[Math] How to calculate the probability distribution function (PDF) and the cumulative distribution function (CDF)

probability distributionsrandom variables

Sorry I'm a novice to both functions and just didn't get a clue how to solve this problem (having been reading the theories for the whole day but still …) The problem is:

We have now two investment opportunities, and the profits will depend on the future markets. We assumed 5 scenarios for the prices, and the probabilities for each scenario 1-5 are 0.10, 0.20, 0.15, 0.25 and 0.30. The profits from the two investments under each scenario are shown below.

Profits for 2 alternatives under 5 Scenarios

We need make choice based on the calculation of both the PDF and CDF of profits for both investments, how should we calculate by these data?

Really appreciated for your help!!!

Best Answer

Fortunately, the scenarios are in increasing order of profit for both investments. This simplifies matters.

If the profits under scenario $i$ are denoted by $p_i$, then the PDF (or more accurately, the probability mass function, or PMF) of the profit is simply given by the scenario probability distributions:

$$ f(p_i) = P(\mbox{scenario } i) $$

For instance, if $p_i = 10i$ ($p_1 = 10, p_2 = 20, p_3 = 30, \ldots$), then the PMF would be given by

$$ f(10) = 0.10 \\ f(20) = 0.20 \\ f(30) = 0.15 \\ f(40) = 0.25 \\ f(50) = 0.30 $$

from the scenario probabilities given in the problem statement. Of course, the profits for Investments $A$ and $B$ are different, so the PMF will be different, too.

Then the CDF is just the probability that the profit is less than or equal to the given amount. For the fictional case I just gave, it would be

$$ F(x) = \begin{cases} \hfill 0.00 \hfill & x < 10 \\ \hfill 0.10 \hfill & 10 \leq x < 20 \\ \hfill 0.30 \hfill & 20 \leq x < 30 \\ \hfill 0.45 \hfill & 30 \leq x < 40 \\ \hfill 0.70 \hfill & 40 \leq x < 50 \\ \hfill 1.00 \hfill & x \geq 50 \end{cases} $$

where the CDF values are determined as running totals of the PDF values. You will, of course, have different cutoff points, depending on the profit profile of the particular investment.