Course Introduction Introduction Returns and Statistics Markets and Margins Utility and Portfolio Review

Finance 385: Finance Theory I

David Newton
Course Introduction Introduction Returns and Statistics Markets and Margins Utility and Portfolio Review

Essentials
Contact information
Section(s): G
Professor: David Newton
Email: davenewt@jmsb.concordia.ca
Classes: Tuesday 8:45 to 11:30 in MB S2.401
Office: MB 12-221
Office hours: Tuesday 15:30 - 16:30
Course information
Required Text: Bodie, Kane, Marcus, Perrakis and Ryan, Investments (8th )
Evaluation: Midterm (30%), Assignments (20%), Final* (50%)
Calculator policy: Select financial models allowed (see Firstclass)
Food policy: GIGO
Laptop policy: Back row only
Attendance policy: As you see fit
*A grade of 40% must be achieved on the final exam in order to pass the course.
Course Introduction Introduction Returns and Statistics Markets and Margins Utility and Portfolio Review

Academic Integrity

The Academic Code of Conduct at Concordia University states that the "integrity
of University academic life and of the degrees, diplomas and certificates the
University confers is dependent upon the honesty and soundness of the
instructor-student learning relationship and, in particular, that of the evaluation
process. As such, all students are expected to be honest in all of their academic
endeavours and relationships with the University." (Undergraduate Calendar,
section 17.10.3 or Graduate Calendar, Academic Code of Conduct).

All students enrolled at Concordia are expected to familiarize themselves with

the contents of this Code. You are strongly encouraged to visit
http://provost.concordia.ca/academicintegrity, which provides useful information
about proper academic conduct. Make sure to take the Academic Integrity Test if
you have not done it already.
Course Introduction Introduction Returns and Statistics Markets and Margins Utility and Portfolio Review

Lecture 1 Overview

Lecture Objectives
By the end of this lecture you should be able to:
1 Define risk premium, risk-free rate, excess and abnormal returns
2 Compute the standard deviation, skewness and kurtosis of a time series
3 Compute the geometric or arithmetic returns of a time series
4 Convert the real rate of interest into nominal and vice versa
5 Convert between and understand difference between APR and EAR
6 Compute the correlation and covariance between time series
7 Compute and interpret the Sharpe ratio
8 Define Value at Risk (VaR)
Course Introduction Introduction Returns and Statistics Markets and Margins Utility and Portfolio Review

Required Definitions

Time Series: A time-series is a set of data that spans some period of time. An example of
such a series is the height of your little nephew, measured at monthly intervals, for the last
five years. In this course most time-series of interest will be those that are financial security
returns over some period of time.
Cross Section: A cross-section is a set of data that spans individual objects of study. An
example of this is the height of everyone in the class. In this course we will not discuss
cross-sectional data as much as time-series data but it is good to keep the term clear in your
mind to distinguish the difference.
Moment: In mathematics we use the term ’moments of a distribution’ to describe the various
characteristics of that distribution. The first moment should be very familiar to you, it is the
Mean (average) of a distribution. The second moment is also familiar, it is the Variance of a
distribution. Skewness and Kurtosis are the third and fourth moments respectively and we’ll
describe them in greater detail in this class.
Course Introduction Introduction Returns and Statistics Markets and Margins Utility and Portfolio Review

Return fundamentals
Throughout this course we will often talk about Returns. When we evoke this term we mean to say a time series or many
time series of rates of return on some set of financial securities.
An example of a returns series is the subset of the (daily) ’returns’ for Atlas Pipeline Partners (APL) in July 2010: -6.15%,
-4.17%, -2.17%, 0.11%, -3.17%, 5.46%, 10.56%, 0.66%
A return is computed by finding the net dollar amount earned on a given date and dividing by the dollar amount original
invested.

The Holding Period Return (HPR) on a financial security Ri , is computed by the expression Ri = TP 0 where PT is
P −P
0
the total cash-flow (price plus any accrued income stream such as dividends) received for a security i at time T and P0 is
the original price paid for that security
Note that if dividends or other payments are received in addition to the sale price this must also be included in the HPR

Timing of returns

Ex Ante (return): Before the fact, an expected event.

