2ND MODULE OF INVESTMENTS

WEEK 7

7.2 - Return Distribution, and Deviation from Normality

In this lecture we will see the assumption that stock returns are normal distributed

The assumption of normality comes with 4 benefits:

- This distribution is symmetric which means that one movement of one standard
deviation on the left side as the same probability of 1 movement of 1 standard
deviation of the right side
- A normal distribution is fully describe by two parameters only that are mean and
standard deviation. So as investors we can conclude that we only care about mean
and standard deviation.
- Normal distribution is part of a family of distributions called stable. This means that
the linear combination of normal random variable is it self normal distributed. This is
useful because a portfolio is nothing else but a linear combination of stocks.
- The comovement between random variables that are normal distributed as stocks can
be fully described by one parameter only the correlation.

A consequence of the second benefit is that we can use the SR as measure of the performance
of our investment. The sharp ratio as on the numerator the difference between the expected
return of stock/portfolio minus the risk free rate. In the denominator there is the volatility
(standard deviation) of the stock/portfolio. This sharp ration reflects what is the expected
return of your investment per unit of risk. How much this investment as compensated you per
each unit of risk that we have assumed.

As we have seen in the last lecture we can’t obtain the true u and sigma we need to estimate it
with a sample. So with that we will obtain also a sharp ration that is estimated it self as well.

What happens if we deviate of the assumption of the stock normality?

The most important thing is that we can’t use anymore the mean and the standard deviation
as our parameters. We instead need to consider two additional parameters to describe our
distribution: Skewness and Kurtosis.

Skewness: Is a measure of the symmetry of a distribution. So starting from a bench mark case
of the normal distribution (blue line) let’s analyze the case of a negatively skewed
distribution. A distribution with a negative value of skewness (red line). The red line has a
large probability mass on the negative side of distribution (normal). So negative stock returns if
this is a true distribution (the red line) are more likely than in the normal case. At the same
time positive realization of returns are less likely. So if we assume normality while in reality the
distribution is negatively skewed we are overestimating the probability of positive returns and
underestimating the probability of negative returns. Given the asymmetry you can’t use
anymore the standard deviation as measure of risk.
Kurtosis: A distribution with a kurtosis that it is higher than the normal distribution is still a
symmetric distribution. However as we can see by comparing the red line with the blue line we
can see that the red line has a larger probability mass in both tails of the distribution. So if we
assume normality but in reality the distribution has x kurtosis then we are underestimating the
probability of extreme events. We are misrepresenting the true risk of the investment.

If we deviate from normality we can not use standard deviation as the only measure of risk.
We need to develop alternative measures of the risk of one investment so let’s see a couple of
them.

The most common is:

Suppose that we observed 100 stock returns and we don’t know the true distribution but we
suspect that this is not normal distributed. So what we can do is to order our returns from the
worst one to the best one. So R1 is the worst return in our sample and R100 is the best
return. So in that case the VaR at a 95% confidence level is precisely R5 so it’s the best return
out of the 5% worst return. Or in other words, with 95% confidence we can lose more than R5.

Another measure (a little bit more conservative) is:

The problem with the previously measure is that it does not consider the distribution of the
worst 5% cases. There might be very extreme cases with huge losses. So in order to take into
account this we can use this new measure. This measure takes with 95% confidence the
average of the 5% worst cases. It is clearly more conservative than just taking R5 into
consideration.

Other 2 measures of risk that are not so common are:

Lower part of standard deviation: It is computed in a similarly way of normal distribution but
just take into account the negative part of the distribution (the negative returns only). So to
take into account the possibility that this part of the distribution is different from the part with
positive returns.

Relatively frequency of large negative returns: Estimate the standard deviation of your
empirical distribution (100 sample for example) as it was a normal distribution and then you
compare how many times in our empirical distribution you observed large negative returns
(for example 3 times standard deviation bellow the mean). We count how many time this large
negative returns occur in our empirical distribution and then we compare to the case of a
normal distribution. How many time this large negative returns should occur in the case of a
normal distribution.