correlation
1.6.6 Multivariate Normal Distribution
1.6.7 Elliptical Distributions
1.6.8 Copula Functions
1.7 Probabilistic Inequalities
1.7.1 Chebyshev’s Inequality
1.7.2 Fr´echet-Hoeffding Inequality
1.8 Summary

CHAPTER 2
Optimization
2.1 Introduction
2.2 Unconstrained Optimization
2.2.1 Minima and Maxima of a Differentiable
Function
2.2.2 Convex Functions
2.2.3 Quasiconvex Functions
2.3 Constrained Optimization
2.3.1 Lagrange Multipliers
2.3.2 Convex Programming
2.3.3 Linear Programming
2.3.4 Quadratic Programming
2.4 Summary

CHAPTER 3
Probability Metrics
3.1 Introduction
3.2 Measuring Distances: The Discrete Case
3.2.1 Sets of Characteristics
3.2.2 Distribution Functions

3.2.3 Joint Distribution
3.3 Primary, Simple, and Compound Metrics
3.3.1 Axiomatic Construction
3.3.2 Primary Metrics
3.3.3 Simple Metrics
3.3.4 Compound Metrics
3.3.5 Minimal and Maximal Metrics
3.4 Summary
3.5 Technical Appendix

19
20
20
21
23
25
30
30
31
32

35
35
36
37
40
46
48
49
52

55
57
58

61
61
62
63
64
68
72
73
74
75
84
86
90
90


ix

Contents

3.5.1
3.5.2
3.5.3

Remarks on the Axiomatic Construction of
Probability Metrics

Examples of Probability Distances
Minimal and Maximal Distances

CHAPTER 4
Ideal Probability Metrics
4.1
4.2

4.3

4.4

4.5
4.6

Introduction
The Classical Central Limit Theorem
4.2.1 The Binomial Approximation to the Normal
Distribution
4.2.2 The General Case
4.2.3 Estimating the Distance from the Limit
Distribution
The Generalized Central Limit Theorem
4.3.1 Stable Distributions
4.3.2 Modeling Financial Assets with Stable
Distributions
Construction of Ideal Probability Metrics
4.4.1 Definition
4.4.2 Examples
Summary

Technical Appendix
4.6.1 The CLT Conditions
4.6.2 Remarks on Ideal Metrics

CHAPTER 5
Choice under Uncertainty
5.1
5.2

5.3

Introduction
Expected Utility Theory
5.2.1 St. Petersburg Paradox
5.2.2 The von Neumann–Morgenstern Expected
Utility Theory
5.2.3 Types of Utility Functions
Stochastic Dominance
5.3.1 First-Order Stochastic Dominance
5.3.2 Second-Order Stochastic Dominance
5.3.3 Rothschild-Stiglitz Stochastic Dominance
5.3.4 Third-Order Stochastic Dominance
5.3.5 Efficient Sets and the Portfolio Choice Problem
5.3.6 Return versus Payoff

91
94
99

103

103
105
105
112
118
120
120
122
124
125
126
131
131
131
133

139
139
141
141
143
145
147
148
149
150
152
154
154

x

CONTENTS

5.4 Probability Metrics and Stochastic Dominance
5.5 Summary
5.6 Technical Appendix
5.6.1 The Axioms of Choice
5.6.2 Stochastic Dominance Relations of Order n
5.6.3 Return versus Payoff and Stochastic Dominance
5.6.4 Other Stochastic Dominance Relations

CHAPTER 6
Risk and Uncertainty
6.1 Introduction
6.2 Measures of Dispersion
6.2.1 Standard Deviation
6.2.2 Mean Absolute Deviation
6.2.3 Semistandard Deviation
6.2.4 Axiomatic Description
6.2.5 Deviation Measures
6.3 Probability Metrics and Dispersion Measures
6.4 Measures of Risk
6.4.1 Value-at-Risk
6.4.2 Computing Portfolio VaR in Practice
6.4.3 Backtesting of VaR
6.4.4 Coherent Risk Measures
6.5 Risk Measures and Dispersion Measures
6.6 Risk Measures and Stochastic Orders

