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Learning Module
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Expected Return
The future is uncertain.
Investors do not know with certainty whether the
economy will be growing rapidly or be in recession.
Investors do not know what rate of return their
investments will yield.
Therefore, they base their decisions on their
expectations concerning the future.
The expected rate of return on a stock represents
the mean of a probability distribution of possible
future returns on the stock.
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Expected Return
The table below provides a probability distribution for the returns on
stocks A and B
State Probability Return On Return On
Stock A Stock B
1 20% 5% 50%
2 30% 10% 30%
3 30% 15% 10%
4 20% 20% -10%
The state represents the state of the economy one period in the future
i.e. state 1 could represent a recession and state 2 a growth economy.
The probability reflects how likely it is that the state will occur. The
sum of the probabilities must equal 100%.
The last two columns present the returns or outcomes for stocks A and
B that will occur in each of the four states. 3
Expected Return
Given a probability distribution of returns, the
expected return can be calculated using the following
equation:
N
E[R] = (piRi)
i=1
Where:
E[R] = the expected return on the stock
N = the number of states
pi = the probability of state i
Ri = the return on the stock in state i.
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Expected Return
In this example, the expected return for stock A
would be calculated as follows:
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Expected Return
Did you get 20%? If so, you are correct.
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Measures of Risk
Probability Distribution:
Where:
N = the number of states
pi = the probability of state i
Ri = the return on the stock in state i
E[R] = the expected return on the stock
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Measures of Risk
The standard deviation is calculated as the positive
square root of the variance:
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Measures of Risk
The variance and standard deviation for stock A is calculated
as follows:
Now you try the variance and standard deviation for stock B!
If you got .042 and 20.49% you are correct.
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Measures of Risk
If you didn’t get the correct answer, here is how to get it:
E[Rp] = wiE[Ri]
i=1
Where:
E[Rp] = the expected return on the portfolio
N = the number of stocks in the portfolio
wi = the proportion of the portfolio invested in stock i
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E[Ri] = the expected return on stock i
Portfolio Risk and Return
For a portfolio consisting of two assets, the above
equation can be expressed as:
E[Rp] = w1E[R1] + w2E[R2]
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Portfolio Risk and Return
The variance/standard deviation of a portfolio reflects not
only the variance/standard deviation of the stocks that make
up the portfolio but also how the returns on the stocks
which comprise the portfolio vary together.
Two measures of how the returns on a pair of stocks vary
together are the covariance and the correlation coefficient.
Covariance is a measure that combines the variance of a stock’s
returns with the tendency of those returns to move up or down at
the same time other stocks move up or down.
Since it is difficult to interpret the magnitude of the covariance terms,
a related statistic, the correlation coefficient, is often used to
measure the degree of co-movement between two variables. The
correlation coefficient simply standardizes the covariance.
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Portfolio Risk and Return
The Covariance between the returns on two stocks can be
calculated as follows:
N
Where:
= the covariance between the returns on stocks A and B
N = the number of states
pi = the probability of state i
RAi = the return on stock A in state i
E[RA] = the expected return on stock A
RBi = the return on stock B in state i
E[RB] = the expected return on stock B 17
Portfolio Risk and Return
The Correlation Coefficient between the returns on two
stocks can be calculated as follows:
A,B Cov(RA,RB)
Corr(RA,RB) = A,B = AB = SD(RA)SD(RB)
Where:
A,B=the correlation coefficient between the returns on stocks A and B
A,B=the covariance between the returns on stocks A and B,
A=the standard deviation on stock A, and
B=the standard deviation on stock B
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Portfolio Risk and Return
The covariance between stock A and stock B is as follows:
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Portfolio Risk and Return
Using either the correlation coefficient or the covariance,
the Variance on a Two-Asset Portfolio can be
calculated as follows:
Note that you can then compare the required rate of return to the
expected rate of return. You would only invest in stocks where
the expected rate of return exceeded the required rate of return.
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Another CAPM Example
Find the beta on a stock given that its expected return is 12%, the
risk-free rate is 4%, and the expected return on the market
portfolio is 10%.
Note that beta measures the stock’s volatility (or risk) relative to
the market.
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