MGNT3125_chapter8_notes

# MGNT3125_chapter8_no - MGNT3125 Fall 2010 Dr Amine Khayati Chapter 8 Notes I Expected Returns and Variances 1 Expected Return Using Historical data

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MGNT3125 Fall 2010 Dr. Amine Khayati Chapter 8 Notes I- Expected Returns and Variances: 1- Expected Return: Using Historical data or any kind of information, we may come up with an estimate of the future stock return. This estimate is called the expected return and the actual return may turn out to be higher or lower than our expected return. So, an expected return is a return on a risky asset expected in the future. We may have different possible expected returns based on different outcomes. For example, if we predict that there is a 50% chance that the economy will boom; in that case we may estimate that the expected return on the stock is 70%. However, we may also predict that there is a 50% chance that the economy will enter a recession, and in this case our expected return on the stock will then be (-20%). In this case, we have two states of the economy, meaning that there are only two possible situations either the economy will boom or the economy will enter a recession. If you hold this stock for a number of years, assuming that the probabilities of the state of nature stay the same, you will earn 70% about half of the time and you will earn (- 20%) the other half. Your expected return on the stock is then: E(R) = 50% 70% + 50% (- 20%) = 35% - 10% = 25% On average, you expect to make 25% return on the stock. Example 1: You want to invest in either stock A or stock B. Assume for now that the two stocks have the same risk, so you will base your investment decision only on the expected return. You assume also that there is 50% chance the economy will boom and 50% chance the economy will enter a recession. If you have the following expected returns on each stock. Which stock you should invest in? State of economy Probability of state of economy Stock returns if state occurs Stock A Stock B Recession Boom 50% 50% - 20% 70% 30% 10% …………………………………………………………………………. . 1

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……………………………………………………………………………. . 2
Risk Premium: it is the compensation that investors require for bearing a risky investment. It is also defined as the difference between the return on a risky investment and that on a risk-free investment. Using the expected returns, we can also calculate the expected (projected) risk premium as follow: Risk premium = Expected return – Risk-free rate Example: suppose the risk-free investment currently offering 8%, what is the expected risk premium on stock A? Risk premium on stock A =……………………………………………………………. . 2-Variance: - Variance is a measure of statistical dispersion that indicates how possible values are spread around the expected value. - The square root of the variance is called the standard deviation.

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## This note was uploaded on 11/06/2010 for the course MGNT 3125 taught by Professor Warsi during the Spring '08 term at SPSU.

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MGNT3125_chapter8_no - MGNT3125 Fall 2010 Dr Amine Khayati Chapter 8 Notes I Expected Returns and Variances 1 Expected Return Using Historical data

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