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Dt + (Pt - Pt-1 )
R=
Pt-1
Return Example
5
n
R = S ( Ri )( Pi )
i=1
R is the expected return for the asset,
Ri is the return for the ith possibility,
Pi is the probability of that return occurring,
n is the total number of possibilities.
How to Determine the Expected
Return and Standard Deviation
9
Stock BW
Ri Pi (Ri)(Pi)
The
-.15 .10 -.015 expected
-.03 .20 -.006 return, R,
.09 .40 .036 for Stock
.21 .20 .042 BW is .09
or 9%
.33 .10 .033
Sum 1.00 .090
Determining Standard Deviation
(Risk Measure)
10
n
s = S ( Ri - R )2( Pi )
i=1
Standard Deviation, s, is a statistical measure
of the variability of a distribution around its
mean.
It is the square root of variance.
Note, this is for a discrete distribution.
How to Determine the Expected
Return and Standard Deviation
11
Stock BW
Ri Pi (Ri)(Pi) (Ri - R )2(Pi)
-.15 .10 -.015 .00576
-.03 .20 -.006 .00288
.09 .40 .036 .00000
.21 .20 .042 .00288
.33 .10 .033 .00576
Sum 1.00 .090 .01728
Determining Standard Deviation
(Risk Measure)
12
n
S ( Ri - R )2( Pi )
s = i=1
s = .01728
s = .1315 or 13.15%
Coefficient of Variation
13
CV = s / R
CV of BW = .1315 / .09 = 1.46
Discrete vs. Continuous
Distributions
Discrete Continuous
0.4 0.035
0.35 0.03
0.3 0.025
0.25 0.02
0.2 0.015
0.15 0.01
0.1 0.005
0.05
0
0
13%
22%
31%
40%
49%
58%
67%
4%
-50%
-41%
-32%
-23%
-14%
-5%
-15% -3% 9% 21% 33%
Determining Expected Return
(Continuous Dist.)
15
n
R = S ( Ri ) / ( n )
i=1
R is the expected return for the asset,
Ri is the return for the ith observation,
n is the total number of observations.
Determining Standard Deviation
(Risk Measure)
16
n
s = S ( Ri - R )2
i=1
(n)
Note, this is for a continuous distribution where the
distribution is for a population. R represents the
population mean in this example.
Continuous Distribution
Problem
17
m
RP = S ( Wj )( Rj )
j=1
RP is the expected return for the portfolio,
Wj is the weight (investment proportion) for
the jth asset in the portfolio,
Rj is the expected return of the jth asset,
m is the total number of assets in the
portfolio.
Determining Portfolio Standard
Deviation
26
m m
sP = S S
j=1 k=1
Wj Wk s jk
Wj is the weight (investment proportion) for
the jth asset in the portfolio,
Wk is the weight (investment proportion) for
the kth asset in the portfolio,
sjk is the covariance between returns for the jth
and kth assets in the portfolio.
Tip Slide: Appendix A
27
s jk = s j s k r jk
sj is the standard deviation of the jth asset in
the portfolio,
sk is the standard deviation of the kth asset in
the portfolio,
rjk is the correlation coefficient between the jth
and kth assets in the portfolio.
Correlation Coefficient
29
RP = (WBW)(RBW) + (WD)(RD)
RP = (.4)(9%) + (.6)(8%)
RP = (3.6%) + (4.8%) = 8.4%
Determining Portfolio Standard
Deviation
33
Two-asset portfolio:
Col 1 Col 2
Row 1 WBW WBW sBW,BW WBW WD sBW,D
Row 2 WD WBW sD,BW WD WD sD,D
Two-asset portfolio:
Col 1 Col 2
Row 1 (.4)(.4)(.0173) (.4)(.6)(.0105)
Row 2 (.6)(.4)(.0105) (.6)(.6)(.0113)
Two-asset portfolio:
Col 1 Col 2
Row 1 (.0028) (.0025)
Row 2 (.0025) (.0041)
10.91% = 11.65%
This is INCORRECT.
Summary of the Portfolio Return
and Risk Calculation
38
Combination
SECURITY E SECURITY F E and F
INVESTMENT RETURN
Unsystematic risk
Total
Risk
Systematic risk
Unsystematic risk
Total
Risk
Systematic risk
Narrower spread
EXCESS RETURN is higher correlation
ON STOCK
Rise
Beta = Run
EXCESS RETURN
ON MARKET PORTFOLIO
Characteristic Line
Calculating “Beta”
on Your Calculator
EXCESS RETURN
ON MARKET PORTFOLIO
Security Market Line
51
Rj = Rf + bj(RM - Rf)
Rj is the required rate of return for stock j,
Rf is the risk-free rate of return,
bj is the beta of stock j (measures systematic
risk of stock j),
RM is the expected return for the market
portfolio.
Security Market Line
52
Rj = Rf + bj(RM - Rf)
Required Return
RM Risk
Premium
Rf
Risk-free
Return
bM = 1.0
Systematic Risk (Beta)
Security Market Line
53
Obtaining Betas
Can use historical data if past best represents the
expectations of the future
Can also utilize services like Value Line, Ibbotson
Associates, etc.
Adjusted Beta
Betas have a tendency to revert to the mean of 1.0
Intrinsic $0.50
=
Value 10.8% - 5.8%
= $10
Stock X (Underpriced)
Required Return
Direction of
Movement Direction of
Movement
Rf Stock Y (Overpriced)
Small-firm Effect
Price / Earnings Effect
January Effect
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