Ex Post (return): After the fact, something that has been realized.

Excess versus Abnormal returns

Excess return: Return that exceeds the risk-free rate, Excess Return = Ri − rf
Abnormal return: Return that exceeds what was predicted, Abnormal Return = Ri − E [Ri ]
Course Introduction Introduction Returns and Statistics Markets and Margins Utility and Portfolio Review

Notation

Notation Interpretation Example

X
e A random variable X The stock return for IBM tomorrow

E[X] or X̄ or µ The expectation of variable X The expected return for IBM tomorrow

E[X|Z] The expectation of a variable condi- The expected return for IBM tomorrow
tioning on some information Z given they win a contract

To compute the expected

P return simply find the probability-weighted average of all outcomes,
namely E [X ] = i πi Xi
Additional Notation: β - The Beta (a risk-measure) of a financial security; α - The Alpha
(abnormal return) of a financial security; σi - The standard deviation of the i th ’s financial
security return; E [RM ] - Expected return of the Market; rf - The risk-free rate; N - The
number of observations in a data set; πi - The probability of state i occurring
Course Introduction Introduction Returns and Statistics Markets and Margins Utility and Portfolio Review

Moment computations
Moment Calculation Use

First/Mean µ = E [X ] Informs you of the average out-

come to expect

Second/Variance σ 2 = E [(X − X̄ )2 ] Informs you of the variability of

outcomes

E [(X −X̄ )3 ] E [(X −X̄ )3 ]

E [(X −X̄ )2 ]3/ 2 σ3
Third/Skewness skew = = Informs you of the relative pre-
ponderance to very-small or very-
large outcomes

E [(X −X̄ )4 ] E [(X −X̄ )4 ]

E [(X −X̄ )2 ]4/ 2 σ4
Fourth/Kurtosis kurt = = Informs you of the likelihood of ex-
treme events (fat-tails)

Note: In your text the formula for kurtosis subtracts 3 from the expression above. This is because your text is computing
Excess kurtosis which is a measure of kurtosis that exceeds the normal distributions’ value of 3. Either method can be correct
it really depends if you are comparing to the normal distribution or not.
Course Introduction Introduction Returns and Statistics Markets and Margins Utility and Portfolio Review

Visually interpreting skew and kurtosis

Kurtosis of well-known distributions

Course Introduction Introduction Returns and Statistics Markets and Margins Utility and Portfolio Review

Measuring Returns
Once returns are realized (have occurred in the past) then you can compute average
returns. You can compute arithmetic (or simple) averages or geometric averages. The
geometric average (mean) considers the effect of compounding.
Pn
ri
Arithmetic mean (AM) = i=1 (1)
n
v
u n
uY 1
Geometric mean (GM) = t n
(1 + ri ) − 1 = [(1 + r1 )(1 + r2 )...] n (2)
i=1

 An example of computing AM and GM follows to illustrate the difference:

r1 r2 r3
Returns 4% 20% -7%

AM = (4%+20%-7%)/3 = 5.67%

3
(1.04)(1.20)(0.93) - 1 = 5.09%
p
GM =
Course Introduction Introduction Returns and Statistics Markets and Margins Utility and Portfolio Review

Real and Nominal rates

An interest rate can be real or nominal. You will observe nominal rates in the economy
whenever you see a rate of return given, such as 3%/year on a GIC.
A real rate of return differs from a nominal one in that it considers the effects of inflation.
Thus a real rate of return tells you how much you receive above and beyond the effects of
inflation. If you earn 10%/year but prices of goods increase by 10%/year then in fact your real
return is zero.
Use the following formula to convert between nominal and real rates of return (if you know of
the Fisher approximation please refrain from using it as it is inaccurate):

1 + rnominal
rreal = −1
1 + inflation rate
(3)

