TSAY

CHAPTER 1
Financial Data and Their Proper:es
What assets might we be interested in?
Types of analysis that rely on nancial data:
Value relevance

Modeling price/return

Modeling risk
Asset volaAlity
Value-at-risk
Expected shorEall

Market microstructure
Why do we use so many
models in nance?
 Financial data and analysis

Financial analysis can

involve cross-
secAonal, Ame series,
and/or panel data

Price is perhaps the

most basic nancial
data
 From prices to returns

Return is the gain or loss on a given investment

over a given period of Ame

Well oNen use returns rather than prices in
nancial analysis because:
1. Thats what people actually care about
2. Returns are easier to handle (i.e. beSer
staAsAcal properAes)
 One-Period Simple Return

Lets start by ignoring dividends

One-Period Simple Gross Return:
Pt
1+R =
P
t
t1

so value of asset aNer 1 period

Pt = Pt1
(1+ Rt
)
 One-Period Simple Return

One-Period Simple Net Return (way we most

commonly use it):

P
1 = P t P
Rt =
t t1

P t1 P t1

Note that we are using rst lags and rst

dierences all the stu we know!

Recall: Taking rst dierence of natural logs approximates this
 Simple versus conAnuous compounding

As we move from single to mulAperiod there

are two ways to calculate returns:

1. Simple compounding
2. ConAnuous compounding
 MulAperiod Simple Return

Discrete compound return (i.e. gross simple

return):
! # P = P *P *...* P
1+R t "k $ =
t t t1 tk+1

P k P
t t1 P t2 P tk

!k #=
1+R t " $ (1+R ) (1+R )...(1+R )
t t1 tk+1
 MulAperiod Simple Return

Discrete compound return :

# k1 &
%$ j=0
(
= % 1+ R t j )(
('

Annualized return (i.e. geometric average):

1/k
# k1 &

%$ j=0
(
= % 1+ R t j )( 1
('
 MulAperiod Simple Return

ApproximaAon of annualized discrete compound

return (using Taylor expansion):
k1
1
Rt j
k j=0
( )


From Simple to ConAnuous Compounding

P = Principle investment
FV = net value of investment aNer earning interest
i = interest rate per annum
m = Ames per year interest is paid

m
FV =P(1+i/m)
From Simple to ConAnuous Compounding

Consider principle investment of $1 with interest

at 10% per annum

m
FV =P(1+i/m)

1
FV =$1(1+0.1/1)
FV =$1.10
From Simple to ConAnuous Compounding

Consider principle investment of $1 with interest

paid semi-annually

m
FV =P(1+i/m)

2
FV =$1(1+0.1/2)
FV =$1.1025
From Simple to ConAnuous Compounding

Consider principle investment of $1 with interest

paid quarterly

m
FV =P(1+i/m)

4
FV =$1(1+0.1/4)
FV =$1.1038
 ConAnuously Compounded Return
ConAnuously compound return (i.e. log return)
where pt = ln(pt)

( ) P
r t = ln 1+ Rt = ln = pt pt1
t

P t1

Benet of using conAnuously compound return is

that mulAperiod return is just sum of one-period
returns
!k # = r + r + .... + r
rt" $ t t1 tk+1
 PorEolio Return
Simple net return
where p = porEolio with weight wi on asset i
N
R p,t
= wi Rit
i=1

ConAnuously compounded return approximaAon

(if simple returns Rit are small):
N
r p,t wi rit
i=1

 Asset Pays Dividend
Simple net return

P D +
Rt =
t t
1
P t1

ConAnuously compounded return:

rt = ln Pt
+ Dt( ln Pt1 ) ( )

 Excess Return
Dierence between an assets return and the
return on some reference asset

Simple net return

Z t = Rt R0t
ConAnuously compounded return:
z = rt r0t
t

 All About Bonds
Bond yield is return realized by bond holder

Current yield for coupon bonds:
=(Annual interest paid / Market price of bond)*100%

Current yield for zero-coupon bonds:

=[ (Face value / Purchase price) ^ (1/k) ] - 1

 All About Bonds
Yield to maturity:

= C C C +F
P + ... +
1 2 k
+
1+ y (1+ y) 2 (1+ y) 2

where P = purchase price
y = YTM
C = coupon payment
k = # of payments (where k = m*n)
m = # of payments per year
n = # of years to maturity
 All About Bonds
Discount yield for T-Bill:

= FP * 360 *100%
F DTM

where P = purchase price
F = face value
DTM = days to maturity
 VolaAlity = staAsAcal measure of the dispersion of
returns; the higher the volaAlity, the riskier the security.
 How to esAmate volaAlity
Given historical prices we know how we can
esAmate historical volaAlity

What measures of dispersion have we learned?

 How to esAmate volaAlity
So if were interested in observed volaAlity weve got
opAons.e.g. can use standard deviaAon or variance
between an assets returns and returns to the overall
market index.

And speaking of opAons (see what I did there?) on

a going forward basis we can use implied volaAlity

Recall: OpAons are nancial contracts that provide
the right to buy or sell an underlying asset at a given
price for a given period of Ame
 Implied volaAlity from Black-Scholes Model

Most commonly valued using Black-Scholes model
which considers opAon price to be a funcAon of a
bunch of stu we can preSy much directly observe
(e.g. Ame to maturity, spot price, strike price, risk free
rate) and volaAlity of returns of the underlying asset.

Use what we know to back into implied volaAlity

 Remember all the distribuAonal and
moments stu from A&P Chapter 1 Slides
Data you can easily work with
Simple returns that are:
IID
Normal
Fixed mean and
variance


Unfortunately..
Asset returns are typically
not normal for a few
reasons, including:
1. MulAperiod returns are
product of simple returns
so not normal
2. Losses are capped at
investment amount (but
normal distribuAon has
tails)
3. Returns oNen exhibit
posiAve excess kurtosis.
Log Normal is beSer bc doesnt suer from rst
two problems but sAll excess kurtosis
 TesAng Normality

T-Test for skewness

S(r)
=
6/T
T-Test for excess kurtosis


K (r) 3
=
24 / T
where T = length of <me series

 TesAng Normality
Jarque-Bera Normality Test examines both
skewness and kurtosis simultaneously

So what distribuAon should we use?
What about stable distribuAons? Their tails are
generally TOO fatand that innite variance si
gonna create another problem
So TBD
 MulAvariate returns
gets even messier
The marginal distribuAon was complicated
enough joint distribuAon (say how stocks
and bonds in your porEolio are correlated
over Ame) takes this to the next level

Its this mess that enables.