6.7 Summary
6.8 Technical Appendix
6.8.1 Convex Risk Measures
6.8.2 Probability Metrics and Deviation Measures

CHAPTER 7
Average Value-at-Risk
7.1
7.2
7.3
7.4

Introduction
Average Value-at-Risk
AVaR Estimation from a Sample
Computing Portfolio AVaR in Practice
7.4.1 The Multivariate Normal Assumption
7.4.2 The Historical Method
7.4.3 The Hybrid Method
7.4.4 The Monte Carlo Method
7.5 Backtesting of AVaR

157
161
161
161
163
164
166

171
171
174
174
176
177
178
179
180
181
182
186
192
194
198
199
200
201
201
202

207
207
208
214
216
216
217
217
218

220


xi

Contents

7.6
7.7
7.8
7.9

Spectral Risk Measures
Risk Measures and Probability Metrics
Summary
Technical Appendix
7.9.1 Characteristics of Conditional Loss
Distributions
7.9.2 Higher-Order AVaR
7.9.3 The Minimization Formula for AVaR
7.9.4 AVaR for Stable Distributions
7.9.5 ETL versus AVaR
7.9.6 Remarks on Spectral Risk Measures

CHAPTER 8
Optimal Portfolios
8.1
8.2

8.3

8.4
8.5

Introduction
Mean-Variance Analysis
8.2.1 Mean-Variance Optimization Problems
8.2.2 The Mean-Variance Efficient Frontier
8.2.3 Mean-Variance Analysis and SSD
8.2.4 Adding a Risk-Free Asset
Mean-Risk Analysis
8.3.1 Mean-Risk Optimization Problems
8.3.2 The Mean-Risk Efficient Frontier
8.3.3 Mean-Risk Analysis and SSD
8.3.4 Risk versus Dispersion Measures
Summary
Technical Appendix
8.5.1 Types of Constraints
8.5.2 Quadratic Approximations to Utility Functions
8.5.3 Solving Mean-Variance Problems in Practice
8.5.4 Solving Mean-Risk Problems in Practice
8.5.5 Reward-Risk Analysis

CHAPTER 9
Benchmark Tracking Problems
9.1
9.2
9.3
9.4
9.5

9.6

Introduction
The Tracking Error Problem
Relation to Probability Metrics
Examples of r.d. Metrics
Numerical Example
Summary

222
224
227
227
228
230
232
235
236
241

245
245
247
247
251
254
256
258
259
262

266
267
274
274
274
276
278
279
281

287
287
288
292
296
300
304


xii

CONTENTS

9.7 Technical Appendix
9.7.1 Deviation Measures and r.d. Metrics
9.7.2 Remarks on the Axioms
9.7.3 Minimal r.d. Metrics
9.7.4 Limit Cases of L∗p (X, Y) and ∗p (X, Y)
9.7.5 Computing r.d. Metrics in Practice

CHAPTER 10
Performance Measures
10.1 Introduction
10.2 Reward-to-Risk Ratios
10.2.1 RR Ratios and the Efficient Portfolios
10.2.2 Limitations in the Application of
Reward-to-Risk Ratios
10.2.3 The STARR
10.2.4 The Sortino Ratio
10.2.5 The Sortino-Satchell Ratio
10.2.6 A One-Sided Variability Ratio
10.2.7 The Rachev Ratio
10.3 Reward-to-Variability Ratios
10.3.1 RV Ratios and the Efficient Portfolios
10.3.2 The Sharpe Ratio
10.3.3 The Capital Market Line and the Sharpe Ratio
10.4 Summary
10.5 Technical Appendix
10.5.1 Extensions of STARR
10.5.2 Quasiconcave Performance Measures
10.5.3 The Capital Market Line and Quasiconcave
Ratios
10.5.4 Nonquasiconcave Performance Measures
10.5.5 Probability Metrics and Performance Measures