For example if a bond is expected to yield 5%/year (nominal) but the inflation rate is 2% then
the real rate of return is (1+0.05)/(1.02)-1 or approximately 2.94%
Course Introduction Introduction Returns and Statistics Markets and Margins Utility and Portfolio Review

APR and EAR

When discussing rates it is very important that you know the difference between the Annual
Percentage Rate (APR) and the Effective Annual Rate EAR
The APR is NOT the actual rate of interest you pay. It is the annual term rate computed from
the nominal rate originally given.
The EAR IS the actual rate of interest you pay. You should always convert your APRs into
EARs before proceeding with any project valuation computations (such as NPV).
For example a credit card company quotes you a 24% APR compounded monthly. This means
that your actual rate of interest is a monthly one (not annual). To get the effective monthly
rate divide the 24% by 12 (12 months per year) and you’ll get 2%/month effective.
Next if you want the EAR or the actual effective annual rate of your credit card you take the
effective monthly rate and compound it twelve times (12 months), thus considering the effects
of geometric growth.
In this case your EAR is 1.0212 − 1 ≈ 26.8% while your APR is 24%. This means your
credit card contract will say you have a 24% rate (APR) but if you borrow $100 at the
beginning of the year you will actually owe $126.80 (EAR) at the end of year.
Course Introduction Introduction Returns and Statistics Markets and Margins Utility and Portfolio Review

Covariance and Correlation

Covariance is the measure of how much one variable varies simultaneously as another
variable varies. For example, the weight of an individual often co-varies with their height.
Correlation is a scaled measure of covariance. The scaling allows for easy interpretation.
The equation for covariance between two series, A and B, is:
n
X
COVAB = πi (rA,i − r¯A )(rB,i − r¯B ) (4)
i=1
The correlation between two series is:

COVAB
ρAB = (5)
σA σB

Correlation Interpretation
-1 Perfect negative correlation: The two series move in exactly opposite directions
>-1,<0 Negative correlation: The two series tend to move in opposite directions
0 Uncorrelated: The movement of one series is not related to movement in the other
>0,<1 Positive correlation: The two series tend to move in the same direction
1 Perfect positive correlation: The two series move in exactly the same direction
Course Introduction Introduction Returns and Statistics Markets and Margins Utility and Portfolio Review

Essential review
Your previous Comm 308 should have already informed you to the basics of financial markets
but we do a quick review here as well to refresh your memory
Financial securities are contracts traded between individuals and firms that state obligations
to be paid under certain conditions
Both stocks/equities and bonds/debt can be traded as financial securities and they may be
traded either in exchange markets or OTC (over the counter)
Exchange markets may vary in their exact operation but generally speaking there is a single
location from which all trades occur and there is often a market-maker who acts as an agent
on behalf of the exchange that facilitates an orderly market
OTC markets in contrast come from a history where many markets might run simultaneously
and where there was no single clearing location of trades; this could result in many different
prices for the exact same financial security in different locations. Modern information
technology has made this aspect of OTC much less severe and so the market can resemble an
exchange market
Market trades are facilitated by both market intermediaries, who serve just to bring buyers
and sellers together, and financial intermediaries, who can serve the role of market
intermediaries but may also transform the financial securities in the process
Course Introduction Introduction Returns and Statistics Markets and Margins Utility and Portfolio Review

Essential review continued

When a financial security trades there is often a transaction fee which is payable to the
broker who executed the trade
Another cost of transacting is that there is not a ‘certain’ price in the market per se but rather
bids and asks
In the case of an exchange market with a market maker, the maker will have access to the
order book that will give them information of all the various bid and ask volumes at various
prices
The market maker then executes trades where the bid of a prospective buyer exceeds the ask
of a prospective seller (eg. the buyer is willing to pay more than the seller is demanding)
Having access to the order book is an obvious and superlative trading advantage but the
market maker’s role is to assist the market transact in an orderly manner. The maker is
therefore often required to maintain an inventory of the financial security and to sell that
inventory when demand is high or buy up slack supply when demand is low
Sometimes markets are said to be illiquid as is the case when converting a security into cash
is a very costly or lengthy process. You might imagine selling antique and jewel encrusted
hair combs as an example of an illiquid market for converting those assets into cash will be
slow and arduous. In contrast an liquid asset is readily convertible into cash as is the case
with most blue-chip stocks
Course Introduction Introduction Returns and Statistics Markets and Margins Utility and Portfolio Review

