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Quant Analyst · CoreTrack
1Quantitative Methods, Financial Data & Programming
iProbability
Probability in FinanceRandom VariableProbability DistributionsThe Normal DistributionNormal Distribution ProbabilityThe Lognormal DistributionRandomness vs Uncertainty
iiStatistics and Inference
Population and SampleMean, Median and ModePrecision and AccuracyVariable TypesVariance, Standard Deviation and…Dispersion MeasuresStatistical BiasEffect SizeHypothesis TestingThe Sampling DistributionSkewnessKurtosisCovarianceConfidence IntervalArithmetic Mean vs Geometric MeanStatistical Significance vs Economic…Confidence Interval vs Prediction IntervalHow to Summarise a…
iiiCorrelation and Regression
RegressionCorrelation and CausationOrdinary Least SquaresInteraction TermsRegression CoefficientsRegression vs ClassificationHow to Build a…Spurious CorrelationRegression, Correlation and FitResidualsMulticollinearityAutocorrelation and Partial Autocorrelation
ivTime Series
Time Series in FinanceSimple, Weighted and Exponential…Moving Average CalculatorPrice, Return and Level SeriesHow to Prepare Time-Series…LagFrequencySeasonalityTimestampsTrendStationarity and the Unit RootHeteroskedasticityLeadRolling WindowsDifferencing
vSimulation and Numerical Methods
SimulationMonte Carlo SimulationHow to Run a…Numerical MethodsIterationResampling and the BootstrapPseudorandom Numbers and the SeedConvergence and ToleranceNumerical Stability
viOptimisation
OptimisationLocal and Global OptimaConstraintsConvex OptimisationThe SolverLinear ProgrammingThe Objective FunctionConstraint ViolationThe Feasible SetLagrange MultipliersQuadratic Programming
viiModelling Practice
Linear, Logistic, Ridge and…Training, Validation and Test…The ModelModel ErrorDependent and Independent VariablesThe ROC Curve and AUCWhat a Model HoldsMSE, RMSE, MAE and MAPEPrecision and RecallCross Validation and RegularisationOverfitting and UnderfittingReturn Series MeasuresSimple, Compound and Log Return
viiiBacktesting and Research Integrity
BacktestingBacktest vs Live PerformanceHow to Document a…How to Prevent Backtest…Out-of-Sample TestingWalk-Forward AnalysisMultiple TestingP-HackingData Snooping
ixData Quality and Structure
Data QualityThe DatasetSelection and Survivorship BiasVersioned DatasetsData Structures in FinanceData CleaningMissing Data and Null ValuesStructured Data vs Unstructured DataMissing Data vs ZeroData Validation vs Data CleaningOutliersDuplicate Records
xProgramming for Finance
Data PipelinesAPIs for Financial DataAPI vs CSV FileDatabases in FinancePython for FinanceJoinsSQL for FinanceThe Analysis Workflow
xiQuantitative Research
Research DesignThe Data Generating ProcessReproducibilityPeer Review in Analytical WorkThe Research HypothesisRobustness and Sensitivity
2Stochastic Calculus & Derivative Pricing Theory
iProbability Foundations
The Probability SpaceRandom VectorsSigma-AlgebraExpectationSample Space and EventsDensity and Distribution FunctionsRisk-Neutral ProbabilityState Price Density vs…
iiStochastic Processes and Jumps
Properties of a Stochastic ProcessMartingaleBrownian Motion and Its PropertiesBrownian Motion vs Geometric…Stopping TimeThe Markov PropertyState VariablesTransition ProbabilityQuadratic VariationQuadratic Variation vs Ordinary…Submartingale and SupermartingaleMartingale RepresentationMarkov Process vs MartingaleOptional StoppingFiltrationJump ProcessesThe Poisson ProcessLevy ProcessesJump Diffusion
iiiIto Calculus
The Ito IntegralThe Ito Integral vs the Riemann IntegralInfinitesimals in Stochastic CalculusQuadratic CovariationIto's LemmaHow to Apply Ito's…The Infinitesimal GeneratorIto Calculus vs Ordinary Calculus
ivStochastic Differential Equations
Stochastic Differential EquationsStochastic Differential Equation vs…Drift and DiffusionStrong and Weak Solutions ComparedDiscretisationGeometric Brownian Motion
vPricing Theory and No-Arbitrage
No-ArbitrageGirsanov, Radon-Nikodym and Change…Physical and Risk-Neutral Measures…The Fundamental Theorems of…The Law of One PriceThe Pricing KernelDiscount Factors and Zero-Coupon PricesReplication vs HedgingComplete Market vs Incomplete MarketClearing Margin Architecture
viOption Pricing Theory
European and American OptionsMonte Carlo European OptionThe Black-Scholes PDEBlack Scholes and the GreeksThe Payoff FunctionThe Binomial ModelBinomial Option PricingDelta Hedging in TheoryBoundary, Initial and Terminal ConditionsThe Exercise BoundaryHow to Check Put-Call…
viiVolatility Models
Constant, Local and Stochastic…Vasicek Model vs CIR ModelThe Heston ModelThe SABR ModelThe Volatility ProcessImplied VolatilityVolatility Smile vs Skew vs Surface
viiiInterest Rate Models
Interest-Rate DerivativesMean ReversionThe Zero-Coupon BondThe Ornstein-Uhlenbeck ProcessThe Discount CurveZero RatesShort-Rate Model vs Market Model
ixNumerical Pricing
Closed Form and Numerical…Monte Carlo PricingEuler and Milstein Schemes ComparedTree MethodsFinite Difference MethodsNumerical Error and StabilityVariance Reduction
xCalibration and Model Risk
Model OverrideMarket Price and Model PriceCalibrationHow to Document a Pricing ModelThe Educational Illustration LabelMarket ConventionsModel Uncertainty and LimitationsBacktesting a Pricing ModelIdentifiabilityCalibrated ParametersThe Calibration Loss Function

