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I have been going through a course for Time Series Analysis. First we learned to make returns from a time-series of stock index by (Xt - Xt-1)/Xt-1 .

This makes the series stationary, which means we can run the Auto-Regressive model. It all makes sense until here.

Than the returns are being normalized, dividing them by some previous performance of the specific index. Now this seems pretty incredulous to me. Also it is accompanied by the statement "They account for the absolute profitability of the investment in contrast to prices." Makes no sense to me. Returns are relative by themselves and than when they are further normalized they are relative to some previous value as well.

My question is does it make sense to use relative returns and if so in what type of situations?

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    $\begingroup$ Please provide more information concerning the normalization. $\endgroup$
    – fes
    Dec 29, 2021 at 17:54

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As far as I know we use Normalization in reviewing the Financial Statements(PnL,Balance Sheets,Cash Flow) of a Company. Now What is that exactly?

If the company is seeking external funding, normalized financial statements provide the investor or lender with a clear picture of the actual expenses, revenues, earnings and cash flow of the company during a particular period. When adjusting the financial statements, you should only remove outliers (discretionary expenses and one-time gains or expenses) that are unrepresentative of normal operating expenses of the business so that you get the clear picture of the performance of the company.

I hope you get the intuition behind it and personally I also never normalise returns when I calculate it because it does not make much difference but what your Course is doing is something intriguing so it was worth answering this question.

Thank you!

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