Research Note

Andreas Steiner Consulting GmbH

October 2011

Geometric And Arithmetic

Volatility
Introduction
Volatility as a risk measure has been criticized and dismissed on various grounds. Yet,
volatility is the dominating risk measure in the investment management industry and has
been carved in stone by several regulators. For example, the Committee of European
Securities Regulators (CESR) requires the risks and rewards of UCITS funds to be
expressed through a Synthetic Risk and Reward Indicator (SRRI). When looking at the
requirements in more detail, one finds that the indicator is mainly based on historic volatility
calculated using five years of return data.
At the same time, it is current industry practice (see for example the Global Investment
Performance Standards, GIPS) to use discrete returns, chain-linked annualized discrete
returns and geometric average discrete returns in investment reporting. Information on
continuous returns is clearly the exception.
In this research note, we show that there exist geometric and arithmetic versions of
volatility. We discuss how they relate and how they should be used. The relevance of the
topic arises from the fact that the current industry practice is to calculate arithmetic volatility
from discrete returns, which can distort reported volatility figures under certain conditions.

Arithmetic and Geometric Moments

Volatility in a time series context is defined as the standard deviation sA of continuous
returns

sA

1 n
2
rcont,i mA
n i 1

Standard deviation is the square root of the mean square deviation from the arithmetic
mean mA calculated as

mA

1 n
rcont,i
n i 1

The deviation measured in volatility is the arithmetic difference of continuous returns from
the mean, the arithmetic mean.

2011, Andreas Steiner Consulting GmbH. All rights reserved.

Electronic copy available at: http://ssrn.com/abstract=1948795

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Remember that continuous returns are called such because they assume continuous
compounding

MVT MV0 exp rcont,0,T

Discrete returns, on the other hand, assume a discrete compounding model

MVT MV0 1 rdisc,0,T

The choice of compounding model does not affect wealth

MVT MV0 exp rcont,0,T MV0 1 rdisc,0,T

This simplifies to

exp rcont,0,T 1 rdisc,0,T

From the above expression, we can derive well-known conversion formulas which allow the
quick and convenient conversion between continuous and discrete rates

rdisc,i exp rcont,i 1

rcont,i ln 1 rdisc,i

If we analyze continuous and discrete returns in a multi-period setting, we see that discrete
compounding is a multiplicative i.e. geometric process and continuous compounding an
additive i.e. arithmetic process

MVt MVt 1 1 rdisc,t 1,t

MVT MV0 1 rdisc,0,1 1 rdisc,1, 2 ... 1 rdisc,T 1,T

MVT MV0 exp rcont,0,T
MVT MV0 exp rcont,0,1 exp rcont,1, 2 ... exp rcont,T 1,T MV0 exp rcont,0,1 rcont,1, 2 ... rcont,T 1,T
Note that there is no such thing as additive or geometric returns: additive and geometric
describe operations that in principle can be applied to any type of returns. Obviously, it
does not make sense to compound discrete returns in an additive fashion or to apply
geometric operations to continuous returns; but in principle, it could be done. That it should
not be done is rather well understood in the calculation of multi-period and average returns:
most performance analysts nowadays are aware that discrete returns require chainlinking, the industrys preferred expression for geometric compounding.
From the above analysis, it follows immediately that the geometric mean mG return is
defined as
1n

mG 1 rdisc,i
i 1

Substituting the definition of continuous returns and taking logarithms

2011, Andreas Steiner Consulting GmbH. All rights reserved.

Electronic copy available at: http://ssrn.com/abstract=1948795

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1n
n
1

ln 1 mG ln exp rcont,i
ln exp rcont,1 ln exp rcont, 2 ... ln exp rcont,n
i 1
n

The above expression simplifies to the arithmetic mean return...

ln 1 mG

1 n
rcont,i mA
n i 1

respectively

mG exp mA 1

...and

mA ln 1 mG

Therefore, the conversion formulas introduced above are not only applicable for single
period returns, but also average returns. Substituting the definition of discrete returns into
the volatility formula

1 n
2
sA
ln 1 rdisc,i ln 1 mG
n i 1
and applying the exponential function to both sides of the above expression and
subtracting one
2

1 n
1 n 1 rdisc,i

2
1 sG
exp s A 1 exp
ln 1 rdisc,i ln 1 mG 1 exp
ln
i 1
i 1
n
n
1

results in what is known as geometric volatility sG. From the above expressions, we see
that geometric volatility can be calculated directly as
2

1 n 1 rdisc,i
sG exp
ln
1
n i 1 1 mG

or indirectly from arithmetic volatility

sG exp s A 1

s A ln 1 sG

We see that the conversion formulas not only apply to return and average returns, but also
standard deviation. In fact, it can be shown that the conversion formulas apply to any
moments1.

The central moments, to be more precise. The conversion formulas cannot be applied to the sample skewness and
excess kurtosis directly.

2011, Andreas Steiner Consulting GmbH. All rights reserved.

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Note that the geometric standard deviation is not equal to the arithmetic standard deviation
calculated from discrete returns

sG

1 n
2
rdisc,i mA
n i 1

with

mA

1 n
rdisc,i
n i 1

Applying an arithmetic operation to geometric data leads to results which do not have a
meaningful financial interpretation. This is most obvious when trying to interpret the
arithmetic mean for discrete returns. Unfortunately, this calculation has been implemented
in many spreadsheets and systems.