The Probability Space: The Formal Setting Behind Every Model

A probability space is three objects taken together: the set of everything that could happen, the collection of subsets that may be assigned a number, and the rule that gives each of those subsets a number between zero and one. Pricing theory changes the third object and leaves the first two alone. One model can therefore carry two probabilities for the same event.

Probability is not a property of a single outcome. Probability is a property of a set of outcomes, handed out by a rule that has to stay consistent across every set at once. The shift from outcomes to sets is the whole purchase of the formal setting, and it is what makes it possible to replace the rule without disturbing anything else in the model.

Why does a model need a formal setting before it needs a number?

Most people use probability for years without once writing down a probability spaceThe three objects together: the outcomes, the allowed subsets, and the rule that assigns each subset a number.. Working without one is fine, right up to the moment somebody changes the probabilities. Then the question no informal account can answer is the only question that matters: what else changed when they did that?

The formal setting exists so that it becomes possible to say exactly what is being held fixed while something else moves. Told only that a probability moved from 0.617911 to 0.559618, nobody can tell whether the world got worse, whether somebody added outcomes nobody had thought of, or whether the same world is simply being weighed on a different scale. A worse world, a wider outcome set and a different scale are not the same situation, and they have completely different consequences. The three part construction is what separates them.

Here is the everyday version. A bag of rice weighed on the kitchen scale and then on the scale at the shop gives two different readings. Nothing happened to the rice. The instrument differs, and no amount of staring at the bag will settle which reading to trust. A model that keeps the bag and the scale in separate boxes can talk about changing scales. A model that keeps only the reading has thrown away the thing the reading was about, so it cannot.

The three objects, written once
$$ \bigl(\Omega,\ \mathcal{F},\ \mathbb{P}\bigr) $$
\(\Omega\)the set of everything that could happen, with each possibility appearing exactly once
\(\mathcal{F}\)the collection of subsets of \(\Omega\) that may have a number attached
\(\mathbb{P}\)the rule, a measure, sending each subset in \(\mathcal{F}\) to a number between zero and one
What it says in wordsA probability model is not one thing but three written together: a set of possibilities, a collection of statements about that set which are permitted to carry a number, and a rule that supplies the number for each permitted statement.
Three objects, stacked. Each one is meaningless without the one below it. 3. THE RULE a number between zero and one for each subset 2. THE ALLOWED SUBSETS the statements that may have a number attached 1. THE OUTCOME SET everything that could happen, each possibility listed exactly once built upward, in this order only replaced by pricing theory never touched never touched
The outcome set comes first, the allowed subsets are built out of it, and the rule assigns numbers only to those subsets, so the three are stacked rather than listed and only the top slab is ever replaced.
Try it out

Of the three objects, which one has to be settled before either of the other two means anything at all?

