The Variance Drain and Jensen's Inequality
AbstractThe well-known approximation of the difference between the arithmetic average and geometric average returns as one-half of the variance of the underlying returns is reexamined using Jensen’s Inequality. The ”defect” in Jensen’s Inequality, is given an exlicit formula in terms of the variance following some ideas put forward by Holder. A new form of the AM-GM Inequality follows and is is applied to financial returns. Both exact, and approximate relations between the arithmetic average, geometric average, and variance of returns are discussed. The mathematical formulation of these relations are free of distributional assumptions governing the underlying returns process.
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Bibliographic InfoPaper provided by Center for Applied Economics and Policy Research, Economics Department, Indiana University Bloomington in its series Caepr Working Papers with number 2012-004.
Length: 14 pages
Date of creation: Mar 2012
Date of revision:
This paper has been announced in the following NEP Reports:
- NEP-ALL-2012-04-03 (All new papers)
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- Goetzmann, William N. & Ibbotson, Roger G., 2006. "The Equity Risk Premium: Essays and Explorations," OUP Catalogue, Oxford University Press, number 9780195148145.
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