Introduction to Computational Finance and

Financial Econometrics
Return Calculations
Eric Zivot
Sept 11, 2012
The Time Value of Money
Future Value
$\ invested for a years at simple interest rate 1 per year
Compounding of interest occurs at end of year
1\
a
= $\ (1 + 1)
a
,
where 1\
a
is future value after a years
Example: Consider putting $1000 in an interest checking account that pays a
simple annual percentage rate of 3%. The future value after a = 1, 5 and 10
years is, respectively,
1\
1
= $1000 (1.03)
1
= $1030,
1\
5
= $1000 (1.03)
5
= $1159.27,
1\
10
= $1000 (1.03)
10
= $1343.92.
FV function is a relationship between four variables: 1\
a
, \, 1, a. Given three
variables, you can solve for the fourth:
Present value:
\ =
1\
a
(1 + 1)
a
.
Compound annual return:
1 =

1\
a
\

1a
1.
Investment horizon:
a =
ln(1\
a
\ )
ln(1 + 1)
.
Compounding occurs n times per year

1\
n
a
= $\

1 +
1
n

na
,
1
n
= periodic interest rate.
Continuous compounding

1\

a
= lim
n
$\

1 +
1
n

na
= $\ c
1a
,
c
1
= 2.71828.
Example: If the simple annual percentage rate is 10% then the value of $1000
at the end of one year (a = 1) for dierent values of n is given in the table
below.
Compounding Frequency
Value of $1000 at
end of 1 year (1 = 10%)
Annually (n = 1) 1100.00
Quarterly (n = 4) 1103.81
Weekly (n = 52) 1105.06
Daily (n = 365) 1105.16
Continuously (n = ) 1105.17
Eective Annual Rate
Annual rate 1

that equates 1\
n
a
with 1\
a
; i.e.,
$\

1 +
1
n

na
= $\ (1 + 1

)
a
.
Solving for 1

1 +
1
n

n
= 1 + 1

=

1 +
1
n

n
1.
Continuous compounding
$\ c
1a
= $\ (1 + 1

)
a
c
1
= (1 + 1

)
1

= c
1
1.
Example. Compute eective annual rate with semi-annual compounding
The eective annual rate associated with an investment with a simple annual
rate 1 = 10% and semi-annual compounding (n = 2) is determined by
solving
(1 + 1

) =

1 +
0.10
2

2
1

=

1 +
0.10
2

2
1 = 0.1025.
Compounding Frequency
Value of $1000 at
end of 1 year (1 = 10%)
1

Annually (n = 1) 1100.00 10%

Quarterly (n = 4) 1103.81 10.38%
Weekly (n = 52) 1105.06 10.51%
Daily (n = 365) 1105.16 10.52%
Continuously (n = ) 1105.17 10.52%
Asset Return Calculations
Simple Returns
1
t
= price at the end of month t on an asset that pays no dividends
1
t1
= price at the end of month t 1
1
t
=
1
t
1
t1
1
t1
= % M 1
t
= net return over month t,
1 + 1
t
=
1
t
1
t1
= gross return over month t.
Example. One month investment in Microsoft stock.
Buy stock at end of month t 1 at 1
t1
= $85 and sell stock at end of
next month for 1
t
= $90. Assuming that Microsoft does not pay a dividend
between months t 1 and t, the one-month simple net and gross returns are
1
t
=
$90 $85
$85
=
$90
$85
1 = 1.0588 1 = 0.0588,
1 + 1
t
= 1.0588.
The one month investment in Microsoft yielded a 5.88% per month return.
Multi-period Returns
Simple two-month return
1
t
(2) =
1
t
1
t2
1
t2
=
1
t
1
t2
1.
Relationship to one month returns
1
t
(2) =
1
t
1
t2
1 =
1
t
1
t1