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What exactly is the set of everything that could happen?

The outcome setEvery single thing that could happen, listed once, with nothing left out and nothing counted twice. is written with the capital Greek letter omega, and a single member of it is written with the small omega. For the standard process, an invented traded quantity this whole subject runs on, one outcome is not a price. One outcome is an entire year of prices: the value at every instant between the start and the horizon, taken as one indivisible thing.

The whole-path outcome is the first genuinely unfamiliar idea in this subject, and it repays sitting with. An outcome is a whole path, not a finishing value, and everything the model can ever be asked has to be a statement about paths. The locked path published for this subject is one member of the outcome set: Rs 100/- at the start, Rs 97.64/- after a month, up to Rs 111.08/- at month six, down to Rs 93.74/- at month nine, and Rs 106.18/- at the horizon. The entire sequence of readings is one omega. Change the reading in month three and the result is a different omega, even if the finish is identical.

Why insist on that? Because it decides what the model can be asked. Pacing out a coastline with a ruler is the same phenomenon. A long ruler gives one length; a shorter ruler finds inlets the long ruler stepped straight over, and the length grows. The ruler is not measuring the coast wrongly, it is measuring a coarser version of it. An outcome set of finishing values only is the long ruler: it can answer where the year ended and can never answer whether the process ever fell below Rs 95/-. Whether the process fell below Rs 95/- is not a statement about anything in that set. Choosing the outcome set is choosing, in advance, the entire list of questions the model is capable of answering.

Which subsets may be given a number?

An eventA subset of the outcome set, so a statement that is either true or false for each individual outcome. is a subset of the outcome set. An event is therefore a statement that is either true or false for each path taken one at a time. The process finishes above Rs 100/- is an event. The process never falls below Rs 95/- is an event. The process is at Rs 106.18/- at the horizon and was above Rs 110/- at month six is an event, and the locked path belongs to it.

The collection of events is written with a script capital F. The collection is not simply every subset that can be imagined; it is a collection with structure, called a sigma-algebra, and the structure is what makes the rule consistent. A sigma-algebra has to contain the whole outcome set, it has to contain the opposite of anything it contains, and it has to contain the union of any endless list of its members. The three closure requirements exist so that any question that can be asked has an askable negation, and so that any run of questions joined by the word or can be asked as well.

When the collection carries a time subscript it becomes the information available at that time, and everything in it is a question that could already have been settled by then. Whether the process rose in the first month sits inside the collection at month one. Whether it finishes above Rs 100/- does not. At month one the year has not happened yet. The subscripted collection is the object the rest of this subject leans on hardest, and it is set out under filtration.

Why the collection is not simply all subsets, and what breaks if it is insisted that it is, is a genuine result rather than a technicality, and it is set out under sigma-algebras. Here it is enough that the collection is chosen first and the rule only ever speaks about its members.

What must the rule satisfy to count as a probability at all?

Probability Measure

A probability measureThe rule assigning each allowed subset a number between zero and one, consistently across all of them at once. is a function whose input is a set and whose output is a number. A measure is not a formula about values and it is not a shape on a chart. Hand it an event and it returns that event's weight. Three conditions decide whether a candidate rule earns the name, and a rule that misses any one of them is not a slightly imperfect probability, it is not a probability.

The three conditions
$$ \mathbb{P}(A)\ \ge\ 0 \qquad \mathbb{P}(\Omega)\ =\ 1 \qquad \mathbb{P}\!\left(\bigcup_{i=1}^{\infty} A_i\right)=\sum_{i=1}^{\infty}\mathbb{P}(A_i) $$
\(A\)any event, meaning any member of the collection \(\mathcal{F}\)
\(\Omega\)the whole outcome set, the event that is true for every path
\(A_i\)an endless list of events, no two of which can both happen
\(\mathbb{P}\)the candidate rule being tested against the three conditions
What it says in wordsA rule counts as a probability only if it never returns a negative number, gives the whole outcome set the number one, and hands any endless list of mutually exclusive events a total that is exactly the sum of their separate numbers.

