Question

In: Finance

A key issue with modeling net returns as a normal distribution is A. Returns are not...

A key issue with modeling net returns as a normal distribution is

A.
Returns are not mean zero

B.
Due to stock price decimalization, some returns are irrational numbers which are not part of the normal distribution

C.
Returns only make sense in the long run. Hence, in the short run, returns do not follow normal distribution

D.
Stock Returns have a finite downside of -100%

Solutions

Expert Solution

Normal distribution is a continuous probability distribution for a real-valued random variable which has both a positive side and a negative side and is a symmetrical distribution. For a variable to follow normal distribution, its mean should be zero. See below.

However, net returns do not have mean of zero as the returns aren’t symmetrical about the mean. For some assets, the likelihood of negative returns may be higher while for other assets, likelihood of positive returns may be higher.

Also, the tendency of net returns to exhibit extreme outcomes (large gains or large losses) is much more than than what can be allowed by normal distribution. In other words, net returns are generally skewed (i.e. have fat tails).

Hence, the correct answer is A.


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