Constructing Probability Distributions9/11/2019
There is a way of thinking about probability distributions that I’ve always found interesting, and to be honest I don’t think I’ve ever seen anyone else write about it. For each probability distribution, the CDF can be thought of as a partial infinite sum, or partial integral identity, and the probability distribution is uniquely defined by this characterisation (with a few reasonable conditions)
I think at this point most people will either have no idea what I'm talking about (probably because I've explained it badly), or they’ll think what I’ve just said is completely obvious. Let me give an example to help illustrate. Poisson Distribution as a partial infinite sum Start with the following identity:
$$ \sum_{i=0}^{\infty} \frac{ x^i}{i!} = e^{x}$$
And let's bring the exponential over to the other side. $$ \sum_{i=0}^{\infty} \frac{ x^i}{i!} e^{x} = 1$$ Let's state a few obvious facts about this equation; firstly, this is an infinite sum (which I claimed above were related to probability distributions  so good so far). Secondly, the identity is true by the definition of $e^x$, all we need to do to prove the identity is show the convergence of the infinite sum, i.e. that $e^x$ is well defined. Finally, each individual summand is greater than or equal to 0. With that established, if we define a function: $$ F(x;k) = \sum_{i=0}^{k} \frac{ x^i}{i!} e^{x}$$ That is, a function which specifies as its parameter the number of partial sumummads we should add together. We can see from the above identity that:
But wait, the formula for $F(x;k)$ above is actually just the formula for the CDF of a Poisson random variable! That’s interesting right? We started with an identity involving an infinite sum, we then normalised it so that the sum was equal to 1, then we defined a new function equal to the partial summation from this normalised series, and voila, we ended up with the CDF of a wellknown probability distribution. Can we repeat this again? (I’ll give you a hint, we can) Exponential Distribution as a partial infinite integral Let’s examine an integral this time. We’ll use the following identity: $$\int_{0}^{ \infty} e^{ \lambda x} dx = \lambda$$ An integral is basically just a type of infinite series, so let’s apply the same process, first we normalise: $$ \frac{1}{\lambda} \int_{0}^{ \infty} e^{ \lambda x} dx = 1$$ Then define a function equal to the partial integral: $$ F(y) = \frac{1}{\lambda} \int_{0}^{ y} e^{ \lambda x} dx $$ And we've ended up with the CDF of an Exponential distribution! Euler Integral of the first kind This construction even works when we use more complicated integrals. The Euler integral of the first kind is defined as:
$$B(x,y)=\int_{0}^{1}t^{{x1}}(1t)^{{y1}} dt =\frac{\Gamma (x)\Gamma (y)}{\Gamma (x+y)}$$
This allows us to normalise:
$$\frac{\int_{0}^{1}t^{{x1}}(1t)^{{y1}}dt}{B(x,y)} = 1$$ And once again, we can construct a probability distribution: $$B(x;a,b) = \frac{\int_{0}^{x}t^{{a1}}(1t)^{{b1}}dt}{B(a,b)}$$ Which is of course the definition of a Beta Distribution, this definition bears some similarity to the definition of an exponential distribution in that our normalisation constant is actually defined by the very integral which we are applying it to. Conclusion So can we do anything useful with this information? Well not particularly. but I found it quite insightful in terms of how these crazy formulas were discovered in the first place, and we could potentially use the above process to derive our own distributions – all we need is an interesting integral or infinite sum and by normalising and taking a partial sum/integral we've defined a new way of partitioning the unit interval. Hopefully you found that interesting, let me know if you have any thoughts by leaving a comment in the comment box below! Beta Distribution in Actuarial Modelling3/11/2019
I saw a useful way of parameterising the Beta Distribution a few weeks ago that I thought I'd write about.
The standard way to define the Beta is using the following pdf:
$$f(x) = \frac{x^{\alpha 1} {(1x)}^{\beta 1}}{B ( \alpha, \beta )}$$
Where $ x \in [0,1]$ and $B( \alpha, \beta ) $ is the Beta Function:
$$ B( \alpha, \beta) = \frac{ \Gamma (\alpha ) \Gamma (\beta)}{\Gamma(\alpha + \beta)}$$
When we use this parameterisation, the first two moments are:
$$E [X] = \frac{ \alpha}{\alpha + \beta}$$
$$Var (X) = \frac{ \alpha \beta}{(\alpha + \beta)^2(\alpha + \beta + 1)}$$
We see that the mean and the variance of the Beta Distribution depend on both parameters  $\alpha$ and $\beta$. If we want to fit these parameters to a data set using a method of moments then we need to use the following formulas, which are quite complicated:
$$\hat{\alpha} = m \Bigg( \frac{m (1m) }{v}  1 \Bigg) $$
$$\hat{\beta} = (1 m) \Bigg( \frac{m (1m) }{v}  1 \Bigg) $$ This is not the only possible parameterisation of the Beta Distribution however. We can use an alternative definition where we define:
$$\gamma = \frac{ \alpha}{\alpha + \beta} $$, and $$\delta = \alpha + \beta$$
And then by construction, $E[X] = \gamma$, and we can calculate the new variance:
$$V = \frac{ \alpha \beta}{(\alpha + \beta)^2(\alpha + \beta + 1)} = \frac{\gamma ( 1  \gamma)}{(1\delta)}$$.
Placing these new variables back in our pdf gives the following equation:
$$f(x) = \frac{x^{\gamma \delta 1} {(1x)}^{\delta (1\gamma) 1}}{B ( \gamma \delta, \delta (1\gamma) 1 )}$$
So why would we bother to do this? Our new formula now looks more complicated to work with than the one we started with. There are however two main advantages to this new version, firstly the method of moments is much simpler to set up, our first parameter is simply the mean, and the formula for variance is easier to calculate than before. This makes using the Beta distribution much easier in a Spreadsheet. The second advantage, and in my mind the more important point, is that since we now have a strong link between the central moments and the two parameters that define the distribution we now have an easy and intuitive understand of what our parameters actually represent. As I’ve written about before, rather than just sticking with the standard statistics textbook version, I’m a big fan of pushing parameterisations that are both useful and easily interpretable, The version of the Beta Distribution presented above achieves this. Furthermore it also fits nicely with the schema I've written about before (most recently in the in the post below on negative binomial distribution), in which no matter which distribution we are talking about, the first parameter of a distribution gives you information about it's mean, the second parameter gives information about its volatility, etc. By doing this you give yourself the ability to compare distributions and sense check parameterisations at a glance. 
AuthorI work as an actuary and underwriter at a global reinsurer in London. Categories
All
Archives
February 2024