The third condition is the one that does the work, and it has a name: countable additivityProbabilities of sets that cannot overlap add together, and this holds even for an endless list of such sets.. Finite additivity, where any two separate events add, sounds like the same thing and is strictly weaker. Extending it to an endless list is what permits limits to be taken, and taking limits is the only way to say anything at all about a set of continuous paths. Almost every interesting event about the standard process is built as a limit of simpler ones.

Notice what the conditions do not say: nothing in them mentions frequency, belief, betting or the world. They are consistency requirements on a bookkeeping system. Consistency requirements are precisely why a second, differently motivated rule can sit on the same outcome set without contradiction. The second rule satisfies the same three conditions, so it is just as much a probability as the first, whatever anybody intends it to mean.

Try it out

Somebody proposes a rule that gives every event a number between zero and one and gives the whole outcome set the number one. The rule then gives two events that cannot both happen the numbers 0.6 and 0.7, and gives the event that either of them happens the number 0.9. Is it a probability measure?

How is a probability measure different from a probability distribution?

Probability Measure vs Probability Distribution

Measure and distribution get used as though they were interchangeable, and they are different kinds of object. A measure eats a set. A distribution eats a value. The confusion is harmless in an applied course and fatal in this one. The entire manoeuvre this subject is built around is replacing one of them while the other side of the model holds still.

Two different kinds of function
$$ \mathbb{P}:\ \mathcal{F}\ \longrightarrow\ [0,1] \qquad\qquad F(x)\ =\ \mathbb{P}\bigl(\{\,\omega\ :\ S_T(\omega)\le x\,\}\bigr) $$
\(\mathbb{P}\)the measure, whose input is a set drawn from \(\mathcal{F}\)
\(F(x)\)the distribution function, whose input is a number on the rupee scale
\(\omega\)one outcome, meaning one complete path of the process over the horizon
\(S_T\)the value of the standard process at the horizon \(T\), read off a path
What it says in wordsThe measure takes a set of paths and returns its weight, while the distribution function takes a rupee value and returns the weight of the set of paths that finish at or below it, so the distribution is something the measure produces rather than a rival to it.

The distribution is downstream: it is what remains after the measure has already spoken. The right hand side above shows it. The braces build a set of paths out of a number, and then the measure weighs that set. With the measure removed, the distribution has nothing to compute with. With the distribution removed, the measure is unharmed. The measure never needed the rupee scale in the first place.

Back to the scales in the shop. The bag of rice is the outcome set. A scale is a measure. The printed table of what the scale reads for each bag size is a distribution: useful, real, and entirely a consequence of which scale was used. Swapping the scale changes the table. Nothing done to the table will swap the scale.

Two functions. Look at what each one is handed. A MEASURE a SET of paths finishes above Rs 100/- 0.617911 Input lives in the collection of allowed subsets, not on any scale. This is the object pricing replaces. A DISTRIBUTION a VALUE on the scale Rs 100/- 0.382089 Input is a rupee amount. The set is assembled first, then weighed. This is a consequence, not a rival. Only the left one can be swapped while the outcome set stands perfectly still.
A probability measure takes a set of outcomes and returns a number, while a probability distribution takes a value and returns a number, and only the first can be changed without changing what is being described.
Try it out

Which of these two is handed a set of outcomes and returns a number: the measure, or the distribution function?

What does arriving information change, and what does it leave alone?

Conditional Probability

ConditioningRestricting attention to the outcomes still possible, then rescaling the rule so the remaining weights total one again. is usually taught as a formula with a fraction in it, and the fraction hides the construction underneath. Conditioning builds a new probability measure on a smaller outcome set. Not a fraction of the old one, and not a temporary adjustment. A full rule in its own right, satisfying all three conditions.

Conditioning, as a new rule
$$ \mathbb{P}(A\mid B)\ =\ \frac{\mathbb{P}(A\cap B)}{\mathbb{P}(B)},\qquad\text{defined whenever }\ \mathbb{P}(B)>0 $$
\(A\)the event being asked about
\(B\)the event the arriving information has established as true
\(A\cap B\)the outcomes on which both are true, meaning the part of \(A\) that survives
What it says in wordsOnce an event is known to have happened, the weight of any other event becomes the weight of the part of it that overlaps with what is known, divided by the weight of what is known, and that division is exactly the rescaling that brings the surviving total back to one.

