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You are on page 1of 62

Chapter 3

A Review of Statistical Principles

Useful in Finance

2

Statistical thinking will one day be as

necessary for effective citizenship as the

ability to read and write.

- H.G. Wells

3

Outline

Introduction

The concept of return

Some statistical facts of life

4

Introduction

Statistical principles are useful in:

The theory of finance

Understanding how portfolios work

Why diversifying portfolios is a good idea

5

The Concept of Return

Measurable return

Expected return

Return on investment

6

Measurable Return

Definition

Holding period return

Arithmetic mean return

Geometric mean return

Comparison of arithmetic and geometric

mean returns

7

Definition

A general definition of return is the benefit

associated with an investment

In most cases, return is measurable

E.g., a $100 investment at 8%, compounded

continuously is worth $108.33 after one year

The return is $8.33, or 8.33%

8

Holding Period Return

The calculation of a holding period return

is independent of the passage of time

E.g., you buy a bond for $950, receive $80 in

interest, and later sell the bond for $980

The return is ($80 + $30)/$950 = 11.58%

The 11.58% could have been earned over one year

or one week

9

Arithmetic Mean Return

The arithmetic mean return is the

arithmetic average of several holding period

returns measured over the same holding

period:

1

Arithmetic mean

the rate of return in period

n

i

i

i

R

n

R i

=

=

=

10

Arithmetic Mean Return

(contd)

Arithmetic means are a useful proxy for

expected returns

Arithmetic means are not especially useful

for describing historical returns

It is unclear what the number means once it is

determined

11

Geometric Mean Return

The geometric mean return is the nth root

of the product of n values:

1/

1

Geometric mean (1 ) 1

n

n

i

i

R

=

(

= +

(

[

12

Arithmetic and

Geometric Mean Returns

Example

Assume the following sample of weekly stock returns:

Week Return Return Relative

1 0.0084 1.0084

2 -0.0045 0.9955

3 0.0021 1.0021

4 0.0000 1.000

13

Arithmetic and Geometric

Mean Returns (contd)

Example (contd)

What is the arithmetic mean return?

Solution:

1

Arithmetic mean

0.0084 0.0045 0.0021 0.0000

4

0.0015

n

i

i

R

n

=

=

+ +

=

=

14

Arithmetic and Geometric

Mean Returns (contd)

Example (contd)

What is the geometric mean return?

Solution:

| |

1/

1

1/ 4

Geometric mean (1 ) 1

1.0084 0.9955 1.0021 1.0000 1

0.001489

n

n

i

i

R

=

(

= +

(

=

=

[

15

Comparison of Arithmetic &

Geometric Mean Returns

The geometric mean reduces the likelihood

of nonsense answers

Assume a $100 investment falls by 50% in

period 1 and rises by 50% in period 2

The investor has $75 at the end of period 2

Arithmetic mean = (-50% + 50%)/2 = 0%

Geometric mean = (0.50 x 1.50)

1/2

1 = -13.40%

16

Comparison of Arithmetic &

Geometric Mean Returns

The geometric mean must be used to

determine the rate of return that equates a

present value with a series of future values

The greater the dispersion in a series of

numbers, the wider the gap between the

arithmetic and geometric mean

17

Expected Return

Expected return refers to the future

In finance, what happened in the past is not as

important as what happens in the future

We can use past information to make estimates

about the future

18

Return on Investment (ROI)

Definition

Measuring total risk

19

Definition

Return on investment (ROI) is a term that

must be clearly defined

Return on assets (ROA)

Return on equity (ROE)

ROE is a leveraged version of ROA

20

Measuring Total Risk

Standard deviation and variance

Semi-variance

21

Standard Deviation and

Variance

Standard deviation and variance are the

most common measures of total risk

They measure the dispersion of a set of

observations around the mean observation

22

Standard Deviation and

Variance (contd)

General equation for variance:

If all outcomes are equally likely:

| |

2

2

1

Variance prob( )

n

i i

i

x x x o

=

= =

| |

2

2

1

1

n

i

i

x x

n

o

=

=

23

Standard Deviation and

Variance (contd)

