Assessment

Module Code: AF5008

Module Title: Financial Mathematics and Statistics
 Table of Content

1. Section A
1.1. monthly simple returns on shares
1.2. variance-covariance matrix of the returns
1.3. expected return of an equally weighted
1.4. standard deviation
2. Section B
2.1. linear regression model
2.2. investment trust with the best risk-adjusted performance
2.3. variance-covariance matrix of the returns
2.4. estimating the regression models
3. Section C
3.1. market price of the bond
3.2. YTM
3.3. NPV
3.4. YTM of the bond
Section A:

1.1. monthly simple returns on shares

In order to calculate your monthly return, you'll need to know three things. By looking at
your monthly statement, you should be able to determine your starting portfolio balance,
your ending portfolio balance, and any net deposits or withdrawals that affected your
account balance during the month.

Once you have those figures, the calculation is simple. Take the ending balance, and
either add back net withdrawals or subtract out net deposits during the period. Then
divide the result by the starting balance at the beginning of the month. Subtract 1 and
multiply by 100, and you'll have the percentage gain or loss that corresponds to your
monthly return.

Monthly returns can be useful to investors in assessing short-term performance and

determining the characteristics of the portfolio that you've put together. For instance, if
you have a stock portfolio, you can compare your monthly return to that of the Dow
Jones Industrials or another stock market benchmark that matches up to your particular
portfolio. If your returns are dramatically different, it can be evidence of whether you
have a strategy that works well or poorly.

However, it's important not to put too much importance on any single monthly return.
Concluding the success or failure of a strategy based on just one month can lead you to
make erroneous decisions. If you note consistent underperformance for multiple
months, then it can make sense to take a closer look.
Monthly returns are easy to calculate, and they can provide some interesting data to
consider. Just don't let a month's performance distract you from the long-term nature of
successful investing.

1.2. variance-covariance matrix of the returns

Variance is a measure of the variability or spread in a set of data. Mathematically, it is

the average squared deviation from the mean score. We use the following formula to
compute population variance.

Var(X) = Σ ( Xi - X )2 / N = Σ xi2 / N

where

N is the number of scores in a set of scores

X  of the N scores.
Xi is the ith raw score in the set of scores
xi is the ith deviation score in the set of scores
Var(X) is the variance of all the scores in the set

1.3. expected return of an equally weighted

The expected return on an investment is the expected value of the probability

distribution of possible returns it can provide to investors. The return on the investment
is an unknown variable that has different values associated with different probabilities.
Expected return is calculated by multiplying potential outcomes (returns) by the chances
of each outcome occurring, and then calculating the sum of those results.

In the short term, the return on an investment can be considered a random variable that
can take any values within a given range. The expected return is based on historical
data, which may or may not provide reliable forecasting of future returns. Hence, the
outcome is not guaranteed. Expected return is simply a measure of probabilities
intended to show the likelihood that a given investment will generate a positive return,
and what the likely return will be.

The purpose of calculating the expected return on an investment is to provide an

investor with an idea of probable profit vs risk. This gives the investor a basis for
comparison with the risk-free rate of return. The interest rate on 3-month U.S. Treasury
bills is often used to represent the risk-free rate of return.

1.4. standard deviation

tandard deviation is a metric used in statistics to estimate the extent by which a random
variable varies from its mean. In investing, standard deviation of return is used as a
measure of risk. The higher its value, the higher the volatility of return of a particular
asset and vice versa.

4. Section B
4.1. linear regression model

The linear regression model can work well for regression, but fails for classification.
Why is that? In case of two classes, you could label one of the classes with 0 and the
other with 1 and use linear regression. Technically it works and most linear model
programs will spit out weights for you. But there are a few problems with this
approach:

A linear model does not output probabilities, but it treats the classes as numbers (0
and 1) and fits the best hyperplane (for a single feature, it is a line) that minimizes the
distances between the points and the hyperplane. So it simply interpolates between
the points, and you cannot interpret it as probabilities.

A linear model also extrapolates and gives you values below zero and above one.
This is a good sign that there might be a smarter approach to classification.

4.2. investment trust with the best risk-adjusted performance

Risk Adjusted Margin means, with respect to an Asset, (1) the stated simple interest
rate applicable to the Loan related to that Asset, less (2) the Net Charge Off Rate for the
Loan Category related to that Asset.

4.3. variance-covariance matrix of the returns

Let us understand how portfolio analysis works. Say we have 4 stocks in our portfolio
and we want to allocate optimal capital to each of these stocks, such that our risk is
minimum. To do this, we need to first create multiple portfolios with different weights
reflecting different capital allocations to each stock and calculate the standard deviation
of each of the resulting portfolios and then choose the one with the lowest risk.

Expected portfolio variance= SQRT (WT * (Covariance Matrix) * W)

The above equation gives us the standard deviation of a portfolio, in other words, the
risk associated with a portfolio. In this equation, 'W' is the weights that signify the capital
allocation and the covariance matrix signifies the interdependence of each stock on the
other. 'WT' is the transpose of the same weights matrix.

4.4. estimating the regression models

linear regression, the least squares estimates of the model parameters β0 and β1 are

denoted b0 and b1. Using these estimates, an estimated regression equation is
constructed:

5. Section C
5.1. market price of the bond

The amount of the semi-annual interest payment is $40 (=$1,000 _ 0.08 / 2). There are
a total of 40 periods; i.e., two half years in each of the twenty years in the term to
maturity. The annuity factor tables can be used to price these bonds. The appropriate
discount rate to use is the semi-annual rate. That rate is simply the annual rate divided
by two. Thus, for part b the rate to be used is 5% and for part c is it 3%.

a. $40 (19.7928) + $1,000 / 1.0440 = $1,000

Notice that whenever the coupon rate and the market rate are the same, the bond is
priced at par.

b. $40 (17.1591) + $1,000 / 1.0540 = $828.41

Notice that whenever the coupon rate is below the market rate, the bond is priced below
par.

c. $40 (23.1148) + $1,000 / 1.0340 = $1,231.15

Notice that whenever the coupon rate is above the market rate, the bond is priced
above par.

5.2. YTM

A bond's yield to maturity (YTM) is the internal rate of return required for the present
value of all the future cash flows of the bond (face value and coupon payments) to equal
the current bond price. YTM assumes that all coupon payments are reinvested at a yield
equal to the YTM and that the bond is held to maturity.

5.3. NPV

It is calculated by taking the difference between the present value of cash inflows and
present value of cash outflows over a period of time. As the name suggests, net present
value is nothing but net off of the present value of cash inflows and outflows by
discounting the flows at a specified rate.

Net present value (NPV) is the difference between the present value of cash inflows and
the present value of cash outflows over a period of time. NPV is used in capital
budgeting and investment planning to analyze the profitability of a projected investment
or project

5.4. YTM of the bond

Bond's yield to maturity (YTM) is the internal rate of return required for the present value
of all the future cash flows of the bond (face value and coupon payments) to equal the
current bond price. YTM assumes that all coupon payments are reinvested at a yield
equal to the YTM and that the bond is held to maturity.
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