Measuring Return

change in asset value + income return = R = initial value

R is ex post
based on past data, and is known R is typically annualized

example 1

Tbill, 1 month holding period buy for $9488, sell for $9528 1 month R:
9528 - 9488 9488 = .0042 = .42%

example 2

100 shares IBM, 9 months buy for $62, sell for $101.50 $.80 dividends 9 month R:
101.50 - 62 + .80 62 = .65 =65%

Expected Return

measuring likely future return based on probability distribution random variable

E(R) = SUM(Ri x Prob(Ri))

example 1
R 10% 5% -5% Prob(R) .2 .4 .4

E(R) = (.2)10% + (.4)5% + (.4)(-5%) = 2%

example 2
R 1% 2% 3% Prob(R) .3 .4 .3

E(R) = (.3)1% + (.4)2% + (.3)(3%) = 2%

examples 1 & 2

same expected return but not same return structure

returns in example 1 are more variable

Risk

measure likely fluctuation in return

how much will R vary from E(R) how likely is actual R to vary from E(R) measured by variance (W  standard deviation W

W = SUM[(Ri - E(R))2 x Prob(Ri)] W!SQRT(W

II. Managing risk

Diversification
holding a group of assets lower risk w/out lowering E(R)

two types of risk

unsystematic risk
specific to a firm can be eliminated through diversification examples: -- Safeway and a strike -- Microsoft and antitrust cases

 systematic risk
market risk cannot be eliminated through diversification due to factors affecting all assets -- energy prices, interest rates, inflation, business cycles

Beta, F

variation in asset/portfolio return

relative to return of market portfolio mkt. portfolio = mkt. index -- S&P 500 or NYSE index
F= % change in asset return % change in market return