Equation for standard deviation:

| |

2

2

1

Standard deviation prob( )

n

i i

i

x x x o o

=

= = =

24

Semi-Variance

Semi-variance considers the dispersion only

on the adverse side

Ignores all observations greater than the mean

Calculates variance using only bad returns

that are less than average

Since risk means chance of loss positive

dispersion can distort the variance or standard

deviation statistic as a measure of risk

25

Some Statistical Facts of Life

Definitions

Properties of random variables

Linear regression

R squared and standard errors

26

Definitions

Constants

Variables

Populations

Samples

Sample statistics

27

Constants

A constant is a value that does not change

E.g., the number of sides of a cube

E.g., the sum of the interior angles of a triangle

A constant can be represented by a numeral

or by a symbol

28

Variables

A variable has no fixed value

It is useful only when it is considered in the

context of other possible values it might assume

In finance, variables are called random

variables

Designated by a tilde

E.g., x

29

Variables (contd)

Discrete random variables are countable

E.g., the number of trout you catch

Continuous random variables are

measurable

E.g., the length of a trout

30

Variables (contd)

Quantitative variables are measured by real

numbers

E.g., numerical measurement

Qualitative variables are categorical

E.g., hair color

31

Variables (contd)

Independent variables are measured

directly

E.g., the height of a box

Dependent variables can only be measured

once other independent variables are

measured

E.g., the volume of a box (requires length,

width, and height)

32

Populations

A population is the entire collection of a

particular set of random variables

The nature of a population is described by

its distribution

The median of a distribution is the point where

half the observations lie on either side

The mode is the value in a distribution that

occurs most frequently

33

Populations (contd)

A distribution can have skewness

There is more dispersion on one side of the

distribution

Positive skewness means the mean is greater

than the median

Stock returns are positively skewed

Negative skewness means the mean is less than

the median

34

Populations (contd)

Positive Skewness

Negative Skewness

35

Populations (contd)

A binomial distribution contains only two

random variables

E.g., the toss of a die

A finite population is one in which each

possible outcome is known

E.g., a card drawn from a deck of cards

36

Populations (contd)

An infinite population is one where not all

observations can be counted

E.g., the microorganisms in a cubic mile of

ocean water

A univariate population has one variable of

interest

37

Populations (contd)

A bivariate population has two variables of

interest

E.g., weight and size

A multivariate population has more than

two variables of interest

E.g., weight, size, and color

38

Samples

A sample is any subset of a population

E.g., a sample of past monthly stock returns of

a particular stock

39

Sample Statistics

Sample statistics are characteristics of

samples

A true population statistic is usually

unobservable and must be estimated with a

sample statistic

Expensive

Statistically unnecessary

40

Properties of

Random Variables

Example

Central tendency

Dispersion

Logarithms

Expectations

Correlation and covariance

41

Example

Assume the following monthly stock returns for Stocks A

and B:

Month Stock A Stock B

1 2% 3%

2 -1% 0%

3 4% 5%

4 1% 4%

42

Central Tendency

Central tendency is what a random variable

looks like, on average

The usual measure of central tendency is the

populations expected value (the mean)

The average value of all elements of the

population

1

1

( )

n

i i

i

E R R

n

=

=

43

Example (contd)

The expected returns for Stocks A and B are:

1

1 1

( ) (2% 1% 4% 1%) 1.50%

4

n

A i

i

E R R

n

=

= = + + =

1

1 1

( ) (3% 0% 5% 4%) 3.00%

4

n

B i

i

E R R

n

=

= = + + + =

44

Dispersion

Investors are interest in the best and the

worst in addition to the average

A common measure of dispersion is the

variance or standard deviation

( )

( )

2

2

2

2

i

i

E x x

E x x

o

o o

(

=

(

= =

45

Example (contd)

The variance ad standard deviation for Stock A are:

( )