Index

304
305
305

307
310
311

317
317
318
320
324
325
329
330
331
332
333
335
337
340
343
343
343
345
353
356
357

361


Preface

odern portfolio theory, as pioneered in the 1950s by Harry Markowitz,
is well adopted by the financial community. In spite of the fundamental
shortcomings of mean-variance analysis, it remains a basic tool in the
industry.
Since the 1990s, significant progress has been made in developing the
concept of a risk measure from both a theoretical and a practical viewpoint.
This notion has evolved into a materially different form from the original
idea behind mean-variance analysis. As a consequence, the distinction
between risk and uncertainty, which translates into a distinction between a
risk measure and a dispersion measure, offers a new way of looking at the
problem of optimal portfolio selection.
As concepts develop, other tools become appropriate to exploring
evolved ideas than existing techniques. In applied finance, these tools are
being imported from mathematics. That said, we believe that probability metrics, which is a field in probability theory, will turn out to be
well-positioned for the study and further development of the quantitative
aspects of risk and uncertainty. Going one step further, we make a parallel.
In the theory of probability metrics, there exists a concept known as an ideal
probability metric. This is a quantity best suited for the study of a given
approximation problem in probability or stochastic processes. We believe
that the ideas behind this concept can be borrowed and applied in the field
of asset management to construct an ideal risk measure that would be ideal
for a given optimal portfolio selection problem.
The development of probability metrics as a branch of probability
theory started in the 1950s, even though its basic ideas were used during the
first half of the 20th century. Its application to problems is connected with
this fundamental question: ‘‘Is the proposed stochastic model a satisfactory
approximation to the real model and, if so, within what limits?’’ In finance,
we assume a stochastic model for asset return distributions and, in order to
estimate portfolio risk, we sample from the fitted distribution. Then we use
the generated simulations to evaluate the portfolio positions and, finally, to

calculate portfolio risk. In this context, there are two issues arising on two
different levels. First, the assumed stochastic model should be close to the
empirical data. That is, we need a realistic model in the first place. Second,
the generated scenarios should be sufficiently many in order to represent a

M

xiii


xiv

PREFACE

good approximation model to the assumed stochastic model. In this way,
we are sure that the computed portfolio risk numbers are close to what they
would be had the problem been analytically tractable.
This book provides a gentle introduction into the theory of probability
metrics and the problem of optimal portfolio selection, which is considered
in the general context of risk and reward measures. We illustrate in numerous
examples the basic concepts and where more technical knowledge is needed,
an appendix is provided.
The book is organized in the following way. Chapters 1 and 2 contain introductory material from the fields of probability and optimization
theory. Chapter 1 is necessary for understanding the general ideas behind
probability metrics covered in Chapter 3 and ideal probability metrics in
particular described in Chapter 4. The material in Chapter 2 is used when
discussing optimal portfolio selection problems in Chapters 8, 9, and 10.
We demonstrate how probability metrics can be applied to certain areas in
finance in the following chapters:
■

■
■

■
■
■

Chapter 5—stochastic dominance orders.
Chapter 6—the construction of risk and dispersion measures.
Chapter 7—problems involving average value-at-risk and spectral risk
measures in particular.
Chapter 8—reward-risk analysis generalizing mean-variance analysis.
Chapter 9—the problem of benchmark tracking.
Chapter 10—the construction of performance measures.

