Bayes' Theorem
Deeksha M
4SH19CS016
Shri Devi Institute Of Technology
Mangalore
What is the Bayes’ Theorem?
• In statistics and probability theory, the Bayes’ theorem is a
mathematical formula used to determine the conditional probability
of events.
• Essentially, the Bayes’ theorem describes the probability of an event
based on prior knowledge of the conditions that might be relevant to
the event.
• The theorem is named after English statistician, Thomas Bayes, who
discovered the formula in 1763.
• It is considered the foundation of the special statistical inference
approach called the Bayes’ inference.
Bayes’ Theorem Statement
• Bayes' theorem is stated mathematically as the following equation
• Where:
• P(A|B) – the probability of event A occurring, given event B has occurred
• P(B|A) – the probability of event B occurring, given event A has occurred
• P(A) – the probability of event A
• P(B) – the probability of event B
Proof
• Bayes' theorem may be derived from the definition of conditional probability:
• Where is the probability of both A and B being true. Similarly,
• Solving for and substituting into the above expression for yields
Bayes' theorem:
Special Case
• Note that events A and B are independent events (i.e., the probability of the
outcome of event A does not depend on the probability of the outcome of event B).
• A special case of the Bayes’ theorem is when event A is a binary variable. In such a
case, the theorem is expressed in the following way:
Where:
• P(B|A–) – the probability of event B occurring given that event A– has occurred
• P(B|A+) – the probability of event B occurring given that event A+ has occurred
Example :
• Imagine you are a financial analyst at an investment bank.
According to your research of publicly-traded companies, 60% of
the companies that increased their share price by more than 5%
in the last three years replaced their CEOs during the period.
• At the same time, only 35% of the companies that did not
increase their share price by more than 5% in the same period
replaced their CEOs. Knowing that the probability that the stock
prices grow by more than 5% is 4%, find the probability that the
shares of a company that fires its CEO will increase by more than
5%.
• Before finding the probabilities, you must first define the notation of the
probabilities.
• P(A) – the probability that the stock price increases by 5%
• P(B) – the probability that the CEO is replaced
• P(A|B) – the probability of the stock price increases by 5% given that the
CEO has been replaced
• P(B|A) – the probability of the CEO replacement given the stock price has
increased by 5%.
• Using the Bayes’ theorem, we can find the required probability:
• Thus, the probability that the shares of a company that replaces
its CEO will grow by more than 5% is 6.67%.
Applications of bayes’ theorem
• Besides statistics, the Bayes’ theorem is also used in various
disciplines, with medicine and pharmacology as the most
notable examples.
• In addition, the theorem is commonly employed in different
fields of finance.
• Some of the applications include but are not limited to,
modeling the risk of lending money to borrowers or forecasting
the probability of the success of an investment.
