Chapter 13Return, Risk, and the Security Market LineSlide 13 - 1Key Concepts and SkillsKnow how to calculate expected returns and variance for individual asset and for portfoliosUnderstand systematic and unsystematic risks and the effect of diversificationUnderstand the risk-return trade offBe able to use the Capital Asset Pricing ModelSlide 13 - 2Expected ReturnsCalculating the Expected ReturnThe expected return, denoted as E(R),is the return investors expected on a risky asset in the future. It is based on the probabilities of possible return outcomes:In this context, “expected” means average if the process is repeated many times. The “expected” return does not even have to be a possible return.∑==niiiRpRE1)(Slide 13 - 3Expected ReturnsExampleYou have predicted the following returns for stocks C and T in three possible states of nature. What are the expected returns?StateProbabilityCT Boom0.315%25%Normal0.510%20%Recession?2%1%E(RC) = .3(15) + .5(10) + .2(2) = 9.9%E(RT) = .3(25) + .5(20) + .2(1) = 17.7%
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