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Expected Rate of
Return (%)
(4) = (2) (4)
Probability
(3)
0.25
0.25
0.25
0.25
1.00
4.63
2.62
0.25
- 1.50
6.00
What is risk? How can risk of a security be calculated? Explain your answer with
the help of an example. A-4 Risk of returns is the variability in rates of return.
The variability of rates of return
may be defined as the extent of the deviations (or dispersion) of individual rates
of return from the average rate of return. There are two measures of this
dispersion: variance or standard deviation. Standard deviation is the square root of
variance.
The formulae calculating variance and standard deviation of historical rates of
return of a share as follows:
2
The share of Hypothetical Company Limited has the following anticipated returns
with associated probabilities:
Return (%) -20 -10 10
15
20
25
Probability
0.05
0.20 0.15
Q-5 What is a risk-free security? What is risk premium? How can it be estimated from
historical data?
A-5 A risk free security is a security which is free from risk of default and the
variability on its returns is the lowest. The 28-year average return on the stock
market (Sensex) is higher by 8.76 per cent in comparison with the average return
on the long-term government bonds for the same period in India. This excess
return is a compensation for the higher risk of the return on the stock market; it is
commonly referred to as risk premium.
Q-6 What is a normal distribution? How does it help to interpret standard deviation?
A-6 The normal distribution is a smooth, symmetric, continuous, bell-shaped curve.
The distribution is neither skewed nor peaked. The spread of the normal
distribution is characterised by the standard deviation. It is useful to notice certain
properties of a normal distribution.