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FM - Chapter 4, Return and Risk
FM - Chapter 4, Return and Risk
FM - Chapter 4, Return and Risk
n
E ( R ) pi Ri
i 1
Example: Expected Returns
• Suppose you have predicted the following
returns for stocks C and T in three possible
states of nature. What are the expected
returns?
– State Probability C T
– Boom 0.3 0.15 0.25
– Normal 0.5 0.10 0.20
– Recession ??? 0.02 0.01
• RC = .3(.15) + .5(.10) + .2(.02) = .099 = 9.99%
• RT = .3(.25) + .5(.20) + .2(.01) = .177 = 17.7%
Variance and Standard Deviation
n
σ 2 pi ( Ri E ( R)) 2
i 1
Example: Variance and Standard Deviation
• Consider the previous example. What are the
variance and standard deviation for each
stock?
• Stock C
2 = .3(.15-.099)2 + .5(.1-.099)2 + .2(.02-.099)2
= .002029
= .045
• Stock T
2 = .3(.25-.177)2 + .5(.2-.177)2 + .2(.01-.177)2
= .007441
= .0863
Another Example
• Portfolio (solutions to portfolio return in each state appear with mouse click
after last question)
• Portfolio return in boom = .5(30) + .5(-5) = 12.5
• Portfolio return in bust = .5(-10) + .5(25) = 7.5
• Expected return = .4(12.5) + .6(7.5) = 9.5 or
• Expected return = .5(6) + .5(13) = 9.5
• Variance of portfolio = .4(12.5-9.5)2 + .6(7.5-9.5)2 = 6
• Standard deviation = 2.45%
Another Example