Read as three steps it stops being a formula and becomes a procedure. Discard the outcomes the information has ruled out. Keep the relative weights of everything that survives untouched. The numerator preserves ratios exactly. Then divide through by the total that is left, so the survivors add to one again. The relative weights never move; only the total is restored, and that is the whole content of conditioning.

The everyday version is a lift that only knows which floor it is on. Standing on the fourth floor, the set of floors reachable next has shrunk, but nothing has changed about how the building is laid out. The lift did not become a different lift when the doors opened. The list of floors that can still be asked about changed, and the weights on what remains were stretched to fill the space the discarded floors used to occupy.

Conditioning in three steps. Only the last one changes any ratio of nothing. 1. BEFORE 0.2 0.3 0.1 0.4, totals 1.00 2. DISCARD, KEEP SHAPE 0.2 0.3 0.1, totals 0.60 3. RESCALE TO ONE 0.333 0.500 0.167, totals 1.00 The middle bar stays one and a half times the first bar in all three panels. Only the total changed.
Conditioning discards the outcomes the information rules out, keeps the relative weights of everything left, and rescales them so they total one again.
Try it out

Conditioning on arriving information rescales the probabilities of whatever outcomes are still possible. What do those rescaled numbers add up to?

Try it out

The standard process has an average finish of Rs 108.33/-. Is the chance of finishing at or above that average more than half, or less?

What do the three objects look like on the standard process?

Time to build one. The standard process starts at Rs 100/-, drifts at 8 per cent a year, carries a volatility of 20 per cent a year, pays nothing out, and is watched for one year. Four numbers describe the rule and nothing else. A rule alone does not describe a probability space, and the gap between the two is where the work sits.

The objectWhat it is hereWhat it decides
The outcome setEvery continuous path the process could trace from Rs 100/- over the yearWhich questions can be asked at all
The allowed subsetsStatements built from where the path sits at stated times, closed under negation and countable unionWhich questions can carry a number
The rule, called PFixed by a drift of 8 per cent and a volatility of 20 per cent a yearWhat each of those numbers is

Now ask the rule a question: what weight does it give the event that the process finishes above Rs 100/-? The event is a set of paths, so the answer is a number the measure returns, and it comes out of the parameters rather than out of any observation.

The weight of one event, under one rule
$$ \mathbb{P}\bigl(S_T>K\bigr)\ =\ N\!\left(\frac{\bigl(\mu-\tfrac{1}{2}\sigma^{2}\bigr)T-\ln\!\bigl(K/S_0\bigr)}{\sigma\sqrt{T}}\right) $$
\(S_0,\ S_T\)the standard process at the start and at the horizon, in rupees
\(K\)the level the event is about, here Rs 100/-
\(\mu\)the drift the rule carries, as a decimal
\(\sigma\)the volatility, as a decimal, the same under either rule
\(T\)the horizon in years, here 1.0
\(N\)the standard normal distribution function
What it says in wordsThe weight of the event that the process finishes above a stated level is the standard normal distribution function evaluated at the drift of the logarithm over the horizon, less the logarithm of the ratio of that level to the starting value, all divided by the volatility scaled by the square root of the horizon.

Put the numbers in. The variance rate is 0.04, so half of it is 0.02 and the drift of the logarithm is 0.06 exactly. The level is the starting value, so the logarithm term is zero. The calculation leaves 0.06 divided by 0.20, or 0.30, and the standard normal distribution function at 0.30 is 0.617911. The rule called P gives the event that the standard process finishes above Rs 100/- a weight of 0.617911, and every digit of that came from the four invented parameters rather than from anything observed.

The same rule gives an average finish of Rs 108.33/- and a middle finish of Rs 106.18/-. Average and middle are not equal, and the gap of Rs 2.15/- is entirely the half variance correction showing up in rupees. The gap is covered separately, under the half variance correction. Here it stands as a fact about the rule rather than as something to unpick.

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Why can one outcome set carry two different rules at once?

Risk-Neutral Probability

Everything above was built with a single rule. Now put a second one on the same outcome set. The first is the physical measureThe rule describing what the model itself says is likely, written with the letter P., written P, and it carries the drift of 8 per cent. The second is the risk-neutral measureThe second rule placed on the same outcome set, written with the letter Q, used for pricing rather than for describing what is likely., written Q, and it carries 5 per cent, the continuously compounded rate this subject holds fixed.

