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Chapter 3

A Review of Statistical Principles
Useful in Finance
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Statistical thinking will one day be as
necessary for effective citizenship as the

- H.G. Wells
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Outline
Introduction
The concept of return
Some statistical facts of life
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Introduction
Statistical principles are useful in:
The theory of finance

Understanding how portfolios work

Why diversifying portfolios is a good idea
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The Concept of Return
Measurable return
Expected return
Return on investment
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Measurable Return
Definition
Holding period return
Arithmetic mean return
Geometric mean return
Comparison of arithmetic and geometric
mean returns
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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%
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Holding Period Return
The calculation of a holding period return
is independent of the passage of time
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
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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
=
=
=

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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
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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
=
(
= +
(

[
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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
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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
=
=
+ +
=
=

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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
=
(
= +
(

=
=
[
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Comparison of Arithmetic &
Geometric Mean Returns
The geometric mean reduces the likelihood
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%
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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
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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
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Return on Investment (ROI)
Definition
Measuring total risk
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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
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Measuring Total Risk
Standard deviation and variance
Semi-variance
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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

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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
=
=

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Standard Deviation and
Variance (contd)
Equation for standard deviation:

| |
2
2
1
Standard deviation prob( )
n
i i
i
x x x o o
=
= = =

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Semi-Variance
Semi-variance considers the dispersion only
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
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Some Statistical Facts of Life
Definitions
Properties of random variables
Linear regression
R squared and standard errors
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Definitions
Constants
Variables
Populations
Samples
Sample statistics
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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
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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
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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

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Variables (contd)
Quantitative variables are measured by real
numbers
E.g., numerical measurement

Qualitative variables are categorical
E.g., hair color
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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)
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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
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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
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Populations (contd)
Positive Skewness
Negative Skewness
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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
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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
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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
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Samples
A sample is any subset of a population
E.g., a sample of past monthly stock returns of
a particular stock
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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
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Properties of
Random Variables
Example
Central tendency
Dispersion
Logarithms
Expectations
Correlation and covariance
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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%
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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
=
=

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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
=
= = + + + =

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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
(
=

(
= =

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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
(
=

( = + + +

= =
= = = =
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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
(
=

( = + + +

= =
= = = =
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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
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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
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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 =
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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 + = +
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Correlations and Covariance
Correlation is the degree of association
between two variables

Covariance is the product moment of two

Correlation and covariance are related and
generally measure the same phenomenon
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Correlations and Covariance
(contd)
( , ) ( )( )
AB
COV A B E A A B B o
(
= =

( , )
AB
A B
COV A B

o o
=
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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
= = =
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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
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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
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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
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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
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R Squared and
Standard Errors
Application
R squared
Standard Errors
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Application
R-squared and the standard error are used
to assess the accuracy of calculated
statistics
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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
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Standard Errors
The standard error is the standard deviation
divided by the square root of the number of
observations:

Standard error
n
o
=
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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