ABSTRACT
Very rarely in the preceding chapters have we allowed the possibility that financial quantities were not perfectly predictable. Loan interest rates remained fixed and known throughout time, annuity payments and other streams of payments that figured into present value calculations were predictable and regular, and defaults on bond payments never happened. Clearly the assumption of determinism of all inputs to a financial problem is inadequate to model the real world. Variable interest rates on loans do happen, investors may miss payments into annuities at random times, bonds can default, and, most important, some of the most interesting investment objects, like common stocks, definitely do not have a predictable evolution in value over time. To cope with these and other sources of random behavior in financial problems, we must establish a good grounding in basic probability theory. You may have seen much of the material of this chapter in other courses, especially elementary statistics, and consequently some of it will be readily reviewed and understood. But the chapter is a worthwhile read, because it adopts a financial point of view, and mostly uses examples from this area of application. After you finish, the stage will be well set for the coming chapters on portfolio optimization and valuation of derivative assets. For more information, you can check out references [7] and [8], or any of a number of fine probability books on the market.