1
t1
1
t2
1
= (1 + 1
t
) (1 + 1
t1
) 1.
Here
1 + 1
t
= one-month gross return over month t,
1 + 1
t1
= one-month gross return over month t 1,
=1 + 1
t
(2) = (1 + 1
t
) (1 + 1
t1
).
two-month gross return = the product of two one-month gross returns
Note: two-month returns are not additive:
1
t
(2) = 1
t
+ 1
t1
+ 1
t
1
t1
1
t
+ 1
t1
if 1
t
and 1
t1
are small
Example: Two-month return on Microsoft
Suppose that the price of Microsoft in month t 2 is $80 and no dividend is
paid between months t 2 and t. The two-month net return is
1
t
(2) =
$90 $80
$80
=
$90
$80
1 = 1.1250 1 = 0.1250,
or 12.50% per two months. The two one-month returns are
1
t1
=
$85 $80
$80
= 1.0625 1 = 0.0625
1
t
=
$90 85
$85
= 1.0588 1 = 0.0588,
and the geometric average of the two one-month gross returns is
1 + 1
t
(2) = 1.0625 1.0588 = 1.1250.
Simple I-month Return
1
t
(I) =
1
t
1
tI
1
tI
=
1
t
1
tI
1
1 + 1
t
(I) = (1 + 1
t
) (1 + 1
t1
) (1 + 1
tI+1
)
=
I1
Y
)=0
(1 + 1
t)
)
Note
1
t
(I) 6=
I1
X
)=0
1
t)
Portfolio Returns
Invest $\ in two assets: A and B for 1 period
a

= share of $\ invested in A; $\ a

= $ amount
a
1
= share of $\ invested in B; $\ a
1
= $ amount
Assume a

+ a
1
= 1
Portfolio is dened by investment shares a

and a
1
At the end of the period, the investments in A and B grow to
$\ (1 + 1
j,t
) = $\
h
a

(1 + 1
,t
) + a
1
(1 + 1
1,t
)
i
= $\
h
a

+ a
1
+ a

1
,t
+ a
1
1
1,t
i
= $\
h
1 + a

1
,t
+ a
1
1
1,t
i
1
j,t
= a

1
,t
+ a
1
1
1,t
The simple portfolio return is a share weighted average of the simple returns
on the individual assets.
Example: Portfolio of Microsoft and Starbucks stock
Purchase ten shares of each stock at the end of month t 1 at prices
1
nc)t,t1
= $85, 1
cb&a,t1
= $30,
The initial value of the portfolio is
\
t1
= 10 $85 + 10 30 = $1, 150.
The portfolio shares are
a
nc)t
= 8501150 = 0.7391, a
cb&a
= 3001150 = 0.2609.
The end of month t prices are 1
nc)t,t
= $90 and 1
cb&a,t
= $28.
Assuming Microsoft and Starbucks do not pay a dividend between periods t1
and t, the one-period returns are
1
nc)t,t
=
$90 $85
$85
= 0.0588
1
cb&a,t
=
$28 $30
$30
= 0.0667
The return on the portfolio is
1
j,t
= (0.7391)(0.0588) + (0.2609)(0.0667) = 0.02609
and the value at the end of month t is
\
t
= $1, 150 (1.02609) = $1, 180
In general, for a portfolio of a assets with investment shares a
i
such that
a
1
+ + a
a
= 1
1 + 1
j,t
=
a
X
i=1
a
i
(1 + 1
i,t
)
1
j,t
=
a
X
i=1
a
i
1
i,t
= a
1
1
1t
+ + a
a
1
at
Adjusting for Dividends
1
t
= dividend payment between months t 1 and t
1
tcto|
t
=
1
t
+ 1
t
1
t1
1
t1
=
1
t
1
t1
1
t1
+
1
t
1
t1
= capital gain return + dividend yield (gross)
1 + 1
tcto|
t
=
1
t
+ 1
t
1
t1
Example. Total return on Microsoft stock.
Buy stock in month t 1 at 1
t1
= $85 and sell the stock the next month
for 1
t
= $90. Assume Microsoft pays a $1 dividend between months t 1 and
t. The capital gain, dividend yield and total return are then
1
tcto|
t
=
$90 + $1 $85
$85
=
$90 $85
$85
+
$1
$85
= 0.0588 + 0.0118
= 0.0707
The one-month investment in Microsoft yields a 7.07% per month total return.
The capital gain component is 5.88%, and the dividend yield component is
1.18%.
Adjusting for Ination
The computation of real returns on an asset is a two step process:
Deate the nominal price 1
t
of the asset by an index of the general price
level C11
t
Compute returns in the usual way using the deated prices
1
Real
t
=
1
t
C11
t
1
Real
t
=
1
Real
t
1
Real
t1
1
Real
t1
=
1
t
C11
t

