PROFESSOR: We will now talk about other dimensions

of return risk.
We will try to think outside of the mean variance framework.
For an investor, properties of returns other than return
variance could be important.
In particular, we can think about such moments
as skewness and kurtosis.
Skewness is a property of the return distribution
that measures its asymmetry.
A distribution that skew to the right
will have the property that large positive outcomes
are more likely than large negative outcomes.
Similarly, if you'll think about negative skewness,
then large negative outcomes are more
likely than large positive.
Skewness is particularly important
when dealing with non-linear investment instruments
such as derivatives.
For investment strategies involving derivatives,
return distribution is often highly skewed
and as a result mean various preferences do not completely
capture all dimensions of risk that
are relevant for the investor.
Kurtosis is another feature of the distribution.
It captures the measure of heavy tails, of fat tails.
A distribution with a high level of kurtosis
has the property that extreme outcomes on the right
or on the left are both relatively likely.
In particular, they're more likely than
under the normal distribution.
When we think about an investment strategy
with a high degree of kurtosis, we
have to worry about the high likelihood
of these outcomes which is an important dimension of risk.
We also need to think about modeling risk.
If a distribution has fat tails, the properties of distribution,
such as the mean and the variance,
are relatively difficult to estimate.
In the following table, we compare return moments, mean,
and standard deviation of two exchange traded funds.
First, let me remind you what the exchange traded funds are.
These are securities that trade just like stocks,
and underneath these securities are portfolios,
investment strategies, that follow
a relatively simple recipe.
These are funds, they're portfolios,
but they trade as stocks.
They're very convenient and increasingly popular
investment vehicles.
We are looking at two types of funds in this exercise.
One is an equity fund with the ticker symbol SPY.
This is a fund that tracks on S&P 500 index.
The second fund is a bond fund, this is a bond ETF,
with the ticker symbol AGG and this fund
tracks a portfolio of bonds.
The average returns over the past decade or so
are around 0.7% for SPY and around 0.3% for AGG.
In the table, you could see the average returns
and the standard deviation of returns
at the monthly frequency starting in January of 2008.
The takeaway here is that the equity ETF, SPY, is much more
volatile than the bond ETF.
The ratio volatilities is practical a four to one.
Next, let's take a closer look at the distribution of returns
on one of these funds.
We're looking at the bond fund here.
As we can see from this graph, there
is a large outcome on the right.
When we evaluate the likelihood of this outcome
under the normal distribution with the same variance
as the historical distribution of returns on this ETF,
we find that this observation which
happens to come from December of 2008
is approximately 5.8 standard deviations away from the mean.
If you recall, December of '08, it was right in the middle
of the great financial crisis.
How likely is this kind of observation?
Under the normal distribution while
would have to wait on average 10 million years
in order to see a draw of returns like this.
What this analysis tells us is that the distribution
of returns on the bond ETF is very far from normal.
This is an example of high kurtosis.
These types of outcomes are extremely
rare under the normal model, yet we do see them
in the financial data series.
High kurtosis is a common feature in financial markets.
Properties of asset returns are not constant.
They change over time.
This is very important to recognize
when modeling the distribution of returns statistically.
It also helps us understand some of the properties of returns,
such as high likelihood of extreme outcomes,
high kurtosis relative to the normal distribution.
Let's take a closer look at the exchange traded fund.
This fund tracks a portfolio of high yield bonds.
The ticker symbol is HYG.
Again, we're looking at the time series starting in 2008.
What we see from the graph is a pretty clear period
of high volatility in the early part of the sample.
This is the crisis period of '08 and '09.
This is not surprising.
As we know from history, this was the period
of significant dislocation in financial markets, credit
markets in particular.
As a result, fixed income investment strategies
such as those represented by this type of fund
were extremely volatile.
During this period, there were many months
with high draws of returns, either large positive returns
or large negative returns.
To be specific, we observed five month with returns
exceeding three standard deviations in magnitude.
And that happened in a span of a single year.
This should be extremely unlikely
under the normal distribution with constant volatility.
Of course, the point here is that volatility is not
constant.
This early period produced so many large observations
of returns precisely reflecting the fact
that the market volatility was relatively high.
What this example illustrates is that it
is important to model time variation
in near-term volatility in order to have
a realistic model of risk.
Risk is time varying.