Analysis and Assessment

There is a simple check for illustrating the plausibility of the derived results: Volatility is
supposed to measure dispersion around the mean. The higher the volatility, the more
scattered the returns. Volatility itself is measured in returns squared, which is a rather
abstract unit of measurement. A more intuitive approach is to express dispersion as the
values that lie k-times the standard deviation from the mean. For continuous returns, this
is

lbA mA k s A

ubA mA k s A

If mA = 10%, sA = 25% and k = 2, we get

lbA 10% 2 25% 40%

ubA 10% 2 25% 60%

For discrete returns, geometric versions of the above formulas have to be used

lbG

1 mG
1
1 sG k

ubG 1 mG 1 sG 1
k

Applying the formulas to our example

sG exp 25% 1 28.4025%

mG exp 10% 1 10.5171%

lbG

1 10.5171%
32.9680%
1 28.4025%2

lbG 1 10.5171% 1 28.4025% 82.2119%

2

If the formulas are consistent, we would expect that

lbG exp lbA 1

ubG exp ubA 1

and

lbA ln 1 lbG

ubA ln 1 ubG

This is the case in our example because

40% ln 1 32.9680%
60% ln 1 82.2119%
2011, Andreas Steiner Consulting GmbH. All rights reserved.

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How relevant is the difference between arithmetic and geometric volatility? The smaller the
period of time over which returns are measured, the smaller the difference between
continuous and discrete returns. Therefore, the higher the data frequency, the smaller the
difference between geometric and arithmetic volatility. For example, when calculating daily
equity volatility
S&P 500 Arithmetic and Geometric Volatility
Daily Volatilities
3.50%
Arithmetic Volatility

Geometric Volatility

3.00%
2.50%
2.00%
1.50%
1.00%

0.50%

18.01.11

18.01.08

18.01.05

18.01.02

18.01.99

18.01.96

18.01.93

18.01.90

18.01.87

18.01.84

18.01.81

18.01.78

18.01.75

18.01.72

18.01.69

18.01.66

18.01.63

18.01.60

18.01.57

18.01.54

18.01.51

0.00%

The line for arithmetic and geometric volatility overlap, i.e. no relevant difference exists. If
we calculate 250 day volatilities from the same data, we get relevant differences
S&P 500 Arithmetic and Geometric Volatility
Annualized Rolling 250-Day Volatilities
70.00%
Arithmetic Volatility

Geometric Volatility

60.00%
50.00%

40.00%
30.00%
20.00%
10.00%

2011, Andreas Steiner Consulting GmbH. All rights reserved.

18.01.11

18.01.08

18.01.05

18.01.02

18.01.99

18.01.96

18.01.93

18.01.90

18.01.87

18.01.84

18.01.81

18.01.78

18.01.75

18.01.72

18.01.69

18.01.66

18.01.63

18.01.60

18.01.57

18.01.54

18.01.51

0.00%

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We see that the difference between geometric and arithmetic volatility only becomes
relevant if the figures are large. This can be seen when plotting the conversion formulas

Geometric Standard Deviation

200.00%

180.00%
160.00%
140.00%
120.00%
100.00%
80.00%
60.00%

40.00%
20.00%
0.00%
0.00%

20.00% 40.00% 60.00% 80.00% 100.00% 120.00%

Arithmetic Volatility

It follows that, the riskier the investment strategy analyzed (e.g. equity versus money
market), the more relevant the difference between geometric and arithmetic volatility.
Both the exponential and logarithmic functions are positive monotone. It can be shown that
this mathematical property implies that rankings are not affected whether they are based on
geometric or arithmetic volatilities. For example, if all UCITS IV funds report their SRRI
expressed in terms of arithmetic volatility, it would not change the relative riskiness of a
UCITS fund if the regulator would switch to geometric volatilities.
While geometric and arithmetic moments can be converted directly, this is not possible with
Sharpe ratios

SharpeG exp SharpeA 1

Sharpe ratio rankings are unaffected by whether the measurement is arithmetic or
geometric (quotient of two positive monotone functions is positive monotone). In fact, the
Sharpe Ratio values do not change at all

SharpeA

m A exp m A 1 mG

SharpeG
sA
exp s A 1 sG

Interestingly, Sharpe ratio rankings are also not affected if returns are measured
geometrically and volatilities arithmetically (or vice versa). Of course, rankings are affected
when geometric Sharpe ratios is compared to arithmetic Sharpe ratios.
The arithmetic mean is always larger than the geometric mean. The same applies to
arithmetic standard deviation; it is always larger than its geometric counterpart. Individuals
typically like return and dislike volatility risk, which would explain the strong interest in
reporting geometric averages of discrete returns and absence of interest in reporting proper
geometric volatility figures.

2011, Andreas Steiner Consulting GmbH. All rights reserved.

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Summary
Arithmetic and geometric averages are part of the established body of knowledge of the
investment industry. We have shown that there also are arithmetic and geometric
volatilities. The choice affects reported figures when they are large, and they never affect
the conclusions derived from comparing figures over time or portfolios: geometric and
arithmetic calculations do not affect the ranking of returns, volatilities or Sharpe ratios.
Comparisons may be distorted when mixing geometric and arithmetic calculations or
applying them in the wrong context. Unfortunately, the current industry practice of reporting
geometric average returns and arithmetic volatilities has the potential to distort risk and
return analysis. Discrete returns should be described with geometric statistics, continuous
returns with arithmetic statistics. The choice of the calculation methodology has to be
aligned with the compounding model chosen. The compounding model itself neither affects
investor wealth nor the performance of investment managers; it is merely a reporting
convention.

2011, Andreas Steiner Consulting GmbH. All rights reserved.

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