Statistics Review 1

Marriott School of Management

Fall 2014
Rob Schonlau
Last updated Sept 10, 2014

Statistics review part 1

As introduced earlier, we think of risk in terms of the likelihood

of observing return outcomes that are far different than the
expected outcome.
Financial theory states that there is a risk-return relationship
where people must be compensated for bearing additional risk.
Before we can discuss the formal financial risk-return models
we need to first review some of the related statistical concepts.

Lecture 4 outline

Discuss statistical concepts that are useful for thinking about an

assets performance and risk.
Random variables
Expectations
Probability density functions (PDFs)
Variance and standard deviation
Review the normal distribution. Use properties of the normal
distribution to answer probability questions and to solve for the
value at risk.

Definitions
Random Variable: A variable whose value is uncertain. I find it helpful
to think of a data generating process that generates all the possible
outcome values in each time period for the variable in question.
Example: IBM stock returns

Observation: The observed value from a single outcome of the random

variable. You can think about an observation as a single draw or a
single example observed out of a whole underlying population of
possible values.
Next years observed IBM annual return will be a single
observation from the underlying possible set of IBM returns.

Average weekly return: .0019

Standard deviation: .046

Definitions continued
Probability density function (PDF): A function that describes the
probability of each outcome for a random variable.

Expectation or Expected Value: The mean or expected value of a

random variable is a single value that summarizes the value you would
observe on average if you could observe the outcome of the random
variable many times. If r is a random variable then the expectation
notation is E[r], or sometimes m.

Discrete PDF
Example of a discrete PDF

0.75 for r 10%

p( s)
0.25 for r 15%
Only a finite number of outcomes (in this example there are two
possible outcomes or two states)
The value of the function, p(s), tells us the exact probability of
observing a given state.
The sum of the probabilities across all possible outcomes
(states) must equal 1.

Discrete PDFs are not very realistic. Why do we use them?

Provides statistical intuition for more complex distributions
Part of the CFA curriculum
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Continuous PDF
Example: Normal PDF

Infinite number of outcomes even within defined range

The integral of the function between two points tells us the
probability of getting an outcome between those two points.
The integral of the function over the range of possible outcomes
must equal 1.
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Expectation
For a discrete probability function with S possible outcomes (states)

E[r ] s 1 p( s )r ( s )
S

where p(s) = probability of each of S possible states

r(s) = observed return if state s occurs
For example given the following probability function:

0.75 for r 10%

p( s)
0.25 for r 15%
E[r]=0.75*(.10)+.25*(-.15)= 3.75%
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Example of calculating expected return

State of
Economy

Scenarios
(states)

Probability of
each state

Returns

Boom

.25

44%

Normal growth

.50

14%

Recession

.25

-16%

Using the general PDF notation the information in this table can be
summarized as:

0.25 for r 44%

p ( s ) 0.50 for r 14%

0.25 for r 16%

E[r]=.25(.44) + .50(.14) + .25(-.16) = .14

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Expectations using continuous PDFs

For a continuous probability function

E[ r ]

p( s)r ( s)dr

The idea is the same as for a discrete PDF. We just integrate

across all possible values rather than sum over the discrete
values.

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Expectation of a function of a random

variable
At times we are interested in the expectation of a function of a random
variable. For example, assume the following discrete PDF for random
variable r:

0.65 for r 8%
p( s)
0.35 for r 10%

What is the E[r], E[r2], and E[3r+5]?

E[r]
E[r2]
E[3r+5]

= .65*(.08)
+ .35*(-.10)
= 0.017
= .65*(.082)
+. 35*(-.102)
= 0.008
= .65*(3*.08+5)+ .35*(3*(-.10)+5) = 5.051

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PDFs, expectations, and stock returns

We never know the true future distribution (PDF) of returns for any
investment.

However, we can observe the actual returns over time of an

investment and with those historical returns infer the nature of the
(unobservable) underlying process generating those outcomes.

For example, we dont know the true underlying PDF for future IBM
stock returns. But if we know that prior IBM returns have averaged
10% a year with a standard deviation of 4% we can get an idea of
the distribution of IBMs future returns.

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Average weekly return: .0019

Standard deviation: .046

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Summary of Expectations

Given an assumed PDF we can find the expectation as follows

E[r ] s 1 p ( s )r ( s )
S

E[r ]

p(s)r (s)dr

When we dont know anything about the PDF, but rather, observe a
sample generated by an underlying process, we can estimate the
expected value as a simple average. This works for both discrete and
continuous PDFs.

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Statistics rule #1
Rule 1: Let x and y be any two random variables. If z = ax + by,
where a and b are constants, and x and y are random variables,
then

E[z] aE[x] bE[y]

Note that

E[ax] aE[ x]

because

E[a] a

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Statistics rule #1: Example

Assume you own portfolio Z with 30% of your wealth in asset A and
70% in asset B. Assume you have gathered data on the returns to A,
and B and inferred the following PDF.

