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Chapter 6
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
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This note was uploaded on 08/30/2011 for the course FIN 3310 taught by Professor Potts during the Fall '08 term at Baylor.
 Fall '08
 Potts

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