1
t1
C11
t1
1
t1
C11
t1
=
1
t
1
t1

C11
t1
C11
t
1
Alternatively, dene ination as

t
= %C11
t
=
C11
t
C11
t1
C11
t1
Then
1
Real
t
=
1 + 1
t
1 +
t
1
Example. Compute real return on Microsoft stock.
Suppose the CPI in months t 1 and t is 1 and 1.01, respectively, representing
a 1% monthly growth rate in the overall price level. The real prices of Microsoft
stock are
1
Real
t1
=
$85
1
= $85, 1
Real
t
=
$90
1.01
= $89.1089
The real monthly return is
1
Real
t
=
$89.10891 $85
$85
= 0.0483
The nominal return and ination over the month are
1
t
=
$90 $85
$85
= 0.0588,
t
=
1.01 1
1
= 0.01
Then the real return is
1
Real
t
=
1.0588
1.01
1 = 0.0483
Notice that simple real return is almost, but not quite, equal to the simple
nominal return minus the ination rate
1
Real
t
1
t

t
= 0.0588 0.01 = 0.0488
Annualizing Returns
Returns are often converted to an annual return to establish a standard for
comparison
Example: Assume same monthly return 1
n
for 12 months:
Compound annual gross return = 1 + 1

= 1 + 1
t
(12) = (1 + 1
n
)
12
Compound annual net return = 1

= (1 + 1
n
)
12
1
Example. Annualized return on Microsoft
Suppose the one-month return, 1
t
, on Microsoft stock is 5.88%. If we assume
that we can get this return for 12 months then the compounded annualized
return is
1

= (1.0588)
12
1 = 1.9850 1 = 0.9850
or 98.50% per year. Pretty good!
Example. Annualized two-year return
Suppose that the price of Microsoft stock 24 months ago is 1
t24
= $50 and
the price today is 1
t
= $90. The two year gross return is
1 + 1
t
(24) =
$90
$50
= 1.800
which yields a two year net return of 1
t
(24) = 0.80 = 80%. The compound
annual return for this investment is dened as
(1 + 1

)
2
= 1 + 1
t
(24) = 1.800
1

= (1.800)
12
1 = 1.3416 1 = 0.3416
or 34.16% per year.
Contnuously Compounded (cc) Returns
v
t
= ln(1 + 1
t
) = ln

1
t
1
t1
!
ln() = natural log function
Note:
ln(1 + 1
t
) = v
t
: given 1
t
we can solve for v
t
1
t
= c
v
t
1 : given v
t
we can solve for 1
t
v
t
is always smaller than 1
t
Digression on natural log and exponential functions
ln(0) = , ln(1) = 0
c

= 0, c
0
= 1, c
1
= 2.7183

o ln(a)
oa
=
1
a
,
oc
a
oa
= c
a
ln(c
a
) = a, c
ln(a)
= a
ln(a j) = ln(a) + ln(j); ln(
a
j
) = ln(a) ln(j)
ln(a
j
) = j ln(a)
c
a
c
j
= c
a+j
, c
a
c
j
= c
aj
(c
a
)
j
= c
aj
Intuition
c
v
t
= c
ln(1+1
t
)
= c
ln(1
t
1
t1
)
=
1
t
1
t1
=1
t1
c
v
t
= 1
t
=v
t
= cc growth rate in prices between months t 1 and t
Result. If 1
t
is small then
v
t
= ln(1 + 1
t
) 1
t
Proof. For a function )(a), a rst order Taylor series expansion about a = a
0
is
)(a) = )(a
0
) +
o
oa
)(a
0
)(a a
0
) + remainder
Let )(a) = ln(1 + a) and a
0
= 0. Note that
o
oa
ln(1 + a) =
1
1 + a
,
o
oa
ln(1 + a
0
) = 1
Then
ln(1 + a) ln(1) + 1 a = 0 + a = a
Computational Trick
v
t
= ln

