Financial returns

Mathematical models
The Empirical Distribution

Evolution of Investment Technology

1938
1952
1964
1973
1981
1988
1993
1994
1997
1999
2000
2006
Present

Bond duration
Markowitzs mean-variance framework
Sharpes CAPM, Modigliani Miller
Black-Scholes option pricing model
Arbitrage pricing theory APT (Ross)
BIS risk-weighted assets
Value at Risk (VaR)
RiskMetricsTM
CreditMetricsTM
LongRunTM and CorporateMetricsTM
PensionMetricsTM, RiskGradesTM and ClearHorizonTM
Basel II
Basel III

Returns
Why returns?
Prices are just levels, returns are what we gain

What can we say about the returns?

Forecasting on the financial markets the
future is now
Probability distributions theoretical way of
looking at the problem of forecasting
Discrete distributions depend on outcomes
Describing the distributions
Mean, variance

Frequency central moments of

the distribution
Possible realizations p

R1
1

R2

pi 1

p2
Pn-1

i1

Rn-1

pn

Rn
Today

Mean
Variance

Tomorrow

N
~
E ( R ) pi Ri
i 1

N
~
~ 2
E R E ( R ) pi ( Ri ) 2
i 1

Probability Density Function (PDF)

Too many possible realizations We use the
continuous distribution
Mean
Variance

E ( R)

Rp ( R)

V ( R) E R E ( R)

Standard Deviation

R V (R)

The Probability Density

Function
The probability of future realizations intervals
under the bell-shaped curve of the normal
distribution
N

p
i 1

f ( R) 1 100%

Standard Normal Distribution

Standard Normal Distribution

Probability
Density

Past realization

Normally
distributed
variable

Future
realization

R z

STANDARD

normally
distributed
variable

Distributions of daily returns

Day 4

Day 2
Day 1

Day 3

Conditional returns
Rt+1 is conditioned by Rt

Realizations of Rt

Realizations of Rt+1

Returns (cont.)
How can Excel help us?
Tools Data Analysis Histogram

Models assumptions
Normal distribution (central limit theorem)
Independent random variables at each point in time
we are dealing with a random variable independent with
respect to the other variables

From discrete to continuous distributions

Too many outcomes (portfolios)
Describing the distributions CDF and PDF
Mean, Variance Standard Deviation, Skewness, Kurtosis
(Excel Tools Data Analysis Descriptive Statistics)
Probability that the return lies in some interval assuming
normality (Excel functions Normdist and Normsdist; they read
the tables)

Returns (cont.)
Time series of returns
Estimation mean (why equal weights?)
How precise is the mean?
Estimation variance

Normal vs. lognormal

Noise

Which returns? (daily, weekly, monthly)