Essential review: Order books and orders

Bid-ask spread is the difference between the highest bid and the lowest ask. Wide spreads are often a sign of an illiquid
market since trading will be infrequent.
Initial market Market cleared
Price Bids (lots) Asks Price Bids (lots) Asks
11 - 5 11 - 5 (unfilled)
10.50 1 7 10.50 - 6 (1 filled)
10.25 5 5 ⇒ 10.25 - -
10 10 - 10 10 (unfilled) -
9.50 10 - 9.50 10 (unfilled) -
7 10 - 7 10 (unfilled) -
Once the market has settled, there is now a bid-ask spread of 50 cents (10.50-10). Since the highest bid (10) does not
overlap with the lowest ask (10.50) there is no trading until new supply or demand comes into the book.
You can also see that between the $10 and $9.50 prices there is a fair bit of buying support (20 lots demanded) but below
the $9.50 price the next layer of support is only at $7. Thus if sellers tried to sell a lot of shares (21 or more) they’d see the
share price slowly decline from 10 to 9.50 but then suddenly drop to 7.
Market makers are aware of the support levels and will try to keep trading in a range where there is a bit of support on both
supply and demand sides to allow for the stock price to evolve more gradually without too much volatility.
Order types

Market order: Execute the trade at the prevailing price

Limit order: Execute the trade so long as the price is past some limit price (don’t buy above price X, don’t sell below price Y)
Day order: Execute the trade today or cancel the order
Fill-or-kill (FOK) order: Execute the entire trade immediately at one price or cancel the entire order
Stop order: Execute the trade when a specific condition arises, such as the price falling. Often used in stop loss orders
where shares begin to sell if the stock price falls below $X/share.
Course Introduction Introduction Returns and Statistics Markets and Margins Utility and Portfolio Review

Essential review concluded

As an investor you will sometimes be interested in knowing how a broad part of an exchange is performing over a period of
time. Exchanges such as the New York Stock Exchange (NYSE) or the Toronto Stock Exchange (TSX) have index securities
which are traded portfolio securities that roughly replicate the holdings of the entire exchange or some subsection. Examples
of this include the S&P500 index which tracks the performance of the 500 largest listed US companies or the Dow Jones
Industrial (average) Index (DJIA)
Investors can buy other kinds of securitized assets which are claims against a part of a portfolio of securities. Examples of
this include Mutual funds, Real estate investment trust certificates (REITs), and Mortgage backed securities (MBS)
When purchasing such securities an investor should inquire as to the Management expense ratio (MER) which is the cost
charged per dollar under management
Index funds as described before often have very low MERs as do many Exchange Traded Funds (ETFs). Mutual funds and
Hedge funds will often have higher MERs than tracking funds such as the SPDR which is meant to track the S&P500.
Higher MERs are often justified by an active management style versus a passive style as the former requires more research
and effort on the part of managers
Canadians will often hold their Mutual funds inside a Registered retirement savings account (RRSP) which allows them to
deduct contributions to this account from their income. Later when they draw out of this account they will pay taxes on the
withdrawals but this is often done at a latter time in life where their marginal tax rate is lower assuming a progressive tax
system
Course Introduction Introduction Returns and Statistics Markets and Margins Utility and Portfolio Review

Buying on Margin

Margin trading occurs when the investor has a portfolio which consists of not only assets but potential liabilities.
The broker of the investor will require the investor to post margin, or put up additional collateral to help insure their portfolio
This is necessary because the investor’s portfolio consists of liabilities which could theoretically dominate the value of the
investor’s assets. At such a moment the portfolio would have negative value and the investor might elect to ‘walk-away’ in the
form of bankruptcy.
The broker would then be left having to settle out the shortfall between the investor’s assets and liabilities
In practice margin accounts often occur when a prospective investor wants to buy a stock but has to borrow money to do so.
The investor can take a short-term loan from the broker but the broker will require that the investor maintains a margin or
buffer of additional cash in case of a market downturn

