BINOMIAL DISTRIBUTION

Applied Statistics and Computing Lab Indian School of Business

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Learning goals
To understand idea behind Binomial distribution To study the behaviour of Binomially distributed variables To look at examples of Binomial distribution To understand the importance of the distribution

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Price increases Price increases

Day 4

Price decreases or remains the same Price increases

Day 3
Price increases Price decreases or remains the same
Day 4

Price of stock A

Day 2

Price decreases or remains the same Price increases

and so on

Day 1
Price increases Price decreases or remains the same

Day 4

Price decreases or remains the same

Day 3
Price increases Price decreases or remains the same
Day 4

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Price decreases or remains the same

Example
Suppose we know the values of 1 and 2 for stock A and they remain the same every day We can easily see that 1 + 2 = 1 Can we find the probability that during the 5 trading days of next week, the price of stock A will increase on 3 of the days? This is an experiment with only two possible outcomes viz. the price will increase or the price will decrease or remain the same The probability of either of these possibilities remains same on each day i.e. in each trial Let us assume that whether the price increases, decreases or remains the same on a particular day, does not have any influence on whether the price increases, decreases or remains the same on the next day
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Calculating the probability

Suppose that event 1 = price increases on (Day 1, day 2, day 3) and decreases or remains the same on (Day 4, day 5) By using rules of probability P 1 = (1 3 2 2 ) where, 1 = 2 = In how many ways can the price increase on 3 out of 5 days? Using the counting principle, 5 . 3 5 = 3
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Bringing together all possibilities

Here are 6 mutually exclusive and collectively exhaustive events under this experiment: 1 = price increases on exactly 0 out of 5 days 2 = price increase on exactly 1 out of 5 days 3 = price increase on exactly 2 out of 5 days 4 = price increase on exactly 3 out of 5 days 5 = price increase on exactly 4 out of 5 days 6 = price increase on exactly 5 out of 5 days Consider . Each simple event contributing to has probability (1 2 5 ) Further, there are
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simple events contributing to

What if we sum all the possibilities and the corresponding probabilities?

5 5 5 5 5 5 (1 0 2 50 )+ (11 2 51 )+ (1 2 2 52 )+ (1 3 2 53 )+ (1 4 2 54 )+ (1 5 2 55 ) 0 1 2 3 4 5

We can check that this adds up to 1 as they are probabilities of 6 mutually exclusive and collectively exhaustive events
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Name of the distribution

The earlier summation of probabilities, is simply the binomial expansion of (1 + 2 ) In general, suppose is the probability of achieving one of the two mutually exclusive and collectively exhaustive outcomes of an event We term = (1 ) and consider the binomial expansion of ( + ) For k = 0,1,2, , , every term of this expansion is of the form () In the binomial expansion, is the binomial coefficient of A variable with such a probability distribution is called the Binomial distribution!

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Binomial distribution
The stock prices example discussed above is an example of Binomial distribution A binomial distribution is characterised by, An experiment that can result in only one of the two possible outcomes, one of which is termed to be success and other as failure Constant probability of success at every trial An experiment consisting of multiple trials, none of which influences the outcome of any other trial (independent trials) The probability of success is generally termed and therefore the probability of failure is (1 ) The stock price experiment had each of these features!
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Binomial distribution (contd.)

The parameters of a binomially distributed variable are Number of trials () and Probability of success and we denote it as ~(, ) The probability mass function (PMF) for such an is given by, = = () where, = 0,1,2, , + = 1 and 0 1
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Bernoulli trial
What if our interest is in only one trial? Bernoulli trial or Bernoulli distribution is characterised by
An experiment that can result in only one of the two possible outcomes, one of which is termed to be success (with probability ) and other as failure (with probability (1 ))

For a Bernoulli random variable , we denote ~() = = 1 where, = 0,1 and + = 1 and 0 < < 1
For this , E = and V = (1 ) Binomial distribution is just an extension of Bernoulli trials, to independently and identically distributed Bernoulli random variables Or we say that, the trials underlying a Binomial distribution are Bernoulli trials
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Scope of Binomial distribution

More situations where binomial distribution can help us evaluate probabilites of certain events: If an insurance company knows the probability of a claim being fraudulent (or not), binomial distribution can help determine the probability that there would be more than k fraudulent claims in the next 1000 claims If an advertising company knows the probability of a customer buying a certain product, if he/she receives an advertisement on their Facebook account, binomial distribution can help them determine whether k purchases would be made from a total of 10000 Facebook ads sent. Effectively, they can determine how many Facebook advertisements to send, if they want to achieve a particular sales target Suppose that a hardware store manager has 3 different suppliers. If he knows the probability of a newly purchased bolt being defective, based on the supplier it is bought from, binomial distribution can help him/her check whether there will be less than k defective bolts in a box of 2000 bolts. This would help his decide which supplier to buy the bolts from. We know that the probability of a newly born child being a boy is equal to the probability that it is a girl, 0.5. Binomial distribution can help us determine the probability that k out of the n children born to a couple would be girls/boys
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Binomial distribution (contd.)

Can coin tossing be considered as an example of binomial distribution?
1. A coin toss can only result in a head or a tail 2. The probability of observing a head, is constant at each toss 3. The outcome of one toss (whether head or tail) does not influence the outcome of the next toss Any Bernoulli variable can be modelled based on a coin tossing experiment!
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History
Independent trials having a common success probability p were first studied by the Swiss mathematician Jacques Bernoulli (1654-1705). In his book Ars Conjectandi (the art of conjecturing), published by his nephew Nicholas eight years after his death in 1713, Bernoulli showed that if the number of such trials were large, then the proportion of them that were successes would be close to p.

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Ross, Sheldon, A First Course in Probability, Pearson Education, Inc., 6th edition

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Alternate definition of success and failure

In a Bernoulli trial, the definition of success and failure is relative A success or a failure can contain multiple simple events The share price will decrease or the share price will remain constant are two simple events In our example, we combined these into one outcome This combined outcome, along with the possible outcome the share price will increase give two mutually exclusive and collectively exhaustive events with respect to what may happen to the price of the share Therefore we could consider it to be a Bernoulli trial Similarly, we could look at something as simple as roll of a die It has six possible outcomes, but if we define events as even number or odd number, we can find the probabilities using Binomial distribution
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Properties of Binomial distribution

For a ~(, ) = V = Suppose we want to calculate the probability that in the next 120 trading days, the price of stock A will increase 37 times 120 = 37 = 1 37 212037 37 Very difficult to calculate! As the value of becomes very large, it becomes increasingly difficult to calculate the probabilities of Binomial distribution Properties of Binomial distribution help us approximate these probabilities easily
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Properties of Binomial distribution (contd.)

As value of increases

If is very large, is very small and is finite, Binomial distribution tends to Poisson distribution

As becomes very large, Binomial distribution tends to Normal distribution

Poisson distribution allows to calculate the probability of successes without specifying the number of trials undertaken ()
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This is a very important property and we will learn the significance of Normal distribution at a later time
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Thank you

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