Chapters 5, 6, and 7 are also a prerequisite for the material in the last
three chapters. Chapter 5 describes expected utility theory and stochastic
dominance orders. The focus in Chapter 6 is on general dispersion measures
and risk measures. Finally, in Chapter 7 we discuss the average value-at-risk
and spectral risk measures, which are two particular families of coherent
risk measures considered in Chapter 6.
The classical mean-variance analysis and the more general mean-risk
analysis are explored in Chapter 8. We consider the structure of the efficient
portfolios when average value-at-risk is selected as a risk measure. Chapter
9 is focused on the benchmark tracking problem. We generalize significantly
the problem applying the methods of probability metrics. In Chapter 10,
we discuss performance measures in the general framework of reward-risk
analysis. We consider classes of performance measures that lead to practical
optimal portfolio problems.
Svetlozar T. Rachev

Stoyan V. Stoyanov
Frank J. Fabozzi


Acknowledgments

vetlozar Rachev’s research was supported by grants from the Division of Mathematical, Life and Physical Sciences, College of Letters
and Science, University of California–Santa Barbara, and the Deutschen
Forschungsgemeinschaft.
Stoyan Stoyanov thanks the R&D team at FinAnalytica for the encouragement and the chair of Statistics, Econometrics and Mathematical Finance
at the University of Karlsruhe for the hospitality extended to him.
Lastly, Frank Fabozzi thanks Yale’s International Center for Finance
for its support in completing this book.

S

Svetlozar T. Rachev
Stoyan V. Stoyanov
Frank J. Fabozzi

xv



About the Authors
vetlozar (Zari) T. Rachev completed his Ph.D. in 1979 from Moscow
State (Lomonosov) University, and his doctor of science degree in
1986 from Steklov Mathematical Institute in Moscow. Currently, he is
Chair-Professor in Statistics, Econometrics and Mathematical Finance at
the University of Karlsruhe in the School of Economics and Business Engineering. He is also Professor Emeritus at the University of California–Santa

Barbara in the Department of Statistics and Applied Probability. He has
published seven monographs, eight handbooks and special-edited volumes,
and over 250 research articles. His recently coauthored books published
by John Wiley & Sons in mathematical finance and financial econometrics
include Fat-Tailed and Skewed Asset Return Distributions: Implications
for Risk Management, Portfolio Selection, and Option Pricing (2005);
Operational Risk: A Guide to Basel II Capital Requirements, Models, and
Analysis (2007); Financial Econometrics: From Basics to Advanced Modeling Techniques (2007); and Bayesian Methods in Finance (2008). Professor
Rachev is cofounder of Bravo Risk Management Group specializing in
financial risk-management software. Bravo Group was recently acquired by
FinAnalytica, for which he currently serves as chief scientist.

S

Stoyan V. Stoyanov is the chief financial researcher at FinAnalytica specializing in financial risk management software. He completed his Ph.D. with
honors in 2005 from the School of Economics and Business Engineering
(Chair of Statistics, Econometrics and Mathematical Finance) at the University of Karlsruhe and is author and coauthor of numerous papers. His
research interests include probability theory, heavy-tailed modeling in the
field of finance, and optimal portfolio theory. His articles have appeared
in the Journal of Banking and Finance, Applied Mathematical Finance,
Applied Financial Economics, and International Journal of Theoretical and
Applied Finance. Dr. Stoyanov has years of experience in applying optimal
portfolio theory and market risk estimation methods when solving practical
client problems at FinAnalytica.
Frank J. Fabozzi is professor in the practice of finance in the School of
Management at Yale University. Prior to joining the Yale faculty, he was a
visiting professor of finance in the Sloan School at MIT. Professor Fabozzi

xvii

xviii

ABOUT THE AUTHORS

is a Fellow of the International Center for Finance at Yale University and
is on the Advisory Council for the Department of Operations Research
and Financial Engineering at Princeton University. He is the editor of the
Journal of Portfolio Management. His recently coauthored books published
by John Wiley & Sons in mathematical finance and financial econometrics
include The Mathematics of Financial Modeling and Investment Management (2004); Financial Modeling of the Equity Market: From CAPM to
Cointegration (2006); Robust Portfolio Optimization and Management
(2007); Financial Econometrics: From Basics to Advanced Modeling Techniques (2007); and Bayesian Methods in Finance (2008). He earned a
doctorate in economics from the City University of New York in 1972.
In 2002, Professor Fabozzi was inducted into the Fixed Income Analysts
Society’s Hall of Fame and is the 2007 recipient of the C. Stewart Sheppard
Award given by the CFA Institute. He earned the designation of Chartered
Financial Analyst and Certified Public Accountant.