Margin

Shortfall
Assets Liabilities
Liabilities Assets
Course Introduction Introduction Returns and Statistics Markets and Margins Utility and Portfolio Review

Maintenance and calls

A diligent broker will not allow a margin account to get into a shortfall situation for once it
does the client may declare bankruptcy and cause the broker to recognize an instantaneous
loss.
Thus, as the value of the assets in the margin account fall, and the margin shrinks the broker
will make a margin call to the investor. The call will notify that the investor must post
additional margin, or put more money into the account to ensure that assets exceed liabilities.
If the investor is unable/unwilling to post the margin the broker will close the account by
settling-out any positions. The broker will do this while the margin is still positive (albeit
small) in order to ensure that they do not lose any value though it is likely that the investor
will suffer severe losses in such a case.
To ensure the account can be settled out a margin ratio is a threshold which determines when
a margin call is made. If the account falls below a pre-specified margin ratio (often 30%) then
a call is made.

Margin ratio
Equity Value Market value of assets - Loan
Margin ratio = Market value of assets = Market value of assets

Please note that some accounts will differentiate between original margin and maintenance
margin. The original margin ratio is often higher than a maintenance margin. In effect the
investor using the margin account needs to make a rather large equity contribution at the
beginning to open the account but then will be allowed to maintain a smaller level of equity
in the account to keep it open before a margin call is triggered.
Course Introduction Introduction Returns and Statistics Markets and Margins Utility and Portfolio Review

Margin call example

Bob wants to buy $13,300 of AAPL stock but only has $9,880 of his own capital. Assuming that AAPL is currently trading at
$380 per share, that Bob’s broker offers a margin account with a 30% margin ratio and that there are no transaction costs
answer the following questions:

1 What is the value of the loan that Bob has to take?

2 What is his current margin ratio?
3 If AAPL collapse to $100 what would be the impact to Bob’s position and how much additional margin would he need to post?
4 What would be his return if AAPL shares instead increase by 10% from their price of $380 each and he settles out his
account?

Let us tackle these questions sequentially:

1) 13,300-9,880 = 3,420
2) (13,300 - 3,420)/(13,300) = 0.7428 or 74.3%
3) Bob originally has 35 shares ($13,300/$380 ea. = 35) so if the price falls to $100 he’ll only have $3500 (100x35) in
assets thus his margin ratio would be (3500-3420)/3500 = 0.0233 or 2.3%. He needs to post enough margin to restore the
ratio to 30% thus:
(3500+x-3420)/(3500+x) = 0.3, 80+x = 1050+0.3x, 0.7x = 970, x = $1385.72
4) Rp = (35(380)(1.1)-3420)/9,880 -1 = 0.1346 or 13.46%

Notice how Bob’s return on his portfolio (13%) exceeds that of the stock price increasing (10%). This is because trading on
margin is the same as borrowing to trade and Bob has leveraged his position using other people’s money. If his bet is correct
and AAPL is increasing his rewards will be greater than if he only invested his own funds but if he’s wrong he stands to lose
his capital on much smaller stock declines
Course Introduction Introduction Returns and Statistics Markets and Margins Utility and Portfolio Review