1
t
1
t1
!
= ln(1
t
) ln(1
t1
)
= j
t
j
t1
= dierence in log prices
where
j
t
= ln(1
t
)
Example. Compute cc return
Let 1
t1
= 85, 1
t
= 90 and 1
t
= 0.0588. Then the cc monthly return can
be computed in two ways:
v
t
= ln(1.0588) = 0.0571
v
t
= ln(90) ln(85) = 4.4998 4.4427 = 0.0571.
Notice that v
t
is slightly smaller than 1
t
.
Multi-period Returns
v
t
(2) = ln(1 + 1
t
(2))
= ln

1
t
1
t2
!
= j
t
j
t2
Note that
c
v
t
(2)
= c
ln(1
t
1
t2
)
1
t2
c
v
t
(2)
= 1
t
=v
t
(2) = cc growth rate in prices between months t 2 and t
Result: cc returns are additive
v
t
(2) = ln

1
t
1
t1

1
t1
1
t2
!
= ln

1
t
1
t1
!
+ ln

1
t1
1
t2
!
= v
t
+ v
t1
where v
t
= cc return between months t 1 and t, v
t1
= cc return between
months t 2 and t 1
Example. Compute cc two-month return
Suppose 1
t2
= 80, 1
t1
= 85 and 1
t
= 90. The cc two-month return can
be computed in two equivalent ways: (1) take dierence in log prices
v
t
(2) = ln(90) ln(80) = 4.4998 4.3820 = 0.1178.
(2) sum the two cc one-month returns
v
t
= ln(90) ln(85) = 0.0571
v
t1
= ln(85) ln(80) = 0.0607
v
t
(2) = 0.0571 + 0.0607 = 0.1178.
Notice that v
t
(2) = 0.1178 < 1
t
(2) = 0.1250.
General Result
v
t
(I) = ln(1 + 1
t
(I)) = ln(
1
t
1
tI
)
=
I1
X
)=0
v
t)
= v
t
+ v
t1
+ + v
tI+1
Portfolio Returns
1
j,t
=
a
X
i=1
a
i
1
i,t
v
j,t
= ln(1 + 1
j,t
) = ln(1 +
a
X
i=1
a
i
1
i,t
) 6=
a
X
i=1
a
i
v
i,t
portfolio returns are not additive
Note: If 1
j,t
=
P
a
i=1
a
i
1
i,t
is not too large, then v
j,t
1
j,t
otherwise,
1
j,t
v
j,t
.
Example. Compute cc return on portfolio
Consider a portfolio of Microsoft and Starbucks stock with
a
nc)t
= 0.25, a
cb&a
= 0.75,
1
nc)t,t
= 0.0588, 1
cb&a,t
= 0.0503
1
j,t
= a
nc)t
1
nc)t,t
+ a
cb&a,t
1
cb&a,t
= 0.02302
The cc portfolio return is
v
j,t
= ln(1 0.02302) = ln(0.977) = 0.02329
Note
v
nc)t,t
= ln(1 + 0.0588) = 0.05714
v
cb&a,t
= ln(1 0.0503) = 0.05161
a
nc)t
v
nc)t
+ a
cb&a
v
cb&a
= 0.02442 6= v
j,t
Adjusting for Ination
The cc one period real return is
v
Real
t
= ln(1 + 1
Real
t
)
1 + 1
Real
t
=
1
t
1
t1

C11
t1
C11
t
It follows that
v
Real
t
= ln

1
t
1
t1

C11
t1
C11
t
!
= ln

1
t
1
t1
!
+ ln

C11
t1
C11
t
!
= ln(1
t
) ln(1
t1
) + ln(C11
t1
) ln(C11
t
)
= v
t

cc
t
where
v
t
= ln(1
t
) ln(1
t1
) = nominal cc return

cc
t
= ln(C11
t
) ln(C11
t1
) = cc ination
Example. Compute cc real return
Suppose:
1
t
= 0.0588

t
= 0.01
1
Real
t
= 0.0483
The real cc return is
v
Real
t
= ln(1 + 1
Real
t
) = ln(1.0483) = 0.047.
Equivalently,
v
Real
t
= v
t

cc
t
= ln(1.0588) ln(1.01) = 0.047