Financial Subject: Return, variance, covariance and beta

Return may be measured either with a discrete or a continuous compounding. Using a

continuous compounding return assumes that P t = P t-1 exp (r t ) where r t is the rate of return
during the period (t-1, t), and P t the price of the asset at period t. Suppose that r 1 , r 2 ,r 12 are
the returns for 12 periods then the price of the stock at the end of the 12 periods will be:

P 12 = P 0 exp (r 1 +r 2 .r 12 )

To measure risk, finance often relies on standard deviation, noted . The standard deviation is
the square root of the variance. Statistically the standard deviation measures the average
dispersion to mean (or central value). Standard deviation has the great advantage when
compared to variance to be expressed in the same unit as the one in which the data are
measured.

Mathematically, for data X, we have thus

= ( 2 ) (())2

E(X) is the expected value of variable X, or by definition its mean value. Let us consider X to
be the return of a stock. Let us also consider that we have n observable values of the return. X
takes thus the observable values where i=1,., n then we have

1
= ( )2
1
=1

Where is the mean of variable X. The division by (n-1) takes into account the loss of one
degree of freedom.

In portfolio theory, the risk corresponds usually to the variance of the stocks return, and not
the stocks price.

The covariance measures the degree to which variables change together. When variables tend to move
on the same direction the variance is positive. When it is negative, the variables tend to move in
opposite direction. Usually the temperature and the number of sales of wool scarfs are two variables
which exhibit a negative covariance: when the temperature goes up, you sell fewer scarfs. If we take
two variables X and Y we have

(, ) = {( [])( [])}

By definition you can notice that the covariance of a variable with itself is equal to its variance.
The equity beta, also referred to as the levered beta, can be estimated by taking a ratio of the
the historical covariance between the daily share price return and the daily index return (used
as a proxy for the whole market) and the variance of the daily market return.

Cov( Ri , RM )
i =
Var ( RM )