CHAPTER 2.

RETURNS
2.1 Introduction

Let Pt be the price of an asset at time

t.

Assuming no dividends the net return

is
Pt Pt − Pt−1
Rt = −1=
Pt−1 Pt−1

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The simple gross return is

Pt
= 1 + Rt
Pt−1

Example: If Pt−1 = 2 and Pt = 2.1

then
Pt 2.1
1+Rt = = = 1.05 and Rt = 0.05
Pt−1 2

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The gross return over k periods (t − k
to t) is

1 + Rt(k) :=     
Pt Pt   Pt−1  Pt−k+1 
=  ··· 
Pt−k Pt−1 Pt−2 Pt−k
= (1 + Rt) · · · (1 + Rt−k+1)

3
Returns are

• scale-free, meaning that they do

not depend on monetary units (dol-
lars, cents, etc.)

• not unit-less — unit is time; they

depend on the units of t (hour, day,
etc.)

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Example:

Time t−2 t−1 t t+1

P 200 210 206 212
1+R 1.05 .981 1.03
1 + R(2) 1.03 1.01
1 + R(3) 1.06

1+R:

1.05 = 210/200

.981 = 206/210

1.03 = 212/206
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Example:

Time t−2 t−1 t t+1

P 200 210 206 212
1+R 1.05 .981 1.03
1 + R(2) 1.03 1.01
1 + R(3) 1.06

1+R(2): 1.03 = 206/200; 1.01 =

212/210

1+R(3): 1.06 = 212/200

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 Log returns

log prices:

pt := log(Pt)

log(x) = the natural logarithm of x

Continuously compounded or log re-

turns are logarithms of gross returns:
 
Pt 
rt := log(1+Rt) = log  = pt−pt−1
Pt−1
where pt := log(Pt)

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Example: Suppose Pt−1 = 2.0 and
Pt = 2.06. Then 1 + Rt = 1.03, Rt =
.03, and rt = log(1.03) = .0296 ≈ .03

Advantage — simplicity of multiperiod

returns

rt(k)
= log{1 + Rt(k)}
n o
= log (1 + Rt) · · · (1 + Rt−k+1)
= log(1 + Rt) + · · · + log(1 + Rt−k+1)
= rt + rt−1 + · · · + rt−k+1

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Log returns are approximately equal
to net returns:

• x small ⇒ log(1 + x) ≈ x

• therefore, rt = log(1 + Rt) ≈ Rt

• Examples:

* log(1 + .05) = .0488

* log(1 − .05) = −.0513

9
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Comparison of functions log(1 + x) and x.

10
Adjustment for Dividends

If a dividend (or interest) Dt is paid

prior to time t, then the gross return
at time t is defined as
Pt + Dt
1 + Rt = ,
Pt−1
and so the net return is
Pt + Dt
Rt = − 1,
Pt−1
and the log return is

rt = log(Pt + Dt) − log(Pt−1).

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 Behavior of returns

What can we say about returns?

• cannot be perfectly predicted — are

random.

Uncertainty in returns

At time t − 1, Pt and Rt are not only

unknown, but we do not know their
probability distributions.

12
Can estimate these distributions: with
an assumption

Leap of Faith:

• Future returns similar to past re-

turns

• So distribution of Pt can be esti-

mated from past data

13
Asset pricing models (e.g. CAPM)
use the joint distribution of cross-section
{R1t, . . . , RN t} of returns on N assets at
a single time t.

• Rit is the return on the ith asset at

time t.

Other models use the time series

R1, R2, . . . , Rt of returns on a single as-
set at a sequence of times 1, 2, . . . , t.
We will start with a single asset.
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Common Model — IID Normal Returns

R1, R2, . . . = returns from single asset.

1. mutually independent

2. identically distributed

3. normally distributed

IID = independent and identically distributed

15
Two problems:

• The model implies the possibility of

unlimited losses, but liability is usu-
ally limited

– Rt ≥ −1 since you can lose no

more than your investment

16
• 1+Rt(k) = (1+Rt)(1+Rt−1) · · · (1+
Rt−k+1) is not normal

– sums of normals are normal but

not products

– but it would be nice to have nor-

mality, so math is simple

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 The Lognormal Model

Assumes: rt = log(1 + Rt) are IID and

normal

Thus,

• we assume that

log(1 + Rt) ∼ N (µ, σ 2)

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• so that 1 + Rt = exp(normal r.v.) ≥
0

• so that Rt ≥ −1.

