QUANTITATIVE METHODS OF

INVESTMENT
ANALYSIS
2.1 INVESTMENT INCOME AND RISK
 2.1 Investment income and risk

A return is the ultimate objective for any investor. But a

relationship between return and risk is a key concept in finance.
As a finance and investments area are built upon a common set
of financial principles, the main characteristics of any investment
are investment return and risk.
 2.1.1 Return on investment and expected rate of return
General definition of return is the benefit associated with and investment. In moset cases the investor can estimate his/her historical return
precisely
Many investment have two components of their measurable return:
•A capital gain or loss;
•Some form of income.
•
The rate of return is the percentage increase in returns associated with the holding period:

Rate of return= income + Capital gains / Purchase price (%) (2.1)

for example, rate of returns of the share(r) will be estimated:
D+ (Pme - Pmb)
R= __________________ (%) (2.2)
(Pmb)

Here D -dividends ;
Pmb- market price of stock at the beginning of holding period;
Pme- market price of stock at the end of the holding period.

here ri – rate of return in period I; (2.3)

n – numbers of observations

2.1.2 Investment risk.

Variance and standard deviation
Risk can be defined as a chance that the actual outcome from
an investment will differ from expected outcome. Obvious,
that most investors are conecerned that the actual outcome
will be less than the expected outcome.
Variance and Standard deviation
Variance can be calculated as a potential deviation of
each possible investment rate or return from the expected
rate of return. Variance and standard deviation are used when
investor is focused on estimating total risk that could be
expected in the defined period in future
Sample variance and sample standard deviation
are more often used when investors evaluates
total risk of his/her investments during
historical period.
For example, the loss of a job Formula of Formula of standard
may cause you to have to sell
Variance Deviation
your investments earlier than
you expected. Longevity risk –
the risk of outliving your savings
or investments. Foreign
investment risk – the risk of loss
when you invest in foreign
countries.

variance measures to calculate the standard

variability from the deviation
average or mean. 1.Work out the mean (the simple
It is calculated by taking average of the numbers)
the differences between
2.Then for each number, subtract
each number in the data
the mean and square the result,
set and the mean,
then squaring the 3.Then work out the mean of
differences to make them those squared differences.
positive, 4.Take the square root
and dividing the sum of

the squares
by the number of values in
the data set.

2.2. RELATIONSHIP BETWEEN RISK

AND RETURN

Relationship between risk and return

The expected rate of return and the

variance or standard deviation provide
investors with information about the
nature of the probability distribution
associated with a single asset. However
all these numbers are only the
characteristics of return and risk of a
the particular asset.
 In simple terms we should ask, How will
this investment work? How will its Risk
and Return pay off for the investor? We
need to consider these as a investor so
we can more precisely make a diversified
portfolio in which we can gain the most
profit. That’s what the investors are
worried about. How can we achieve this?
 Covariance.
What is Covariance? Covariance
measures the direction of the
relationship between two variables. A
positive covariance means that both
variables tend to be high or low at the
same time. A negative covariance
means that when one variable is high,
the other tends to be low.

Now we know what covariance is, lets talk about the two methods of
covariance estimation. The sample covariance and the population
 I will let maam handle how to explain the Sample covariance
equation, as I myself am still having trouble learning it but the
basic concept is, though the covariance number doesn’t tell the
investor how much about the relationship between the returns
on the two assets if only this pair of assets in the portfolio is
analysed. The important thing is using the covariance for
measuring relationship between two assets the identification
of the direction of this relationship
 As positive number of
covariance shows that rates of
return which appear positive,
tend to reflect on the other
asset, Asset B. And the same
goes for negative.
So in conclusion for this when using covariance for
a portfolio formation it is important to identify
which one of the three possible outcomes exist.

- Positive covariance (“+”)

- Negative covariance (“-”) or
- Zero covariance (“0”)
 Positive covariance – If the positive
covariance between two assets is identified,
the common recommendation for the
investor would be not to put both of these
assets to the same portfolio as their returns
move is in the same direction and will not be
diversified
Negative covariance – If the negative
covariance between the pair of
assets is identified, the common
recommendation for the investor
would be to include both of these
assets to the portfolio, because their
returns move in the contrariwise
direction and the risk in the portfolio
could decrease.
 Zero covariance

Between the two assets is identified it

means that there is no relationship between
the rates of return of two assets. The
assets could be included in the same
portfolio, but likely it is a rare case in
practice and usually covariance tend to be
positive or negative.
 2.3 RELATIONSHIP BETWEEN THE RETURNS
ON STOCK AND MARKET PORTFOLIO
When picking the relevant assets to the investment portfolio on
the basis of their risk and return characteristics and the
assessment of the relationship of their return investor must
consider to the fact that these assets are traded in the market.

