Chapter 3

A Review of Statistical Principles

Useful in Finance

1
Statistical thinking will one day be as
necessary for effective citizenship as the
ability to read and write.

- H.G. Wells

2
 Outline
Introduction
Theconcept of return
Some statistical facts of life

3
 Introduction
Statistical principles are useful in:
The theory of finance

Understanding how portfolios work

Why diversifying portfolios is a good idea

4
 The Concept of Return
Measurable return
Expected return
Return on investment

5
 Measurable Return
Definition
Holding period return
Arithmetic mean return
Geometric mean return
Comparison of arithmetic and geometric
mean returns

6
 Definition
A generaldefinition 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%

7
 Holding Period Return
The calculation of a holding period return
is independent of the passage of time
E.g., you buy a bond for $950, receive $80 in
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

8
 Arithmetic Mean Return
The arithmetic mean return is the
arithmetic average of several holding period
returns measured over the same holding
period:
n
Ri
Arithmetic mean
i 1 n

Ri the rate of return in period i

9
 Arithmetic Mean Return
(contd)
Arithmeticmeans 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

10
 Geometric Mean Return
The geometric mean return is the nth root
of the product of n values:

1/ n
n

Geometric mean (1 Ri ) 1
i 1

11
 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
12
 Arithmetic and Geometric
Mean Returns (contd)
Example (contd)

What is the arithmetic mean return?

Solution:
n
Ri
Arithmetic mean
i 1 n

0.0084 0.0045 0.0021 0.0000

4
0.0015 13
 Arithmetic and Geometric
Mean Returns (contd)
Example (contd)

What is the geometric mean return?

Solution:
1/ n
n

Geometric mean (1 Ri ) 1
i 1
1.0084 0.9955 1.0021 1.0000 1
1/ 4

0.001489 14
 Comparison of Arithmetic &
Geometric Mean Returns
Thegeometric mean reduces the likelihood
of nonsense answers
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%

15
 Comparison of Arithmetic &
Geometric Mean Returns
Thegeometric 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

16
 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

about the future

17
 Return on Investment (ROI)
Definition
Measuring total risk

18
 Definition
Returnon 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

19
 Measuring Total Risk
Standarddeviation and variance
Semi-variance

20
 Standard Deviation and
Variance
Standard
deviation and variance are the
most common measures of total risk

Theymeasure the dispersion of a set of

observations around the mean observation

21
 Standard Deviation and
Variance (contd)
General equation for variance:
n 2

Variance 2 prob( xi ) xi x
i 1

If all outcomes are equally likely:

n 2
1
xi x
2

n i 1
22
 Standard Deviation and
Variance (contd)
Equation for standard deviation:

n 2

Standard deviation 2 prob( x ) x x

i 1
i i

23
 Semi-Variance
Semi-variance considers the dispersion only
on the adverse side
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
24
 Some Statistical Facts of Life
Definitions
Propertiesof random variables
Linear regression
R squared and standard errors

25
 Definitions
Constants
Variables
Populations
Samples
Sample statistics

26
 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 constantcan be represented by a numeral

or by a symbol

27
 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

Infinance, variables are called random

variables
Designated by a tilde
E.g., x
28
 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

29
 Variables (contd)
Quantitative variables are measured by real
numbers
E.g., numerical measurement

Qualitative variables are categorical

E.g., hair color

30
 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)
31
 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
32
 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
33
 Populations (contd)
Positive Skewness Negative Skewness

34
 Populations (contd)
A binomial distribution contains only two
random variables
E.g., the toss of a die

A finitepopulation is one in which each

possible outcome is known
E.g., a card drawn from a deck of cards

35
 Populations (contd)
Aninfinite 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

36
 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

37
 Samples
A sample is any subset of a population
E.g., a sample of past monthly stock returns of
a particular stock

38
 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

39
 Properties of
Random Variables
Example
Central tendency
Dispersion
Logarithms
Expectations
Correlation and covariance

40
 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%

41
 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 n
E ( Ri ) Ri
n i 1
42
 Example (contd)
The expected returns for Stocks A and B are:

1 n 1
E ( RA ) Ri (2% 1% 4% 1%) 1.50%
n i 1 4

1 n 1
E ( RB ) Ri (3% 0% 5% 4%) 3.00%
n i 1 4

43
 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
E xi x
2 2

E xi x
2 2

44
 Example (contd)
The variance ad standard deviation for Stock A are:

2 E xi x
2

1
(2% 1.5%) 2 (1% 1.5%) 2 (4% 1.5%) 2 (1% 1.5%) 2
4
1
(0.0013) 0.000325
4

2 0.000325 0.018 1.8%

45
 Example (contd)
The variance ad standard deviation for Stock B are:

2 E xi x
2

1
(3% 3.0%)2 (0% 3.0%) 2 (5% 3.0%) 2 (4% 3.0%) 2
4
1
(0.0014) 0.00035
4

2 0.00035 0.0187 1.87%

46
 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
Logarithmsmake other statistical tools
more appropriate
E.g., linear regression
47
 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
48
 Expectations
Theexpected value of a constant is a
constant:
E (a ) a
Theexpected value of a constant times a
random variable is the constant times the
expected value of the random variable:
E (ax) aE ( x)
49
 Expectations (contd)
Theexpected 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 )

50
 Correlations and Covariance
Correlationis the degree of association
between two variables

Covariance is the product moment of two

random variables about their means

Correlationand covariance are related and

generally measure the same phenomenon
51
 Correlations and Covariance
(contd)

COV ( A, B) AB E ( A A)( B B )

COV ( A, B)
AB
A B
52
 Example (contd)
The covariance and correlation for Stocks A and B are:
1
AB (0.5% 0.0%) (2.5% 3.0%) (2.5% 2.0%) (0.5% 1.0%)
4
1
(0.001225)
4
0.000306

COV ( A, B) 0.000306
AB 0.909
A B (0.018)(0.0187)
53
 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

54
 Linear Regression
Linearregression 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
55
 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
56
Linear Regression (contd)
Example (contd)
0.01
Intercept = 0
Slope = 0.96 0.008
R squared = 0.99 0.006
Return (Stock)

0.004
0.002
0
-0.01 -0.005 -0.002 0 0.005 0.01
-0.004
-0.006
Return (Market)
57
 R Squared and
Standard Errors
Application
R squared
Standard Errors

58
 Application
R-squared and the standard error are used
to assess the accuracy of calculated
statistics

59
 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
60
 Standard Errors
Thestandard error is the standard deviation
divided by the square root of the number of
observations:

Standard error
n

61
 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

62