Where Q comes from, why anybody would want it, and how it is constructed are all set out under physical and risk-neutral measures. Here it is an object and nothing more: a second rule, satisfying the same three conditions, sitting on the same outcome set and the same collection of allowed subsets. A second rule of that kind is all the argument needs.

Run the formula again with 0.05 in place of 0.08. The drift of the logarithm becomes 0.03, dividing by 0.20 gives 0.15, and the distribution function at 0.15 is 0.559618. The identical event now carries 0.559618 instead of 0.617911, a difference of 0.058293, and not one path was added to the outcome set or removed from it. The set of things that could happen is byte for byte what it was. Only the weights moved.

One event: the standard process finishes above Rs 100/-. Two rules. THE MODEL'S OWN RULE P, drift 8 per cent 0.617911 THE PRICING RULE Q, rate 5 per cent 0.559618 0.058293, the whole difference 5.83 percentage points on one event Not one path was added or removed between the two rows.
Under the first rule the standard process finishes above Rs 100/- with probability 0.617911 and under the second with probability 0.559618, and not one path was added or removed between the two.

The move is easier to believe seen as a shape rather than as two numbers. Each rule spreads a total weight of one across the same range of finishing values, and the second spreads it slightly further to the left. The whole difference between the two pictures is a shift of the drift of the logarithm, from 0.06 down to 0.03, exactly the difference between the drift and the rate. Nothing about the width changes. The volatility is the same under both.

Same values on the scale. Same width. The second curve simply sits to the left. the whole gap between the two rules a shift of 0.03 in the drift of the logarithm Rs 100/- the first rule, drift 8 per cent the second rule, rate 5 per cent 70 80 90 100 110 120 130 140 150 finishing value of the standard process, in rupees. Educational illustration.
The two rules place two curves over the same finishing values, and the second sits to the left of the first by exactly the difference between the drift and the interest rate.
Try it out

The same event carries 0.617911 under one rule and 0.559618 under another. Which of the two, if either, is the chance the event happens?

Try it out

The rule is about to change from a drift of 8 per cent to one of 5 per cent. What happens to the set of paths the process could take?

Play with it

Move the rule. Watch the outcome set refuse to move.

One control: the drift the rule carries, from 0 to 12 per cent a year. The curve over the finishing value redraws, the shaded weight above Rs 100/- moves with it, and the panel underneath, the outcome set itself, is drawn once and never touched again. The volatility stays at 20 per cent, the horizon stays at one year, and the starting value stays at Rs 100/-.

The rule moves. The outcome set below it does not. the shaded weight above Rs 100/- is 0.617911 70 80 90 100 110 120 130 140 150 finishing value of the standard process, in rupees THE OUTCOME SET, WHICH THE CONTROL NEVER TOUCHES the locked path, in pine, with four of its neighbours one year later today, Rs 100/-
0 per centthe rule carries 8.0 per cent12 per cent
Weight above Rs 100/-
0.617911
Average finish
Rs 108.33/-
Middle finish
Rs 106.18/-
Paths in the set
unchanged
At a drift of 8.0 per cent a year the rule gives the event that the standard process finishes above Rs 100/- a weight of 0.617911, and the outcome set drawn below has not moved.
Educational illustration. Every reading is computed from the formula above rather than sampled, so it reproduces identically on every reload. At 8 per cent the reading is 0.617911 with an average finish of Rs 108.33/- and a middle finish of Rs 106.18/-; at 5 per cent it is 0.559618 with an average finish of Rs 105.13/- and a middle finish of Rs 103.05/-. Those are the two rules named in this guide. The volatility is held at 20 per cent, the horizon at one year, the starting value at Rs 100/-, and the outcome set is drawn once and never redrawn.
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How is the space written out for a teaching example?

How to Define a Probability Space for a Financial Teaching Example

Here is the practical residue of everything above, and it fits on a card. Five lines, in this order, and a teaching example that cannot fill all five has a hole in it rather than a shorthand.

