Course:

COMMODITIES AND
ALTERNATIVE INVESTMENTS
Course Instructor: Umang Somani, CAIA (vf-umang@gim.ac.in)

Session 12: Understanding the Key

Statistical Measures
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Disadvantages of using the IRR

• One of the main benefits of using IRR is that it is easy to understand and
communicate. Unlike other methods, such as NPV, the IRR does not depend
on the cost of capital or the time value of money.

• However, using IRR as a decision criterion can also have some drawbacks.
One of the main problems with IRR is that it can be misleading or
inconsistent in some situations. For instance, if a project has multiple cash
flows with different signs, such as positive and negative cash flows, it may
have more than one IRR, which can create confusion and ambiguity.

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Disadvantages of using the IRR

• Another issue is that the IRR may not reflect the true profitability of a project
if it has different scales or durations. For example, a project with a higher IRR
may not necessarily be better than a project with a lower IRR if the former
has a smaller initial investment or a shorter lifespan.

• Another limitation of using IRR as a decision criterion is that it assumes that

the cash flows generated by a project can be reinvested at the same rate as
the IRR.

• Another drawback of using IRR is that it does not consider the risk or
uncertainty of a project's cash flows.

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Understanding Distributions and Dispersion Measures

• Histograms
• Moments of return distribution:
• Mean
• Variance
• Skewness
• Kurtosis
• Normal and Non-normal return distributions

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Understanding Distributions and Dispersion Measures

• Histograms
• Normal and Non-normal return distributions
• Moments of return distribution:
• Mean
• Variance
• Skewness
• Kurtosis
• Normal and Non-normal return distributions

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Histograms

• A histogram is an approximate
representation of the distribution of
numerical data.

• Histograms give a rough sense of

the density of the underlying
probability distribution of the data.

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Understanding Distributions and Dispersion Measures

• Histograms
• Moments of return distribution:
• Mean
• Variance
• Skewness
• Kurtosis
• Normal and Non-normal return distributions

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Moments of Return Distributions

• In mathematics, the moments of a function are quantitative measures

related to the shape of the function's graph.

• These can be raw moment, central moment and standard/ordinary moment

• If the function is a probability distribution, then the first moment is the

expected value, the second moment is the variance, the third moment is the
skewness, and the fourth moment is the kurtosis.

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Moments of Return Distributions

The shape of any distribution can be described by its various ‘moments’. The
first four are:

• The first moment Mean indicates the central tendency of a distribution.

• The second moment Variance indicates (squared) deviation from the mean.

• The third moment Skewness indicates any asymmetric ‘leaning’ either to the
left or to the right.

• The fourth moment Kurtosis indicates the degree of central ‘peakedness’ or

equivalently the ‘fatness’ of the outer tails.
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Understanding Distributions and Dispersion Measures

• Histograms
• Moments of return distribution:
• Mean
• Variance
• Skewness
• Kurtosis
• Normal and Non-normal return distributions

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Mean

• A mean return (also known as expected return) is the estimated profit or loss
an investor expects to achieve from a portfolio of investments.

• An investor can calculate the mean return on an investment given the

investment's historical returns or probable rates of return under different
scenarios.

• A mean return does not guarantee a future rate of return but it is a tool that
an investor should consider while evaluating an investment.

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Mean

• The mean is the average of a data set.

• There are two other commonly used alternatives to mean.

• The mode is the most common number in a data set.

• The median is the middle of a set of numbers.

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Understanding Distributions and Dispersion Measures

• Histograms
• Moments of return distribution:
• Mean
• Variance
• Skewness
• Kurtosis
• Normal and Non-normal return distributions

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Variance

• Variance is a measurement of the

spread between numbers in a data set.

• Investors use variance to see how

much risk an investment carries.

• Variance is also used to compare the

relative performance of each asset in a
portfolio to achieve the best asset
allocation.

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Understanding Distributions and Dispersion Measures

• Histograms
• Moments of return distribution:
• Mean
• Variance
• Skewness
• Kurtosis
• Normal and Non-normal return distributions

15
Skewness

• Skewness is the degree of asymmetry observed in a probability distribution.

• Distributions can exhibit right (positive) skewness or left (negative) skewness

to varying degrees. A normal distribution (bell curve) exhibits zero skewness.

Skewness =

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Skewness

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Understanding Distributions and Dispersion Measures

• Histograms
• Moments of return distribution:
• Mean
• Variance
• Skewness
• Kurtosis
• Normal and Non-normal return distributions

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Kurtosis

• Kurtosis is a statistical measure used to describe the degree to which returns

cluster in the tails or the peak of a frequency distribution. The peak is the
tallest part of the distribution, and the tails are the ends of the distribution.
• Leptokurtic: More values in the
distribution tails and more values
close to the mean (i.e. sharply
Leptokurtic
peaked with heavy tails).
Mesokurtic

• Platykurtic: Fewer values in the

tails and fewer values close to the Platykurtic
mean (i.e. the curve has a flat
peak and has more dispersed
returns with lighter tails). 19
Understanding Distributions and Dispersion Measures

• Histograms
• Moments of return distribution:
• Mean
• Variance
• Skewness
• Kurtosis
• Normal and Non-normal return distributions

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Normal and Non-normal return distributions

• Normal distribution, also known as the Gaussian distribution, is a probability

distribution that is symmetric about the mean, showing that data near the
mean are more frequent in occurrence than data far from the mean.

• In graph form normal distribution will appear as a bell curve.

• In a normal distribution the skewness is zero and the kurtosis is 3.

• Normal distributions are symmetrical, but not all symmetrical distributions

are normal.

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Normal and Non-normal return distributions

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Questions?

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