MATH 2274 Lecture 10 Applications of Expectation

1) FAIR GAMES e.g. Simple lotto, spinning wheel games, pensions etc.
Cost of playing = c.
X is the r.v. amount won.
For game to be fair, E(X) = c.
In the long run, amount won = amount paid.

Note: See egs. 2.9 and 2.10 in Lecture notes.

i) Application of fair games to pensions and life distributions

Pension e.g. Consider the amount of pension a 60 year old man receives at the start of
the xth. year after retirement to be $1000.

No inflation:
$1000 $1000 $1000 $1000 $1000
Age
60

0 1 2 3 x-1 x

[0,1) 1st. Year of retirement , [1,2) 2nd. Year of retirement, ..., [x-1, x) xth. Year of
retirement.
Value of pension at xth. Year of retirement, A(x) = 1000x, (that is, granted that the man
survives to the xth. Year of retirement he will receive this amount).

Amount expected to receive, E(A(X)) = (). ()

=
=1 1000. ()

Where f(x) is a probability function for the probability that the man dies in the xth. Year

after retirement.

Note: See example 2.8 in Lecture notes

Inflation :
Rate of inflation annual rate of increase of a price index e.g. a consumer price. It is a
percentage rate of change in price level over time.
Purchasing power no. of goods/services that can be purchased with a unit of currency.
Inflation usually causes a rate of decrease in the purchasing power of money.

After a year, the Purchasing power of a unit of money is multiplied by a factor of

 1
1 +

e.g. Consider an item costs $1.00 at present and the rate of inflation is 3% or 0.03.
1 year later , item costs $1 + 0.03 = $1.03
2 years later, item costs $1.03 + ($1.03* 0.03) = 1.03( 1 + 0.03) 1.032
3 years later, item costs 1.032 + (1.032 * 0.03) 1.032(1+0.03) 1.033
n years later item costs 1.03n

Therefore, Purchasing power of $P, at xth. year after some starting year = .
1.03

Applying this idea to pensions, if a man who is currently 60 years of age, dies in xth. Year after
retirement (applying inflation):

Note: the period [0,1) is the first year. At the start of the first year he should receive $1000.
Every year after that the inflation rate is applied.

For this to be a fair game, the retiree should pay an amount equal to the expected
purchasing power, E(P(X)) of the annuity.

X is the random variable representing the length of life (duration of annuity) and P(x) is also a
random variable representing the purchasing power of his annuity (similar to the amount won
in fair games).
1000 1000 1000 1000 1000
Value of pension/ Purchasing power, P(x) = 1.030 + 1.031 + 1.032 + 1.033 + 1.031

1 1
= 1000( 1 ) , where = 1.03

1
Recall: Sum of n terms in an arithmetic progression is = ( 1 ) where r is the common
ratio.

Average/ Expected Total purchasing power = E(P(X))

= (). ()
 1
=
=1 1000 ( 1 ) . ()

Where f(x) is a probability function for the probability that the man dies in the xth. Year after
retirement.

Note: See example 2.9

ii) Conditional Expectation

Definition (informal) - The conditional expected value (or conditional expectation) of a random
variable X given Y is the weighted average of the values that X can take on, where each possible
value is weighted by its respective conditional probability (conditional on the information that Y
= y).

E.g. When calculating the expected winnings of a player in a Lotto game, e.g. 2.10 (Lecture
notes pg46) only considered one player and his winnings if he wins first, second or third prize.
However, we may encounter situations where a number of players have placed a certain number
of bets and more than one player can win first, second or third prize etc. Conditional expectation
can be used to find the expected winnings in case such as this (i.e. no. of persons playing affects
how much you win).

Consider the following:

Example: See e.g. 2.16, pg 57-58 Lecture notes.

Question:
Little Mac is boxing for glory and prize money. In his first match he faces Super Macho Man. If
Little Mac wins, then he faces Mike Tyson in a championship bout. If Little Mac loses, then he
faces Glass Joe in a consolation match. The prize money is $10,000 for winning the
championship bout, $1,000 for loosing the championship bout, $100 for winning the consolation
match, and $0 loosing the consolation match. Little Mac has a 50% chance of beating Super
Macho Man, only a 10% chance of beating Tyson, and a 90% chance of beating Glass Joe.

(a) Draw the event tree for this situation.

(b) What is the expectation of the prize money, conditional on winning the first match?

(c) What is the expectation of the prize money, conditional on losing the first match?

(d) What is the expectation of the prize money before the result of the first match is known?