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Lecture No.3
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 R

e very centra
terms n our ana
ys s and t s
essent a
that Re c
ear
y understand the mean ng of each term and hoR
assets R th d fferent payout structures can e compared.

Genera
ut
ty theory suggests that the average nvestor s r sk averse.

G ven the same expected return of tRo assets R th d fferent r sks, he
Rou
d prefer the one R th
ess r sk. (Th s assumpt on may not e
perfect
y true for a

nd v dua
s n a

s tuat ons, ut for the nvestor
commun ty as a Rho
e t s proa
y true).

For an asset R th uncerta n cash f
oRs and payoffs, Rh ch are norma

y

d str uted, the mean of the d str ut on R

e the expected return Rh
e
the standard dev at on forms some k nd of ³r sk´.

Choos ng the ³
ess r sky´ asset therefore comes doRn to choos ng the
asset R th the
oRest standard dev at on n ts payout d str ut on.

An nvestor cou
d a
so approach the pro
em from the other d rect on,
choos ng among assets R th the same r sk and then choose the asset
R th the h ghest expected return.

  



Dy mean one often refers to the s mp
e average of a numer of oservat ons. Th s
va
ue s more correct
y denoted as ar thmet c mean, to d st ngu sh t from the
geometr c mean. In order, the formu
as e
oR shoR the ar thmet c and the
geometr c mean, respect ve
y:
„
v

£
„
£ v

D fferent Symo
s of Mean = Mean = X = E(|)


 „

£  „ Kv

v
The var ance measures the f
uctuat on of the oservat ons around the r mean. The
£ v

arger the va
ue of var ance, the greater the f
uctuat on.

(s gma squared)
£ | ± E(|)]2 X P



  



  
The standard dev at on a
so measures the var a
ty of oservat ons around the
mean. It s def ned as the square root of the var ance. The standard dev at on R


as a consequence have the same un t as the oservat on and s n a Ray eas er to
nterpret. In f nanc a
terms, var a
ty measured as standard dev at on equa
s r sk
and the not on of r sk has a very centra
p
ace n the f nanc a
theory. From the
def n t on of var ance aove fo

oRs that the standard dev at on s g ven y:

£ | ± E(|)]2 X P


 


= Mean = X = E(|)


 Sma

cap stocks
Greater Var ance/ SD
Greater r sk, Greater
returns

Large cap stocks

Lesser Var ance/ SD
Lesser r sk,
Lesser returns
Mun c pa
Donds
Even Lesser Var ance/ SD
Lesser r sk,
Lesser returns

6
|
|

|
 

 R

e very centra
terms n our ana
ys s and t s
essent a
that Re c
ear
y understand the mean ng of each term and hoR
assets R th d fferent payout structures can e compared.

Genera
ut
ty theory suggests that the average nvestor s r sk averse.

G ven the same expected return of tRo assets R th d fferent r sks, he
Rou
d prefer the one R th
ess r sk. (Th s assumpt on may not e
perfect
y true for a

nd v dua
s n a

s tuat ons, ut for the nvestor
commun ty as a Rho
e t s proa
y true).

For an asset R th uncerta n cash f
oRs and payoffs, Rh ch are norma

y

d str uted, the mean of the d str ut on R

e the expected return Rh
e
the standard dev at on forms some k nd of ³r sk´.

Choos ng the ³
ess r sky´ asset therefore comes doRn to choos ng the
asset R th the
oRest standard dev at on n ts payout d str ut on.

An nvestor cou
d a
so approach the pro
em from the other d rect on,
choos ng among assets R th the same r sk and then choose the asset
R th the h ghest expected return.