0.80 for rA 10% and rB 5% (expansion)

p( s)
0.20 for rA 0% and rB 3% (recession)

If there is an expansion: rZ= .3(10%) + .7(5%) = 6.5%. Expansions

occur with probability 0.80.
If there is a recession: rZ= .3(0%)+.7(3%) = 2.1%. Recessions occur
with probability 0.20.
What is the expected return for portfolio z?
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0.80 for rA 10% and rB 5% (expansion)

f (s)
0.20 for rA 0% and rB 3% (recession)
The return on portfolio Z (rZ) is a random variable that is itself a
function of two other random variables (rA and rB). In either state of
the world (expansion or recession) rZ can be represented by the
formula rZ =.3(rA) + .7(rB).
Using expectations (statistics rule #1):
E[rZ] = .3 E(rA) + .7 E(rB)
First solve for E(rA) and E(rB) and then for E[rZ]

E[rA ] (.80 .10) (.20 0)

0.08

E[rB ] (.80 .05) (.20 .03) 0.046

E[rZ ] 0.3(0.08) 0.7(0.046) 5.62%
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Discrete PDF Example: Which of these

investments would you choose? Why?
Investment #1 PDF:

0.75 for r 10%

p( s)
0.25 for r 15%
E[r] = 3.75%

Investment #2 PDF:

1 for r 3.75%
p( s)
0 otherwise
E[r] = 3.75%

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One possible measure of risk: Expected

deviation from mean.
To estimate the risk involved with the two investments, lets
calculate the expected deviation from the mean.
The deviation from the mean for any observed return is r - E[r].
Hence the expected deviation from the mean is: E[r - E[r]]
#1:
#2:

E[r-E[r]] = .75*(.10 - .0375) + .25*(-.15 - .0375) = 0

E[r-E[r]] = 1*(.0375 - .0375) = 0

Not a very helpful measure!

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Another possible measure of risk: Variance

How about finding the expected squared deviation (variance) from

the mean?

Investment #1
variance = .75*(.10-.0375)2 + .25*(-.15-.0375)2
= 0.0117

Investment #2
variance = 1*(.0375-.0375)2 = 0

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Variance

For a discrete probability function with S outcomes

S

Var (r ) p ( s )(r ( s ) E[r ]) 2 2

s 1

An alternative formula for variance:

Var (r ) E[r 2 ] E[r ]2 2

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Theoretical vs estimated

Again . . . we consider PDFs to be the underlying number

generating machines
In real life, we dont know the true properties of the underlying
(theoretical) PDF that generates the returns we observe. But the
returns we observe allow us to learn something about the
properties of the PDF that created them.
We have formulas for the theoretical expectation and the
variance. But the underlying PDF is not known so we have to use
estimates of the expectation and the variance.

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Estimation
To estimate the variance using sample observations, just take the
simple average of the squared deviations from the estimated mean
with a slight correction for estimation error.

1

n 1
2

( ri r ) .

Example:
Sample of returns: 0.10, 0.05, 0, -.03

r (0.10 0.05 0 .03) / 4 .03

2 [1 /(4 1)] *[(0.10 .03) 2 (0.05 .03) 2 (0 .03) 2 (.03 .03) 2 ]
.0033
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Statistics rule #2
If z = ax + c, where a and c are constants, and x is a random
variable, then
2
2

z a 2 x
z a x

If z = ax + by + c, where a and c are constants, and x and y are

random variables, then

z a x b y 2a x b y xy
2

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Lecture 4 outline

Discuss statistical concepts that are useful for thinking about an

assets performance and risk.
Random variables
Expectations
PDFs
Variance and standard deviation
Review the normal distribution. Use properties of the normal
distribution to answer probability questions and to solve for the
value at risk.

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What are the benefits of assuming a normal

distribution?

Easy to use in math models.

The normal distribution has well known properties and is easily
accessible via Excel and other software packages.
Are returns distributed normally?

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Normal distribution

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Are returns normally distributed?

This is a time series plot of the return process. The x-axis is
time, and the y-axis is the value of the return at that time.

0.3

Ann Taylor

0.2
0.1
0
-0.1
-0.2
-0.3
-0.4
-0.5

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How good is the normal assumption?

This is a histogram of returns. The x-axis represents possible outcomes for
the return. We divide the x-axis into bins or intervals and count the number
of returns that fall into each interval. The y-axis tells us how many days had a
return within the corresponding interval.

Ann Taylor

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The mean-variance framework

The variance on any investment measures the disparity between
actual and expected returns.

Low Variance Investment

High Variance Investment

Expected Return

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Normal distribution

Assume the PDF for your investment return is a normal

distribution.
If we know E[r] and [r] we can integrate under the normal
curve over any region using calculus (or Excel). That is we can
find the probability the return will fall within any given range.

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Using the PDF distribution to gain

understanding of possible outcomes.
Assume the PDF for your investment return is a normal
distribution with E[r]=10% and [r]=0.15.

What is the probability that r < - 20%?

What is the probability that r > 30%?

What is the probability that -20% < r <30?

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Example application of the normal

distribution: 5% Value-at-Risk (VAR)
According to your calculations, over the next year:
E[r] = 0.10
= 0.20
Find the losses you expect to incur with 5% probability.
5% VAR = 0.10 1.64*0.20 = -0.23
During any given year, you should expect to lose 23% or
more of your portfolio value with 5% probability.

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