Utility theory primer

The utility function u(X) maps the consumption of some quantity of goods/wealth, X, into utiles (a measure of utility)
Expected utility theory (EUT) predicts that individuals will attempt to optimize their expected utility
EUT arose as a result of the formation of the insurance industry and problems associated with computing the value individuals
would be willing to pay for insurance. An example that demonstrates the need for EUT is the St.Petersbourg Paradox
Paradox example: How much would you pay for a game of chance that where you consecutively flip a fair coin and receive
$2N where N is the number of flips made without heads appearing?
The expectation of this game is: E [X ] = 1/ 2 ∗ 20 + 1/ 22 ∗ 21 + 1/ 23 ∗ 22 + ... = 1/ 2 + 1/ 2 + 1/ 2 + ... → ∞ and
yet nobody would ever be willing to pay infinite dollars to play this game; this was the paradox that Bernouilli tackled in
1738 when he introduced the idea of a utility function with marginally decreasing utility in the argument, e.g. E [X ] = ∞
but allows E [u(X )] 6= ∞
EUT was not put into general use by economists until the seminal work of Von Neumann and Morgenstern (hereafter VNM,
Theory of Games and Economics Behavior 1944). This was because previous to VNM it was not clear that ’utiles’ existed.
VNM’s contribution was to show that utiles didn’t to exist at all for EUT to be useful as an economist could write down a
function with particular cardinality that would reflect a set of ordinal preferences.
Course Introduction Introduction Returns and Statistics Markets and Margins Utility and Portfolio Review

Utility examples

Some commonly used utility functions include:

Title Equation First derivative

Quadratic utility u(x) = αx − γx 2 α − 2γx
Power utility u(x) = x 1−γ /(1 − γ) x −γ
Log-utility u(x) = ln(x) 1/x
Exponential utility u(x) = −e −γx γe −γx

Example of use: Bob could receive $15 without any risk or could receive $20 80% of the time
and $5 20% of the time; which would Bob prefer if his preferences are represented by the
power utility function where γ = 0.5?
His first option yields an expected utility of 7.746 (1.0u($15) = 150.5 /(0.5) = 7.746)
whereas his second option yields an expected utility of
(0.80u($20)+0.20u($5) = 0.80∗200.5 /(0.5)+0.20∗50.5 /(0.5) = 7.155+0.894 = 8.05).
As 8.05>7.746 Bob prefers the second choice.
Course Introduction Introduction Returns and Statistics Markets and Margins Utility and Portfolio Review

Risk-Aversion
To be risk averse means that you prefer certain outcomes to uncertain ones of equal
expectation. In Finance we take this to mean that you dislike risk as often measured by
variance of returns.
To demonstrate risk-aversion consider a gamble which pays $10 50% of the time and $0 the
remaining 50% of the time. The expectation of this gamble is clearly 0.50($10)+0.50($0) =
$5.
√
However for a person with root-utility (u(x) = x) the utility of this gamble is just
0.5(u(10))+0.5(u(0))=1.5811. We can use this expected utility to compute the certainty
equivalent (CEQ) which is the certain/guaranteed dollar amount this person would be equally
happy to have as the gamble. The calculation for this is 1.0u(x) = 1.5811 ⇒ x = $2.50.
Thus the individual described would only be willing to pay $2.50 for this game of chance
even though the expected payoff is $5. The difference between these two values is what we
call a risk premium.
A risk-premium is an amount of money required by an investor to compensate them for
bearing risk. In the example above the individual investor required a premium of $2.50 to hold
the risky security (E(R)-CEQ=$5-$2.50=$2.50).
As an aside, individuals are normally thought to be risk-averse while corporations or
diversified funds are thought to be risk-neutral. Obsessive gamblers are thought to be
risk-lovers.
Course Introduction Introduction Returns and Statistics Markets and Margins Utility and Portfolio Review

Indifference curves and utility

One can plot the Indifference curve of a utility function
In the left panel below we demonstrate an intuitive tradeoff between salary and leisure time.
Generally everyone prefers to have more salary and everyone prefers to have more leisure
time. The indifference curve plots the various combinations of leisure and salary to which an
individual is indifferent.
In the right panel the depiction is of the risk-reward tradeoff. Generally individuals are
assumed to prefer reward but dislike risk. They only take on risk in order to gain reward.
The portfolio on the furthest out indifference curve that contacts the border of the available set
is the preferred portfolio of an individual with the preferences depicted by the indifference
curves on the plot.
Course Introduction Introduction Returns and Statistics Markets and Margins Utility and Portfolio Review

