Expected Return Defined and Measured
Holding period return (historical or realized rate of return): the rate of
return earned on an investment, which equals the dollar gain divided
by the amount invested.
•
Holding period dollar gain= price at end of period + cash
distribution – Price at beginning of period
•
Rate of return = (dollar gain/Pbeginning of period) = (p end of
period +dividend – p beginning of period) / p beginning of period
Expected rate of return: the arithmetic mean or average of all possible
outcomes where those outcomes are weighted by the probability that
each will occur.
•
Expected cash flow = (CF1 x Pb1) + (CF2 x Pb2) + (CF3 x Pb3)
•
Expected rate of return = (r1 x Pb1) + (r2 x Pb2) + (r3 x Pb3)
Risk Defined and Measured
Risk: potential variability in future cash flows. The wider the range of
possible events that can occur, the greater the risk.
Standard Deviation: a statistical measure of the spread of a probability
distribution calculated by squaring the difference between each
outcome and its expected value, weighting each value by its
probability, summing over all possible outcomes, and taking the square
root of this sum.
*For the publishing company’s common stock, we calculate the
standard deviation using the following fivestep procedure:
1. Calculate the expected rate of return of the investment
2. Subtract the expected rate of return from each of the possible
rates of return and square the difference
3. Multiply the squared differences calculated in step 2 by the
probability that those outcomes will occur
4. Sum all the values calculated in step 3 together. The sum is the
variance of the distribution of possible rates of return. Note that
the variance is actually the average squared difference between
the possible rates of return and the expected rate of return.
5. Take the square root of the variance calculated in step 4 to
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 Fall '08
 Potts
 Capital Asset Pricing Model

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