Probability
BeginnerProbability is a measure of how likely an event is to happen, expressed as a number between 0, meaning it will certainly not happen, and 1, meaning it will certainly happen.
Probabilities can also be written as percentages, from 0% to 100%, or as fractions. A fair coin has a probability of 0.5, or 50%, of landing heads. A standard six-sided die has a probability of 1 in 6, or about 17%, of landing on any particular number.
Probabilities can be based on logic, as with coins and dice; on historical data, such as the share of loans of a certain type that have defaulted in the past; or on judgment, such as an analyst's estimate of the chance a merger will be approved.
Probability is fundamental to finance. Insurers use it to estimate the likelihood of claims and set premiums. Lenders use it to estimate the chance that borrowers will default. Investors use it to think about the range of possible returns and risks. Options prices depend on the probability of different price movements.
People often misjudge probabilities. They tend to overestimate the likelihood of dramatic, memorable events and underestimate common risks. Thinking carefully about probabilities, rather than relying on intuition, can lead to better financial decisions.
For worked examples and full lessons, visit notesbysara.org.