CHAPTER

1

Concepts of Probability

1.1

INTRODUCTION

Will Microsoft’s stock return over the next year exceed 10%? Will the
one-month London Interbank Offered Rate (LIBOR) three months from
now exceed 4%? Will Ford Motor Company default on its debt obligations
sometime over the next five years? Microsoft’s stock return over the next
year, one-month LIBOR three months from now, and the default of Ford
Motor Company on its debt obligations are each variables that exhibit
randomness. Hence these variables are referred to as random variables.1 In
this chapter, we see how probability distributions are used to describe the
potential outcomes of a random variable, the general properties of probability distributions, and the different types of probability distributions.2
Random variables can be classified as either discrete or continuous. We
begin with discrete probability distributions and then proceed to continuous
probability distributions.
1 The precise mathematical definition is that a random variable is a measurable
function from a probability space into the set of real numbers. In this chapter, the
reader will repeatedly be confronted with imprecise definitions. The authors have
intentionally chosen this way for a better general understandability and for the sake
of an intuitive and illustrative description of the main concepts of probability theory.
In order to inform about every occurrence of looseness and lack of mathematical
rigor, we have furnished most imprecise definitions with a footnote giving a reference
to the exact definition.
2 For more detailed and/or complementary information, the reader is referred
to the textbooks of Larsen and Marx (1986), Shiryaev (1996), and Billingsley
(1995).

1


2

1.2

ADVANCED STOCHASTIC MODELS

BASIC CONCEPTS

An outcome for a random variable is the mutually exclusive potential result
that can occur. The accepted notation for an outcome is the Greek letter ω.
A sample space is a set of all possible outcomes. The sample space is
denoted by . The fact that a given outcome ωi belongs to the sample space
is expressed by ωi ∈ . An event is a subset of the sample space and can be
represented as a collection of some of the outcomes.3 For example, consider
Microsoft’s stock return over the next year. The sample space contains
outcomes ranging from 100% (all the funds invested in Microsoft’s stock
will be lost) to an extremely high positive return. The sample space can
be partitioned into two subsets: outcomes where the return is less than or
equal to 10% and a subset where the return exceeds 10%. Consequently,
a return greater than 10% is an event since it is a subset of the sample
space. Similarly, a one-month LIBOR three months from now that exceeds
4% is an event. The collection of all events is usually denoted by A. In the
theory of probability, we consider the sample space together with the set
of events A, usually written as ( , A), because the notion of probability is
associated with an event.4

1.3

DISCRETE PROBABILITY DISTRIBUTIONS

As the name indicates, a discrete random variable limits the outcomes where
the variable can only take on discrete values. For example, consider the
default of a corporation on its debt obligations over the next five years. This

random variable has only two possible outcomes: default or nondefault.
Hence, it is a discrete random variable. Consider an option contract where
for an upfront payment (i.e., the option price) of $50,000, the buyer of the
contract receives the payment given in Table 1.1 from the seller of the option
depending on the return on the S&P 500 index. In this case, the random
variable is a discrete random variable but on the limited number of outcomes.
3 Precisely,

only certain subsets of the sample space are called events. In the case
that the sample space is represented by a subinterval of the real numbers, the events
consist of the so-called ‘‘Borel sets.’’ For all practical applications, we can think of
Borel sets as containing all subsets of the sample space. In this case, the sample space
together with the set of events is denoted by (R, B). Shiryaev (1996) provides a
precise definition.
4 Probability is viewed as a function endowed with certain properties, taking events
as an argument and providing their probabilities as a result. Thus, according to the
mathematical construction, probability is defined on the elements of the set A (called
sigma-field or sigma-algebra) taking values in the interval [0, 1], P : A → [0, 1].


