Chapter 13
Return, Risk, and the Security Market Line
Slide 13 - 1
Key Concepts and Skills
Know how to calculate expected returns and variance
for individual asset and for portfolios
Understand systematic and unsystematic risks and the
effect of diversification
Understand the risk-return trade off
Be able to use the Capital Asset Pricing Model
Slide 13 - 2
Expected Returns
Calculating the Expected Return
The 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.
∑
=
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Slide 13 - 3
Expected Returns
Example
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
15%
25%
Normal
0.5
10%
20%
Recession
?
2%
1%
E(R
C
) = .3(15) + .5(10) + .2(2) = 9.9%
E(R
T
) = .3(25) + .5(20) + .2(1) = 17.7%

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