THE STANDARD PROCESS: THE SPACE, IN FIVE LINES 1 Outcome set: every continuous path from Rs 100/- over the horizon 2 Allowed subsets: statements about where the path sits at stated times 3 The rule: named P, fixed by drift 8 per cent and volatility 20 per cent a year 4 Horizon: one year, stated, because without it line 1 has no content 5 Label: invented for teaching, an educational illustration, not a market Delete line 1 or line 4 and the other three have nothing left to act on.
The standard process has its outcome set, its allowed subsets, its rule, its horizon and its label written out in five lines, and everything later in the sequence checks itself against those five.

Most incomplete teaching examples are missing line 1 and line 4, and they are missing them together. A worked example that states a starting value, a drift and a volatility has described the rule and nothing else. Ask it whether the process ever touched Rs 95/- and it cannot answer, not because the arithmetic is hard but because it never said what a single outcome is or how long the year runs. Parameters describe the scale. Parameters do not say what is being weighed.

Line 5 is not decoration either. A computed illustration and an observed figure look identical once written down, and the label on the card is the only thing that separates them.

Try it out

A teaching example states a starting value, a drift and a volatility, and nothing else. What is missing from its probability space?

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What is actually done when somebody hands over a probability?

The three part construction is abstract, and the use it gets put to is not. Any time a number arrives describing how likely something is, whether it comes out of a model, a report or a product illustration, the three part construction supplies three questions to ask in order, and they take about ten seconds.

First, what is the outcome set? If nobody can say what a single outcome is, the number is decorative. A weight has to be a weight on something, and there is a real difference between a statement about a year of readings and a statement about one reading at the end of it.

Second, which rule produced it? Here two rules on one outcome set produced 0.617911 and 0.559618 for the identical event. Both are correct arithmetic. The two numbers answer different questions, and only the number naming its own rule is usable. A figure handed over without its rule attached is a reading without a scale.

Third, is this a likelihood or a weight? A number can satisfy all three conditions of a probability and still make no claim whatever about how often anything happens. That is not a defect. The gap between a weight and a likelihood is what makes the second rule useful in the first place, and it is the single most common thing practitioners get wrong about this subject.

The household version costs nothing. When a shopkeeper quotes the weight of a bag, the number is accepted because the scale it came off is visible and the bag it was on is known. When neither is on show, the bag gets weighed again. Numbers about likelihood deserve the same reflex and rarely get it.

The artefact: one printed line, and nothing on it names the rule. MODEL OUTPUT, ONE YEAR HORIZON Standard process, starting value Rs 100/- Chance of finishing above Rs 100/- 0.5596 no rule named anywhere on this line The word is wrong, not the number. Under the pricing rule 0.5596 is a weight. The model's own answer to that question is 0.6179, and every step of the arithmetic behind both is valid.
The same event carries 0.559618 under the pricing rule and 0.617911 under the model's own view, and nothing in the calculation distinguishes the two once one of them has been written down.

The error that gets made, and what it costs

Reading the second rule as a forecast. The number 0.559618 attaches to exactly the same event as 0.617911, and a reader who meets it first will naturally take it as the chance the standard process finishes above Rs 100/-. The number is not a forecast. The number 0.559618 is the weight under which discounted values behave consistently, and the model's own statement about what is likely is the other number, 5.83 percentage points away.

The cost is a figure presented to somebody as a likelihood when the model never claimed it was one, and the arithmetic will never flag the error. Every step of the arithmetic is valid. The mistake happened at the point the word chance was typed next to the number, before any calculation began and after every calculation has finished checking itself.

Constructing the second rule and saying where it comes from needs the change of measure argument, set out under measure change tools. Which subsets can be assigned a probability, and why not all of them can, is set out under sigma-algebras. Averages taken against a measure are set out under expectation, and how the pricing weights are computed is set out under risk-neutral probability. What any contract pays is settled before the probability space is reached. No jurisdiction sets a probability axiom, so no country specific rule applies here.
Nobody can name one outcome, so the probability is decorative. See what to ask.

References

SourceDocumentWhere
arXiv, Quantitative FinancePreprints on probability spaces and measure change in derivative pricingarxiv.org
Social Science Research NetworkWorking papers on measure-theoretic foundations for pricing modelsssrn.com

The standard process and its locked path are invented.
Educational material. Not advice on any investment, tax, budget or market position.

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