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Excess Return and Risk Analysis Methods

The document discusses the estimation of return, excess return, and risk in investments, detailing how returns are calculated for assets like gold and equities. It explains the computation of excess returns over a risk-free rate and the expected return as the average of historical returns. Additionally, it outlines the assessment of investment risk through variance and standard deviation, indicating the level of volatility and uncertainty in asset returns.

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Monaj Jana
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5 views2 pages

Excess Return and Risk Analysis Methods

The document discusses the estimation of return, excess return, and risk in investments, detailing how returns are calculated for assets like gold and equities. It explains the computation of excess returns over a risk-free rate and the expected return as the average of historical returns. Additionally, it outlines the assessment of investment risk through variance and standard deviation, indicating the level of volatility and uncertainty in asset returns.

Uploaded by

Monaj Jana
Copyright
© All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd

Estimation of Return, Excess Return, and Risk

Return Estimation
The concept of return refers to the gain or loss realized from an investment over a specific
holding period. For gold, return is derived purely from price appreciation. In the case of
equities, the return comprises both capital gains (price appreciation) and income generated
in the form of dividends.
Daily closing prices were collected for each asset, and the return was calculated using the
following formula:
r = (P₁ - P₀) / P₀
Where:
- P₁: Price at the end of the period
- P₀: Price at the beginning of the period
- r: Return over the period
This formula captures the proportional change in price, which forms the basis for further
risk and performance analysis.

Excess Return Computation


To evaluate the true investment performance beyond risk-free alternatives, excess returns
were calculated. The excess return represents the additional return an asset generates over
the prevailing risk-free rate, which in this study is proxied by the average annual yield of the
364-day Treasury Bill.
Eᵣ = r - r𝒻
Where:

r𝒻:
- Eᵣ: Excess return
- Risk-free rate
- r: Asset return
This measure is essential in risk-adjusted performance analysis, particularly within
frameworks such as the Sharpe Ratio and Capital Market Line.

Expected Return
The expected return of an asset is expressed as the arithmetic mean of historical returns
over the sample period:
r̄ = (1/n) ∑ rᵢ
Where:
- r̄: Expected return
- rᵢ: Individual period return
- n: Number of observations
This average serves as a forecast of future performance based on past trends.

Risk Assessment: Variance and Standard Deviation


Investment risk is quantitatively evaluated by the dispersion of returns around the mean,
which is represented by variance and standard deviation.
- Variance (σ²) is the average of the squared deviations from the mean:
σ² = ∑(r - r̄)² / (n - 1)
- Standard Deviation (SD) is the square root of the variance:
SD = √[∑(r - r̄)² / (n - 1)]
These metrics capture the volatility inherent in an asset's return distribution. A higher
standard deviation implies a greater level of uncertainty and, hence, higher investment risk.
Conversely, lower standard deviation indicates more stable returns.

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