Gross and Net Return

Log Return

Returns as Random Variables

Moments of Returns

Applications

Basic Properties of Asset Returns

Jan Bena Jason Chen Carolin Pueger

Sauder School of Business University of British Columbia January 1, 2013

Basic Properties of Asset Returns

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Gross and Net Return

Log Return

Returns as Random Variables

Moments of Returns

Applications

Key Concept: Return on Investment

Focus for now on stock returns Return is the payo per $1 invested Rt +1 = where Rt + 1 Pt +1 Dt +1 Pt = Gross return = Price at time t + 1 = Dividends received at t + 1 = Price paid at t Pt +1 + Dt +1 Pt

Historical returns are known Future returns are uncertain because

1 2

Future dividends are unknown Future prices are unknown

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Gross and Net Return

Log Return

Returns as Random Variables

Moments of Returns

Applications

Components of Gross Return

Rt +1 = =

Pt +1 + Dt +1 Pt Pt +1 Dt +1 + Pt Pt

Capital gain RtP +1 = Dividend yield DYt +1 = Dt +1 Pt Pt +1 Pt

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Gross and Net Return

Log Return

Returns as Random Variables

Moments of Returns

Applications

Example
Jan-4-2011 Mar-31-2011 Jan-4-2012

Pt

Dt + 1

Pt +1
Pt +1 +Dt + 1
4

Rt +1 =
Compute gross return if
Pt = 1270.2 Dt + 1 = 6 4 Pt +1 = 1257.6?

Pt

What assumption have you made about reinvesting dividends? What other assumptions are reasonable?

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Gross and Net Return

Log Return

Returns as Random Variables

Moments of Returns

Applications

Example with Reinvested Dividends

Pt + 1 = 1260.1
4

Number of shares per dollar invested at time t : x = Additional shares at time t + 1 4: x = x P Gross return: Rt +1 = (x + x )Pt +1
D
t+ 1 4 t+ 1 4

$1 Pt

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Gross and Net Return

Log Return

Returns as Random Variables

Moments of Returns

Applications

Gross vs. Net Return

The above is a gross return Net return = gross return - 1 Returns relate to horizon t t + 1 1 period can be a day, a minute, a decade, etc. Dividends dont all arrive at a point in time

t
6

t +1 -

Dividends arrive at some time between t and t + 1

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Gross and Net Return

Log Return

Returns as Random Variables

Moments of Returns

Applications

Indices

Indices track groups of assets (e.g., stocks, bonds, commodities) Examples of dierent equity indices and methods
Russell 2000 Index Russell S&P 500 Index S&P

Compounding gross returns from the group of assets leads to Return Index (e.g., the Russell 2000) Compounding capital gains from the group of assets leads to Price Index (e.g., the S&P 500 index) Index levels over time can be used to produce a time series of returns

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Gross and Net Return

Log Return

Returns as Random Variables

Moments of Returns

Applications

Equity Indexes in the US

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Gross and Net Return

Log Return

Returns as Random Variables

Moments of Returns

Applications

Simple vs. Log Return

Simple (i.e., gross and net) returns are convenient when aggregating returns of assets in portfolios. The weighted average of simple returns is the simple return on the portfolio. This is not true for log returns. Log returns are convenient when aggregating returns of assets over time. For statistics, it is more convenient to work with sums than products. For example, the sum of normally distributed log returns is normally distributed, whereas the product is not.

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Gross and Net Return

Log Return

Returns as Random Variables

Moments of Returns

Applications

Log Return

Returns can be stated in logarithmic form rt +1 Rt +1 Rt +1 : gross return rt +1 : log return Log and gross returns contain the same information Note
rt +1 Rt +1 1 For example, if Rt +1 = 1.1 then rt +1 = ln(1.1) = 0.0953

= =

ln(Rt +1 ) e rt +1

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Gross and Net Return

Log Return

Returns as Random Variables

Moments of Returns

Applications

Compounding Simple Returns Over Time

t

10% Rt + 1

t+1

5% Rt +2

t+2

$1

Rt + 1 Rt + 2
Two 1-period returns: Rt +1 , Rt +2 The 2-period return Rt t +2 = Rt +1 Rt +2 = 1.10 1.05 Long-horizon simple returns are products of short-horizon simple returns

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Gross and Net Return

Log Return

Returns as Random Variables

Moments of Returns

Applications

Compounding Log Returns Over Time

To generate long-horizon returns from short-horizon returns Rt t +2 = Rt +1 Rt +2 = e rt +1 e rt +2 = e rt +1 +rt +2 The 2-period log return: rt t +2 rt t +2 = ln(Rt t +2 ) = ln(e rt +1 +rt +2 ) = rt +1 + rt +2 Long-horizon log returns are sums of short-horizon log returns

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Gross and Net Return

Log Return

Returns as Random Variables

Moments of Returns

Applications

Returns Summary
Gross simple return Rt +1 = Net simple return Rt +1 1 Log return rt +1 = ln(Rt +1 ) = ln(e rt +1 ) 2-year gross simple return Rt +1 Rt +2 = e rt +1 e rt +2 = e rt +1 +rt +2 2-year log return rt +1 + rt +2
Basic Properties of Asset Returns

Pt +1 + Dt +1 Pt

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Gross and Net Return

Log Return

Returns as Random Variables

Moments of Returns

Applications

Exercise
1 2

Select an index from the MSCI website For December 2012, calculate:
The The The The The The gross return excluding dividends gross return including dividends net return excluding dividends net return including dividends log return excluding dividends log return including dividends

MSCI

For the calendar year 2012, calculate:

The The The The The The gross return excluding dividends gross return including dividends net return excluding dividends net return including dividends log return excluding dividends log return including dividends
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Gross and Net Return

Log Return

Returns as Random Variables

Moments of Returns

Applications

Model Returns Using Probability Distributions

Question: What will be this months S&P 500 return? Answer: Nobody knows! BUT, if you can answer questions like the following then returns have a distribution:
What is the probability that the S&P 500 index will fall during the next month? What is the probability that the S&P 500 index will increase by more than 5% during the next month?