2

2

2 2 2 2

2

1

(2% 1.5%) ( 1% 1.5%) (4% 1.5%) (1% 1.5%)

4

1

(0.0013) 0.000325

4

0.000325 0.018 1.8%

i

E x x o

o o

(

=

( = + + +

= =

= = = =

46

Example (contd)

The variance ad standard deviation for Stock B are:

( )

2

2

2 2 2 2

2

1

(3% 3.0%) (0% 3.0%) (5% 3.0%) (4% 3.0%)

4

1

(0.0014) 0.00035

4

0.00035 0.0187 1.87%

i

E x x o

o o

(

=

( = + + +

= =

= = = =

47

Logarithms

Logarithms reduce the impact of extreme

values

E.g., takeover rumors may cause huge price

swings

A logreturn is the logarithm of a return

Logarithms make other statistical tools

more appropriate

E.g., linear regression

48

Logarithms (contd)

Using logreturns on stock return

distributions:

Take the raw returns

Convert the raw returns to return relatives

Take the natural logarithm of the return

relatives

49

Expectations

The expected value of a constant is a

constant:

The expected value of a constant times a

random variable is the constant times the

expected value of the random variable:

( ) E a a =

( ) ( ) E ax aE x =

50

Expectations (contd)

The expected value of a combination of

random variables is equal to the sum of the

expected value of each element of the

combination:

( ) ( ) ( ) E x y E x E y + = +

51

Correlations and Covariance

Correlation is the degree of association

between two variables

Covariance is the product moment of two

random variables about their means

Correlation and covariance are related and

generally measure the same phenomenon

52

Correlations and Covariance

(contd)

( , ) ( )( )

AB

COV A B E A A B B o

(

= =

( , )

AB

A B

COV A B

o o

=

53

Example (contd)

The covariance and correlation for Stocks A and B are:

| |

1

(0.5% 0.0%) ( 2.5% 3.0%) (2.5% 2.0%) ( 0.5% 1.0%)

4

1

(0.001225)

4

0.000306

AB

o = + + +

=

=

( , ) 0.000306

0.909

(0.018)(0.0187)

AB

A B

COV A B

o o

= = =

54

Correlations and Covariance

Correlation ranges from 1.0 to +1.0.

Two random variables that are perfectly

positively correlated have a correlation

coefficient of +1.0

Two random variables that are perfectly

negatively correlated have a correlation

coefficient of 1.0

55

Linear Regression

Linear regression is a mathematical

technique used to predict the value of one

variable from a series of values of other

variables

E.g., predict the return of an individual stock

using a stock market index

Regression finds the equation of a line

through the points that gives the best

possible fit

56

Linear Regression (contd)

Example

Assume the following sample of weekly stock and stock

index returns:

Week Stock Return Index Return

1 0.0084 0.0088

2 -0.0045 -0.0048

3 0.0021 0.0019

4 0.0000 0.0005

57

Linear Regression (contd)

Example (contd)

-0.006

-0.004

-0.002

0

0.002

0.004

0.006

0.008

0.01

-0.01 -0.005 0 0.005 0.01

Return (Market)

R

e

t

u

r

n

(

S

t

o

c

k

)

Intercept = 0

Slope = 0.96

R squared = 0.99

58

R Squared and

Standard Errors

Application

R squared

Standard Errors

59

Application

R-squared and the standard error are used

to assess the accuracy of calculated

statistics

60

R Squared

R squared is a measure of how good a fit we get

with the regression line

If every data point lies exactly on the line, R squared is

100%

R squared is the square of the correlation

coefficient between the security returns and the

market returns

It measures the portion of a securitys variability that is

due to the market variability

61

Standard Errors

The standard error is the standard deviation

divided by the square root of the number of

observations:

Standard error

n

o

=

62

Standard Errors (contd)

The standard error enables us to determine

the likelihood that the coefficient is

statistically different from zero

About 68% of the elements of the distribution

lie within one standard error of the mean

About 95% lie within 1.96 standard errors

About 99% lie within 3.00 standard errors

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