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ch07 fn202
ch07 fn202
ch07 fn202
Chapter 7
Equation 7.1
ΔP CF1 ΔP + CF1
R T = R CA + R I = + =
P0 P0 P0
One year ago today, you purchased a share of Twitter, Inc., stock for
$32.05. Today it is worth $44.00. What total return did you earn on
this stock over the past year if Twitter paid no dividend? Since
Twitter paid no dividend, and assuming you received no other
income from holding the stock, the total return for the year equals
the return from the capital appreciation. The total return is
calculated as follows:
P1 Po + CF1
RT = R CA + RI =
Po
$44.00 $32.05 + $0.00
=
$32.05
= 0.373,or 37.3%
• Expected Returns
n
Var R = σ = pi × R i - E R
2 2
R
i =1
R
2 12
R
• Outcomes that occur most often are closest to the mean convert
to fewer standard deviations, outcomes that rarely occur are
farthest from the mean and convert to more standard deviations
• For a normal distribution, a standard deviation is associated
with the probability that an outcome occurs within a certain
distance from the mean
o 90% of outcomes are within 1.645 standard deviations from the
mean
o 95% of outcomes are within 1.960 standard deviations from the
mean
o 99% of outcomes are within 2.575 standard deviations from the
mean
L.O. 7.4 Copyright ©2022 John Wiley & Sons, Inc. 20
Exhibit 7.2: Standard Deviation and
Width of the Normal Distribution
LEARNING OBJECTIVE
Explain what an arithmetic average return is and what a geometric
average return is, and calculate these returns for an asset
n
i =1
Ri
R Arithmetic average =
n
Equation 7.5
1
R Geometric average = 1+ R 1 × 1+ R 2 × × 1+ R n 1
n
Equation 7.6
σ Ri
CVi =
E R i
Equation 7.7
E R i R rf
Sharpe Ratio = S =
σRi
n
E R Portfolio = xi × E R i
i =1
Equation 7.10
n
Cov R 1 ,R 2 = σ R1, 2 = pi × R1,i E R1 × R 2,i E R 2
i=1
R1 ,2
R 1 ,2
R1 R2
• The variance of the annual returns for the American Airlines and
Target stocks are 0.1795 and 0.0847, respectively. The
covariance between the annual returns on these two stocks is
0.0255. Calculate the variance of a portfolio consisting of that
consists of 50 percent American Airlines stock and 50 percent
Target stock
R2Portfolio of AAL and TGT x 2 AAL 2AAL x2 TGT 2TGT 2 xAAL xTGT R AAL,TGT
Equation 7.12
E R i = R rf + βi E R m R rf
E R i = R rf + βi E R m R rf
A stock has a beta of 1.5. The expected return on the market is 10%
and the risk-free rate is 4%. What is the expected return for the
stock?
E R i = R rf + βi E R m R rf
= 0.04 +1.50 0.10 0.04
= 0.13, or13%
n
βn Asset portfolio = xi βi
i =1
n
βPortfolio = xi βi = 0.25×1.0 + 0.25× 0.0 + 0.5× 2.0 = 1.25
i =1
E RPortfolio = R rf + βPortfolio E R m R rf
= 0.04 +1.25 0.10 0.04
= 0.115, or11.5%