3

Concepts of Probability

TABLE 1.1 Option Payments Depending on the Value of the S&P 500 Index.
If S&P 500 Return Is:

Payment Received By Option Buyer:

Less than or equal to zero

Greater than zero but less than 5%
Greater than 5% but less than 10%
Greater than or equal to 10%

$0
$10,000
$20,000
$100,000

The probabilistic treatment of discrete random variables is comparatively easy: Once a probability is assigned to all different outcomes, the
probability of an arbitrary event can be calculated by simply adding the
single probabilities. Imagine that in the above example on the S&P 500
every different payment occurs with the same probability of 25%. Then
the probability of losing money by having invested $50,000 to purchase
the option is 75%, which is the sum of the probabilities of getting either
$0, $10,000, or $20,000 back. In the following sections we provide a
short introduction to the most important discrete probability distributions:
Bernoulli distribution, binomial distribution, and Poisson distribution. A
detailed description together with an introduction to several other discrete
probability distributions can be found, for example, in the textbook by
Johnson et al. (1993).

1.3.1

Bernoulli Distribution

We will start the exposition with the Bernoulli distribution. A random
variable X is Bernoulli-distributed with parameter p if it has only two
possible outcomes, usually encoded as 1 (which might represent success or
default) or 0 (which might represent failure or survival).

One classical example for a Bernoulli-distributed random variable occurring in the field of finance is the default event of a company. We observe a
company C in a specified time interval I, January 1, 2007, until December 31,
2007. We define
X=

1 if C defaults in I
0 else.

The parameter p in this case would be the annualized probability of default
of company C.

1.3.2

Binomial Distribution

In practical applications, we usually do not consider a single company but a
whole basket, C1 , . . . , Cn , of companies. Assuming that all these n companies


4

ADVANCED STOCHASTIC MODELS

have the same annualized probability of default p, this leads to a natural
generalization of the Bernoulli distribution called binomial distribution. A
binomial distributed random variable Y with parameters n and p is obtained
as the sum of n independent5 and identically Bernoulli-distributed random
variables X1 , . . . , Xn . In our example, Y represents the total number of
defaults occurring in the year 2007 observed for companies C1 , . . . , Cn .
Given the two parameters, the probability of observing k, 0 ≤ k ≤ n defaults

can be explicitly calculated as follows:
P(Y = k) =

n k
p (1 − p)n − k ,
k

where
n!
n
.
=
(n − k)!k!
k
Recall that the factorial of a positive integer n is denoted by n! and is equal
to n(n − 1)(n − 2) · . . . · 2 · 1.
Bernoulli distribution and binomial distribution are revisited in
Chapter 4 in connection with a fundamental result in the theory of probability called the Central Limit Theorem. Shiryaev (1996) provides a formal
discussion of this important result.

1.3.3

Poisson Distribution

The last discrete distribution that we consider is the Poisson distribution.
The Poisson distribution depends on only one parameter, λ, and can be
interpreted as an approximation to the binomial distribution when the
parameter p is a small number.6 A Poisson-distributed random variable is
usually used to describe the random number of events occurring over a
certain time interval. We used this previously in terms of the number of

defaults. One main difference compared to the binomial distribution is that
the number of events that might occur is unbounded, at least theoretically.
The parameter λ indicates the rate of occurrence of the random events, that
is, it tells us how many events occur on average per unit of time.

5A

definition of what independence means is provided in Section 1.6.4. The reader
might think of independence as no interference between the random variables.
6 The approximation of Poisson to the binomial distribution concerns the so-called
rare events. An event is called rare if the probability of its occurrence is close to zero.
The probability of a rare event occurring in a sequence of independent trials can be
approximately calculated with the formula of the Poisson distribution.