Risk Management and

Derivatives
Lecture 02
Financial Statistics

Unit Content
Week 1: Introduction to Risk, Risk Management and Derivatives
Week 2: Financial Statistics
Week 3: Value-at-Risk 1
Week 4: No Classes Ekka Public Holiday
Week 5: Value-at-Risk 2
Week 6: Forwards and Futures: commodity and equity
Week 7: Forwards and Futures: interest rates
Week 8: Mid-Semester Exam and Reflective Practices
Week 9: Swaps: interest rate
Week 10: Options: introduction and pricing with the binomial
model
Week 11: Options: pricing with the Black-Scholes model
Week 12: Options: trading strategies and risk management
Week 13: Derivative Disasters
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Week 14: Revision

Lecture Outline
Prices and Returns:

Definitions
Measuring Returns
Preference to using Returns
Downloading Data
Distributional Characteristics
Simulating Prices and Returns
Time Varying volatility

Readings:
RiskMetrics (1996) Technical Document, pp. 5-9, 45-56, 64-72, 77-88 and
93-101. Skim pp.21-30. Note: use the lecture notes as a guide to what to
focus on.
Hull et al. (2013) Fundamentals of Futures and Options, Ch. 20, pp. 419-431
and 436-442. Mathematical Appendix, pp-531-538.
Note: use the lecture notes as a guide to what to focus on through these
topics.
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Definitions
Price Definition
The current price at which an asset or service can be
bought or sold (Investopedia http://
www.investopedia.com/terms/m/market-price.asp ).
Note that Investopedia defines market price. I would
contend that price is the amount at which a transaction
can occur (quoted price) or has occurred (historical price).
Return Definition
When a price change is defined relative to some initial
price, it is known as a return (RiskMetrics, 1996, p. 45).
A measure of the price change over a holding period.

Note that we observe prices but measure returns.

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Measuring Returns
Given
the price at , , and price from previous period, ,

return can be measured as,

Absolute (Dollar) Return:
Relative (Simple) Return:
Log (Continuous) Return:

What are log returns?

Measuring Returns
Log Returns are also known as continuously
compounding returns. This is shown from
,

where m is the compound period

continuous compounding
,
,

,
and

Preference to using Returns

Why do we work with returns?
1. Returns have more attractive statistical properties. That is
they are stationary (mean reverting and finite variance) while
prices are non-stationary (non-mean reverting and infinite
variance). Furthermore, we can approximate the distribution of
returns with a normal distribution.
2. Relative and log returns do not depend on the given price level
or investment amount. This allows us to compare different
investments or varying amounts. Moreover, we can easily
return back to the given price level if required.
3. Risk relates to changes. Returns measure change.
4. Within the utility framework of an economic agent, we think of
the risk/return trade-off/relationship.

Downloading Data
Time to get some prices and calculate some
returns:

Source:
http://finance.yahoo.com/
Stock:
CBA cba.ax in yahoofinance
Go to:
Historical Data
Download:Daily prices from now to sometime a long, long
time
ago (e.g. 90s).
Open/Save: Open CSV file then save as XLSX file
Information: Date, Open, High, Low, Close, Volume and
Adjusted Close (dividend and split adjusted)
Sort:
Default is for last date quoted first. Change this to
first date first.
Clean:
Frequency issues and formatting
Note:
Start and end dates and no. of observations
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Downloading Data

No trade day

Date order

Formatting
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Downloading Data

are not daily prices and theres no volume. Maybe a data issue given that the da
so so long ago the 90s Need to clean data for poor collection and non-tradin
el, I will use an IF function to clean data. For example =IF(F2=0,1,0)
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Downloading Data
Ive used the
Filter to
display nontrade days
=IF(F7=0,1,0)

Start Date: 4/01/1999

End Date: 12/06/2014
Obs.:
3,901 15.5 x 252 3,906, assuming 252 trading days per year
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Downloading Data
Calculate Returns
Price Used:
To start, we will use adjusted close price.
This
ensures that the returns calculated adjust for
dividends and splits. Note that in adjusting these prices,
they do not reflect actual market prices.
Returns: To start, we will calculate dollar, simple and log
returns for comparison.
Plot: A line graph of prices and returns (log).
Characteristics include: Prices meander (dont
mean
revert), Returns have a mean and finite variance,
although variance changes through
time.
Plot: A histogram of prices and returns (log)
Highlight price distribution changes through time and is
non-symmetric while the return
distribution is somewhat
stable and symmetric.
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Downloading Data
Minor difference in Rt and rt
can be noted.

Changed date format because

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Distributional
Characteristics

The mean is?

have a sample mean but do we expect prices to consistently revert back to this
No! More to say later

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Distributional
Characteristics
All show similar patterns up to and including

the global financial crisis (GFC). However,

post GFC, the volatility of Dt is different to th
of Rt and rt.
Why?

CBAs adjusted price post GFC goes up from

low 20s to the 80s. As such, as the relative
Volatility percentage remains constant, the
variance of Dt will increase as the price level
increases.
Rt and rt are very similar.

Note also that volatility, the spread of returns

is changing through time. For example, it is
low prior to the GFC, spikes at the GFC and
decreases post GFC volatility clusters.
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Distributional
Characteristics
Creating Histograms / Using Array Functions
Frequency(Data, Bins)
It is an array function, and theyre hard to use.
When finished writing the function, you have to hit
CTRL, SHIFT and ENTER at the same time to get it to
work
You then highlight your whole output range, hit F2
and then press CTRL, SHIFT and ENTER again to
complete.
Practice, practice, practice and then practice some
more

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Distributional
Characteristics
The characteristics of the price distribution

(mean and variance) are changing through

time. As such, the distribution is multi-moda
and displays reversion to an unconditional
(not conditional on time) mean.

