EFB344 Risk Management and Derivatives

Tutorial W2: Financial Statistics

Readings: RiskMetrics (1996) Technical Document, pp. 5-9, 45-56, 64-72, 77-88 and 93-101.
Skim pp.21-30.

Hull et al. (2014) Fundamentals of Futures and Options, Ch. 20, pp. 419-431 and
436-442. Mathematics Appendix, pp. 531-538.

Note: use the lecture notes as a guide to what to focus on through these topics.
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Question 1

Why might it be useful to assume that returns follow a particular statistical distribution when trying
to think about risk?

Question 2

If we have a random variable X that is normally distributed X ~ N(0, 1) with mean 0 and variance 1,
what is the distribution of Y = μ + σ X?. How does this enable us to make statements about any
random variable with a normal distribution?

Question 3

Let’s say that the annual returns on Stock X are normally distributed with an average return of 10%
and a standard deviation of 50% (which implies a variance of 0.25), such that X ~ N( 0.1 , 0.25). What
is the probability that the stock return is between than -40% and +60% in the next year?

Question 4

Let’s say that the annual returns on Y are distributed Y ~ N( 0.05, 0.16). What is the probability that
the stock return is less than -35% in the next year?
Question 5

Let’s say that the annual returns on Stock X are normally distributed with an average return of 10%
and a standard deviation of 50% (which implies a variance of 0.25), such that X ~ N( 0.1 , 0.25) , and
the returns on Stock Y are distributed Y ~ N( 0.05, 0.16). Let’s also say that the two sets of returns
move together such that the correlation between them is ρ = 0.3.

a) What is the distribution of the annual returns of a portfolio consisting of 40% in stock X and
60% in stock Y (Hint: the portfolio return is normally distributed with mean and variance
found using your portfolio theory from Finance 1)?
b) What is the probability that the portfolio return is less than -29% in the next year?
c) What is the probability that the portfolio return is less than -25% in the next year? You will
need to use a Z-score table for this. There is one on Blackboard.

Question 6

What are some of the dangers associated with calculating a stock’s returns and their associated
statistics straight from the stock’s historical closing price?

Question 7 – Explain what the EWMA model for estimating volatility is designed to achieve that to
the sample variance cannot.