Univariate Vs Multivariate Distributions and the role of Correlation in the Multivariate Normal Distribution

Univariate and multivariate normal distributions are very robust and useful in most statistical procedures. Understanding their form and function will help you learn a lot about most statistical routines.

Univariate Distribution

A univariate distribution is defined as a distribution that involves just one random variable. For instance, suppose we wish to model the distribution of returns on an asset, such as a holding of stocks; such a model would be a univariate distribution. In previous learning outcome statements, we have been focusing on univariate distributions such as the binomial, uniform, and normal distributions. We now look at multivariate distributions:

Multivariate Distribution

A multivariate distribution describes the probabilities for a group of continuous random variables particularly if the individual variables follow a normal distribution. Each variable has its own mean and variance. In this regard, the strength of the relationship between the variables (correlation) is very important. As you will recall, a linear combination of 2 normal random variables results in the creation of another normal random variable.

The Role of Correlation in Multivariate Normal Distributions

We could be interested in the distribution of returns on a group of assets. Correlation defines the strength of the linear relationship between any 2 random variables. For us to define a multivariate distribution (n variables), we need the following:

1. The individual mean value for each asset (μ1, μ2, μ3, …, μn-1, μn)
2. A list of variances of return for each asset (σ12, σ22, σ32, …, σn-12, σn-12)
3. Pairwise return correlations – n(n-1)/2 correlations in total.

Correlation is the distinguishing feature between univariate and multivariate normal distributions.

Example

Suppose we wish to model the distribution of two asset returns: To describe the return multivariate distribution, we will need two means, two variances and just one correlation – 2(2 – 1)/2 = 1.

On the other hand, if we had 5 assets, we would need to establish 5 means, 5 variances, and 10 distinct correlation values – 5(5 – 1)/2 = 10.

In conclusion, if we have individual security returns that are jointly, normally distributed, the return of a portfolio made up of such assets will also be normally distributed and we can come up with a multivariate distribution provided we have the three items that we have listed above.

Reading 10 LOS 10j:

Distinguish between a univariate and a multivariate distribution, and explain the role of correlation in the multivariate normal distribution.

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