Sharpe Ratio

The Sharpe Ratio is a measure of return per unit of risk

Reward is measured as the excess holding period return of a particular financial security
Risk is measures as the standard deviation of the returns of said security over the holding
period
All else equal investors are expected to prefer higher Sharpe Ratios as that would imply they
are receiving large excess returns for minimal variance in their portfolio value
Equilibrium arguments can be used to show how all securities should have the same identical
Sharpe ratio. This argument can be thus used to produce the Capital Asset Pricing Model
(CAPM)
Be aware that the Sharpe Ratio is only as good as the theory guiding it (which says
investors dislike all variance of returns) and the numbers you feed into it (the estimates of
return and risk)

Reward E [Ri ] − rf
= (6)
σ
| {zi
Risk
}
Sharpe ratio
Course Introduction Introduction Returns and Statistics Markets and Margins Utility and Portfolio Review

Treynor Measure
Though the Sharpe ratio is a little dated, it’s still a useful way of getting a general feel for
the rate of return per unit of risk for an investment.
The Sharpe ratio can of course be criticized on the basis that risk in a CAPM world is not
measured by variance but by Beta.
Thus Treynor proposed an alternative measure that scales return by units of risk as measured
by the CAPM beta.
Of course, the Treynor measure suffers many of the same criticisms as the Sharpe ratio. The
estimate is only as good as the input variables and furthermore, in the case of Treynor, the
estimate relies on the validity of the CAPM. This is because risk is ostensibly being
measured by Beta.
As modern Finance has developed we’ve come to accept some additional risk factors which
we’ll discuss later in the course but which we can state now challenge the Treynor measure.
In fact, the entire idea of a return-risk ratio is difficult if risk is multidimensional. That is, if
there should be a few different factors in the denominator it is not clear how we should add
them together.

Reward E [Ri ] − rf
= (7)
Risk β
| {z }
Treynor measure
Course Introduction Introduction Returns and Statistics Markets and Margins Utility and Portfolio Review

Value at Risk

Value at Risk, often referred to as VaR and not to be confused with VAR(iance), is another
way (other than standard deviation) of measuring the risk of investing.
To compute VaR you must first know the distribution of returns for some security. You then
find the dollar amount than N% of the distribution is below.
For example if someone tells you that their portfolio has a VaR daily loss of $1M at 5% they
are informing you that 95% of the time their portfolio will sustain losses less than $1M over
the span of a single day. VaR thus measure ’how bad’ the left tail of a distribution is.
Common VaRs are at 1% and 5%.
While VaR is extremely popular and used in industry it is sometimes described as ’an airbag
that works all the time excepts during accidents’.
The principle idea of VaR is to control risk by limiting the dollar loss that a particular
portfolio or trading strategy will sustain over a specified period of time. The difficulty arises
from the fact that during extraordinary market conditions the distribution of returns may not
be known, a concept defined as Knightian Uncertainty.
In fact the distribution of returns may even change over time, violating the assumption of
Stationarity, and rendering any VaR value meaningless.
Course Introduction Introduction Returns and Statistics Markets and Margins Utility and Portfolio Review

Value at Risk example

Suppose you observe the dollar losses of a trading strategy given below. You assume stationarity so that the past empirically
measured distribution can be used to estimate the future losses and thus you can compute Value at Risk (VaR).
As you can see from the histogram below this particular strategy suffers $0 37% of the time (37 days of 100). The strategy
suffers losses greater than $5 million 2% of the time and losses greater than $4 million 7% of the time (5+0+2).
If a bank needed to maintain enough capital to ensure solvency 90% of the time on this trading strategy they would need just
over $3.54M; 93% of the time losses are equal to or less than this amount.
Course Introduction Introduction Returns and Statistics Markets and Margins Utility and Portfolio Review

Next Class

Next Lecture
In the next lecture we’ll continue the discussion on utility theory and begin our treatment
of portfolio theory.

Homework
Read chapters 5,6 and 7
Ensure your FirstClass account is working