Probability distributions describe the probability of outcomes or events

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Gross and Net Return

Log Return

Returns as Random Variables

Moments of Returns

Applications

Distribution of S&P 500 Index Returns

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Gross and Net Return

Log Return

Returns as Random Variables

Moments of Returns

Applications

Assumption 1: Gross Returns are Normal

Basic Properties of Asset Returns

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Gross and Net Return

Log Return

Returns as Random Variables

Moments of Returns

Applications

Assumption 2: Log Returns are Normal

Basic Properties of Asset Returns

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Gross and Net Return

Log Return

Returns as Random Variables

Moments of Returns

Applications

Properties of Normal Distributions N ( , 2 )

Basic Properties of Asset Returns

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Gross and Net Return

Log Return

Returns as Random Variables

Moments of Returns

Applications

Empirical Return Distributions are Skewed

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Gross and Net Return

Log Return

Returns as Random Variables

Moments of Returns

Applications

Empirical Return Distributions have Fat Tails

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Gross and Net Return

Log Return

Returns as Random Variables

Moments of Returns

Applications

Empirical Estimates of Moments of Returns

Random variables can be characterized by their moments Unfortunately the moments are typically unknown If you are willing to assume a model of the returns, then there are many ways to produce estimates of moments using historical data
Be careful here, because your model might be wrong!

Typically, estimates of the rst two moments are needed 1st moment: Mean
1 T Estimate of mean = T t =1 Rt This point estimate is measured with error (i.e., it is a noisy measure of the true return mean)

2nd moment: Variance

Estimate of variance = T 1 T (R mean)2 1 t =1 t Standard deviation = variance
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Gross and Net Return

Log Return

Returns as Random Variables

Moments of Returns

Applications

Higher-Order Moments
3rd moment: Skewness
Estimator =
1 T 3 T t =1 (Rt mean)

4th moment: Kurtosis

Estimator =
1 T 4 T t =1 (Rt mean)

For a Normal distribution

Skewness = 0 Kurtosis = 3 (Excess Kurtosis = Kurtosis - 3 = 0)

Negative skewness
Big left tail Bubbles bust Crashes

Excess kurtosis
Fat tails Extreme outcomes more frequent than predicted by normal
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Gross and Net Return

Log Return

Returns as Random Variables

Moments of Returns

Applications

Exercise
1

Download the S&P 500 Index data from WRDS

username: c374y13 password: B3ta1sR1sk

WRDS

Using monthly data from 1926, calculate the rst four moments of
gross return excluding dividends gross return including dividends net return excluding dividends net return including dividends log return excluding dividends log return including dividends

Using annual data from 1926, calculate the rst four moments of
gross return excluding dividends gross return including dividends net return excluding dividends net return including dividends log return excluding dividends log return including dividends

Produce a table comparing the moments for the monthly and annual data frequency. How do they compare?
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Gross and Net Return

Log Return

Returns as Random Variables

Moments of Returns

Applications

Some Applications

Estimating long-run mean return using geometric vs. arithmetic average Measuring risk using Value-at-Risk (VaR)
Answers questions like: x% of the time the maximum n-day loss will be less than y (or y%) The Economist article VaR

Testing for normality

The Economist article
Mandelbrot

Simulating returns, producing empirical histograms of returns

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Gross and Net Return

Log Return

Returns as Random Variables

Moments of Returns

Applications

Geometric Average of Returns

Suppose we have 85 years of monthly index observations (1926-2010) Level of index at end of year 85 in terms of monthly returns P85 = R1 R2 ... R1020 P0 , P0 = 1 = e r1 e r2 ... e r1020 = e r1 +r2 +...+r1020 Geometric average g = (R1 R2 ... RT )1/T Relationship to index level:
1020 g = P85 1

= (e r1 +r2 +...+r1020 ) 1020 =e

r1 +r2 +...+r1020 1020

Relationship to the average of log returns: ln(g ) =

r1 +r2 +...+r1020 1020

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Basic Properties of Asset Returns

Gross and Net Return

Log Return

Returns as Random Variables

Moments of Returns

Applications

Expectations of Simple and Log Returns

A useful relationship rt E [Rt ] Var [Rt ] N ( , 2 ) = e +

2 2 2 2

= e 2 +

e 1

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Gross and Net Return

Log Return

Returns as Random Variables

Moments of Returns

Applications

Simulating Returns

The following steps can be followed to generate draws from a normal distribution using Excel:
1 2

Generate a series of uniform random numbers on (0,1) using =rand() Use the inverse of the Standard Normal CDF (i.e., zero mean, unit variance normal distribution) to generate a series of N(0,1) random variables, =normsinv() Multiply the standard normal by the desired standard deviation and add the desired mean to create the simulated draws from the normal distribution.

To achieve a log-normal distribution, exponentiate and subtract 1.

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Gross and Net Return

Log Return

Returns as Random Variables

Moments of Returns

Applications

Do you

Know how to access WRDS, Bloomberg Know how to access index data with and without dividends reinvested Know how to calculate moments of returns at a variety of horizons Know how to produce a histogram of various returns at a variety of horizons Have a general idea of the magnitude of return statistics for some common asset classes at a variety of horizons Know how to simulate returns from common distributions

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