• this solves the first problem

19
For second problem:

• First,

1 + Rt(k) = (1 + Rt) · · · (1 + Rt−k+1)

= exp(rt) · · · exp(rt−k+1)
= exp(rt + · · · + rt−k+1).

• Therefore,

log{1 + Rt(k)} = rt + · · · rt−k+1

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• Sums of normals are normal ⇒ the
second problem is solved

– normality of single period returns

implies normality of multiple pe-
riod returns.

21
Example:

• A simple gross return (1 + R) is

lognormal{0,(0.1)2}

– which means that log(1 + R) is

N {0, (0.1)2}

• What is P (1 + R < 0.9)?

22
Answer:

• Since log(0.9)= −0.1053605,

P (1+R < 0.9) = P {log(1+R) < log(0.9)}

= Φ{(−0.1053605−0)/0.1} = Φ(−1.05360

= 0.1460319.

• In R, pnorm(−1.053605);

plnorm(0.9,mean=0,sd=0.1)

23
Example:

• Assume again that 1 + R is

lognormal{0,(0.1)2}

• Find the probability that a simple

gross two-period return is less than
0.9

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Answer:

• The two-period gross return is log

normal{0, 2(0.1)2} so this probabil-
ity is
 
log(0.9) 
Φ √ = Φ(−0.7450114)
( 2)(0.1) 

= 0.2281324

25
Let’s find a general formula for the
kth period returns:

Assume that

• 1 + Rt(k) = (1 + Rt) · · · (1 + Rt−k+1)

• log(1 + Ri) ∼ N (µ, σ 2) for all i

• the {Ri} are mutually independent

26
Then log{1 + Rt(k)} is the sum of k
independent N (µ, σ 2) random variables

• so that log(1 + Rt(k)) ∼ N (kµ, kσ 2)

• therefore
 
−
 log(x) kµ 
P {1 + Rt(k) < x} = Φ  √
kσ 

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 2.2 Random Walk

Let Z1, Z2, . . . be IID

• with mean µ and standard deviation

σ.

Z0 is an arbitrary starting point. Let

• S0 = Z0

• St := Z0 + Z1 + · · · + Zt, t ≥ 1.
28
S0, S1, . . . is called a random walk.

• E(St|Z0) = Z0 + µt

• Var(St|Z0) = σ 2t

√
• SD(St|Z0) = σ t

29
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Mean and probability bounds on a

random walk with S0 = 0, µ = .5
and σ = 1. At any given time, the
probability of being between the
probability bounds (dashed curves)
is 68%.
30
 Geometric Random Walk

Recall that log{1 + Rt(k)} = rt + · · · +

rt−k+1. Therefore
Pt
= 1+Rt(k) = exp(rt+· · ·+rt−k+1)
Pt−k
so taking k = t we have

Pt = P0 exp(rt + rt−1 + · · · + r1).

31
Skewed returns: if log returns are IID
N (µ, σ 2), then gross returns are
lognormal(µ, σ 2) and are skewed

• then {Pt : t = 1, 2, . . .} is exponential

of random walk

• such a process is a “geometric ran-

dom walk”

32
• median of R is exp(µ) − 1 since

P {R < exp(µ)−1} = P {1+R < exp(µ)}

1
= P {r < µ} = P {N (µ, σ 2) < µ} = .
2

• E(R) = exp(µ + σ 2/2) − 1 > median

(fact about lognormals)

33
• 1 + Rt(k) = exp{rt + · · · + rt−k+1} is
lognormal(kµ, kσ 2) and also skewed

• see the densities in the following Fig-

ure

34
 Lognormal densities
0.7
!=0, !=1
!=1,!=1
0.6 !=0, !=1.2

0.5

0.4
density

0.3

0.2

0.1

0
0 2 4 6 8 10
x

Log normal densities.

35
 The effect of the drift µ

• The geometric random walk model

does not imply that one cannot make
money

• since µ is generally positive, there is

an upward “drift”

• the log returns on the US stock mar-

ket as a whole have a mean of about
10% and a standard deviation of
about 20%
36
• next figure shows two independent
simulations of 25 years of a geomet-
ric random walk with these values of
µ and σ

37
• the prices start at 100

• the two series of log returns look

quite different

• the log prices and prices look much

more similar, reason is that they both
have µ = 0.1

– so the long run gives an upward

trend

• medians of the log returns, log prices,

and prices are also plotted
38
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39
Questions: i) Are log returns really
normally distributed? ii) if not, what
stylized facts do them exhibit?

Homework: Exercises 1,4,7,10.

40