Explanation
To convert a simple return to a continuously compounded return, we use the relationship:
β1` + R_t = e^{r_t}$$
Where:
- Rtβ = simple return (15% or 0.15)
- rtβ = continuously compounded return
Solving for rtβ:
rtβ=ln(1+Rtβ)=ln(1.15)
Calculating this:
rtβ=ln(1.15)=0.1398=13.98%
Therefore, the equivalent continuously compounded return is 0.1398 or 13.98%.
This conversion is important in quantitative finance because continuously compounded returns have several advantages:
- They are additive over time
- They are normally distributed in many financial models
- They are used in options pricing models like Black-Scholes