FIN 371:
Financial Management
CHAPTER 11: RISK AND RETURN
PROFESSOR JARED I. WILSON

Chapter 11 – Objectives
•
CALCULATE EXPECTED RETURNS AND STOCK VARIANCE
•
DESCRIBE THE IMPACT OF DIVERSIFICATION
•
DIFFERENTIATE SYSTEMATIC AND UNSYSTEMATIC RISK
•
CALCULATE THE SECURITY MARKET LINE

Historical Average vs. Expected Return
•
Both provide useful insight about assets of interest
•
Historical average return
•
Does not take into consideration possible economic outcomes
•
Can give some insight about the future
•
BUT
, not perfect
•
We want to know what will happen in the future
•
Expected return

Expected Returns
•
Weighted average of the possible outcomes based on the probability
that each outcome will occur
•
Realized return may be very different from expected return
•
Expected return

Expected Returns Example
•
Determine the expected returns of the following:
•
U.S. Treasury Bill (risk-free rate)
•
Alphabet (technology firm)
•
Pepsi (beverage & food company)
•
Wal-Mart (retailer)
•
S&P 500 (stock market index)

Expected Returns Example
•
Probability distribution of stock returns
Economy
Probability
T-Bill
Alphabet
Pepsi
Wal-Mart
S&P 500
Recession
10%
Below average
20%
Average
40%
Above average
20%
Boom
10%
100%

Expected Returns Example

Expected Returns Example
•What is the expected risk premium?

Expected Returns In Class Problem
•Suppose that you have predicted the following returns for stocks C and T in three possible states of nature•What is the probability of a recession?•What are the expected returns of stocks C and T?•If the risk-free rate is 2.5%, what is each stock’s risk premium?StateProbabilityCTBoom30%15%25%Normal50%10%20%Recession???2%1%

Expected Returns In Class Problem
•What is the probability of a recession?•What are the expected returns of stocks C and T?•If the risk-free rate is 2.5%, what is each stock’s risk premium?

Variance and Standard Deviation
•
Variance and standard deviation measure volatility of returns
•
Now we have to consider the probability of different outcomes
•
Weighted average of squared deviations

Variance Example
•
Calculate the variance of Alphabet’s possible returns
Economy
Probability
(A)
Returns
(B)
Expected
Return
(C)
Deviation
(D)=(B)-(C)
Squared
Deviation
(E)=(D)
2
Probability
x Squared
Deviation
(F)=(A)x(E)
Recession
10%
-22.0%
17.4%
Below average
20%
-2.0%
17.4%
Average
40%
20.0%
17.4%
Above average
20%
35.0%
17.4%
Boom
10%
50.0%
17.4%
100%

Variance Example
•
Calculate the variance of Pepsi’s possible returns
Economy
Probability
(A)
Returns
(B)
Expected
Return
(C)
Deviation
(D)=(B)-(C)
Squared
Deviation
(E)=(D)
2
Probability
x Squared
Deviation
(F)=(A)x(E)
Recession
10%
28.0%
1.74%
Below average
20%
14.7%
1.74%
Average
40%
0.0%
1.74%
Above average
20%
-10.0%
1.74%
Boom
10%
-20.0%
1.74%
100%

Variance In Class Problem

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