The return distribution indicates that there i

an unconditional mean (approx. 0.05% at th
daily frequency but 13.7% when scaled to p
Distribution is symmetric and is similar to
The normal distribution with the same mean
and variance. However, there are more obs.
around 0% and in the tails. This is known as
Leptokurtosis high kurtosis and fat-tails.
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Distributional
Characteristics

Skewness measures symmetry

Kurtosis measures peakiness

Things to
note:
stdev measures sample standard deviation
kurt measures excess kurtosis, i.e. kurtosis in excess of the normal dist.s 3
mean p.a. = mean daily x 252 there are 252 trading days
Stdev p.a. = stdev daily x - it is variance that scales by 252

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Distributional
Characteristics
A
random walk is a special statistical model that
describes the movement of a random variable over time
where the change over successive steps is a random
shock.
We use the terminology loosely in finance, as a true
random walk has specific requirements around the
random shock.
Anyway, the model in terms of prices is:

where:
is the mean return
scales the shocks standard deviation
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Distributional
Characteristics
Price:
Conditional Mean

The mean at t conditional on past information at t-1.

Price: Conditional Variance

The variance at t conditional on past information at t-1.

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Distributional
Characteristics
Price: Unconditional Mean

The mean at t conditional on the initial information at 0.

Price: Unconditional Variance

The variance at t conditional on the initial information at 0.

Result: Prices are non-stationary as their mean and variance change through time
and blow-up as .

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Distributional
Characteristics
Returns:
Conditional Mean

The mean at t conditional on past information at t-1.

Returns: Conditional Variance

The variance at t conditional on past information at t-1.

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Distributional
Characteristics
Returns:
Unconditional Mean

The mean at t conditional on the initial information at 0.

Returns: Unconditional Variance

The variance at t conditional on the initial information at
0.

Result: Returns are stationary as there is mean-reversion and

variance does not blow-up as .

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Simulating Prices and

Returns
Simulation Example:
Simulate:
1000 returns (T = 1000) 10 times (S = 10)
Starting Values: P0 = 30, Annual Mean = 10%, Annual
STD = 25%
Frequency:
Daily, assume 252 trade days per year
Distribution: Normal [=mean + normsinv(rand())*STD]
Plot:
Prices and Returns
Comment: What do you see and what dont you see
relative
to the empirical data (i.e the CBA
data)?

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Simulating Prices and

Returns
Dollar
Price Model

where:

- it is the mean return

it scales

note: mean and standard deviation are dependent on the

initial
price level, P0.

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Simulating Prices and

Returns

Returns,

Dt, display mean reversion and ten

have a certain level of volatility.

However, returns are measured in dollars n

as a percentage

Prices, Pt, display trends similar to what is

seen in stock prices. That is, a tendency to
increase over time given, , but
periods of decline as well.

Interestingly, there are no volatility clusters

were present in the empirical data. The
reason for this is that variance has not been
allowed to vary with time.
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Simulating Prices and

Returns

Dt display similar characteristics.

Pt paths are somewhat different.

Most tend to rise over time,
however, a couple decrease. But
most importantly, P5 becomes
negative This is possible given
the model specified but it should
not happen with limited liability
investments, i.e. equity cannot
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be worth less than 0.

Simulating Prices and

Returns
Log
Price Model:

where:

is referred to as the log of price

and is the mean return
and scales

note:

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Simulating Prices and

Returns

Returns,

rt, display mean reversion and tend

have a certain level of volatility.

Returns are measured as a percentage.

Prices, Pt, display trends similar to what is
seen in stock prices.

Still no volatility clusters but we shouldnt b

surprised.

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Simulating Prices and

Returns

rt display similar characteristics

Pt paths are somewhat different.

Inline with the mean set for the
simulation, most rise over time.
More importantly, they cannot
become negative because
and
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Time Varying Volatility

Empirical return plots displayed volatility clusters! That is, there are

periods of low volatility and periods of volatility.

We can add volatility clustering by making depend on time.
Specifically:
,
where
at the daily frequency
is the last periods conditional variance
is the last periods return squared
This model of time varying volatility is know as the Exponentially
Weighted Moving Average (EWMA) model or the RiskMetrics Model.
It captures the clustering of volatility in that todays volatility is 94% of previous
periods volatility plus 6% of the variance of previous periods squared shock.
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Time Varying Volatility

The EWMA volatility responds to the volatility environment

Low volatility pre-GFC
High volatility in GFC and around European Debt Crisis
Low volatility recently (SMH article)
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Time Varying Volatility

Simulation Example:
Simulate:
1000 returns (T = 1000) 1 time (S = 1)
Starting Values: P0 = 30, Annual Mean = 10%, Annual
STD = 25%
= 0.94
Frequency:
Daily, assume 252 trade days per year
Distribution: Normal [=mean + norminv(rand())*STDt]
Plot:
Prices and Returns
Comment: What do you see and what dont you see
relative
to the empirical data (i.e the CBA
data)?

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Time Varying Volatility

The level time varying volatility
changes with time as opposed to
the constant volatility
Returns display volatility
clustering.
Both returns and prices are
similar to those displayed in the
market.

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