How could the changes in the market influences the returns of

the assets in the investor's portfolio?
What is the relation between the returns on an asset and returns
in the whole market (market portfolio)?
 2.3 RELATIONSHIP BETWEEN THE RETURNS
ON STOCK AND MARKET PORTFOLIO
When picking the relevant assets to the investment portfolio on
the basis of their risk and return characteristics and the
assessment of the relationship of their return investor must
consider to the fact that these assets are traded in the market.

How could the changes in the market influences the returns of

the assets in the investor's portfolio?
What is the relation between the returns on an asset and returns
in the whole market (market portfolio)?
 2.3 RELATIONSHIP BETWEEN THE RETURNS
ON STOCK AND MARKET PORTFOLIO
When picking the relevant assets to the investment portfolio on
the basis of their risk and return characteristics and the
assessment of the relationship of their return investor must
consider to the fact that these assets are traded in the market.

How could the changes in the market influences the returns of

the assets in the investor's portfolio?
What is the relation between the returns on an asset and returns
in the whole market (market portfolio)?
2.3.1. THE CHARACTERISTIC LINE
AND THE BETA FACTOR
Before examining the relationship between a specific
asset and the market portfolio the concept of "market
portfolio" needs to be defined. Theoretical interpretation
of the market portfolio is that involves every single risky
asset in the global economic system, and contains each
asset in proportion to the total market value of all other
assets ( value weighted portfolio).
The most often the relationship between the
asset return and market portfolio return is
demonstrated and examined using the
common stock as assets, but the same
concept can be used analyzing bonds, or any
other assets. With the given historical data
about the returns on the particular common
stock (rJ) and marlet intex return (rM) in the
same periods of time investor can draw the
stock's characteristics line
STOCK'S CHARACTERISTICS LINE
describes the relationship between the stock and the
market;
shows the return investor expect the stock to roduce, given
that aparticular rate of return appears for the market;
helps to assess the risk characteristics of one stock relative
to the market.
The slope of the characteristics line is called the Beta facstor.
Beta factor for the stock and can be calculated using following
Cov (rJ,rM)
formula: βJ = ---------------------------
g² (rM)
Cov(rJ,rM) - covariance between returns of stock J and
the market portfolio;
g²(rM) - variance of returns on market portfolio

The Beta factor of the stock is an indicator of the degree to which the stock reacts of
the changes in the returns of the market portfolio. The Beta gives the answer to the
investor how much the stock return will change when the market will change by 1
percent.
Intercept AJ (the point where characteristics line
passes through the vertical axis) can be calculated
using following formula:
rJ - rate of return of stock J;
βJ - Beta factor for the stock J;
AJ = rJ - βJ x rM rM - rate of return of the market.

The intercept technically is a convinient point for drawing a

characteristic line. The interpretation of the intercept from trh investor's
point of view is that it shows what would be the rate of return of the
stock, if the return in the market is zero.
 RESIDUAL VARIANCE
The characteristic line is a line-of-best-fit through somr data points. A chaaractteristic
line is what in statistics is called as ti,e-series regression line. But in reality the stock
produce returns that deviate from the characteristic line. In statistics this propensity is
called the residual variance.
 Ressidual variance is the variance in the stock's residuals and for the
stock J can be calcculated using formula:

-ressiduaall of the stock J in period t;;

3
JJ
n - numbeer of period observed.

To calculate residual variance the residual in every period of observations must be identified. Residual is
the vertical distance between the point which reflect the pair of returns (stock J and market) and the
characteristic line of stock J. The residual of the stock J can be calculated:
It is useful for the interpretation of residual to investor to accentuate two
components in formula of residual

Component reflects the return actually generated by the stock J during period t;
Component 2 ( in the bracket) represents investor's expectations ffor the stockk's
return, given its characteristic line and market's return.

Note the difference between the variance and the residual variance:
The variance describes thee deeviation of the aasset returns from its expected value;
The residual variaance describes the deviation of the aasset returns from its
characteristic line.