Expected Rates of Return

Expected Rates of Return - Expected Rates of Return • •...

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Unformatted text preview: Expected Rates of Return • • In previous examples, we discussed realized historical rates of return. In contrast, an investor would be more interested in the expected return on a future risky investment. Risk refers to the uncertainty of the future outcomes of an investment – – There are many possible returns/outcomes from an investment due to the uncertainty 1-1 Probability is the likelihood of an outcome Expected Rates of Return • Computing Expected Rate of Return n E(R i ) = ∑ (Probabilit y of Return) × (Possible Return) i =1 = [(P1 )(R 1 ) + (P2 )(R 2 ) + .... + (Pn R n )] n = ∑( Pi )( Ri ) i =1 where P i = Probability for possible return i 1-2 Probability Distributions Exhibit 1.2 Risk-free Investment 1.00 0.80 0.60 0.40 0.20 0.00 -5% 0% 5% 10% 15% 1-3 Probability Distributions Exhibit 1.3 Risky Investment with 3 Possible Returns 1.00 0.80 0.60 0.40 0.20 0.00 -30% -10% 10% 30% 1-4 Probability Distributions Exhibit 1.4 Risky investment with ten possible returns 1.00 0.80 0.60 0.40 0.20 0.00 -40% -20% 0% 20% 40% 1-5 Risk of Expected Return • • • Risk refers to the uncertainty of an investment; therefore the measure of risk should reflect the degree of the uncertainty. The risk of expected return reflects the degree of uncertainty that actual return will be different from the expected return. The common measures of risk are based 1-6 on the variance of the rates of return Risk of Expected Return • Measuring the Risk of Expected Return – The Variance Measure Variance (σ ) n Possible Expected 2 = ∑ (Pr obability ) x ( − ) Re turn Re turn i= 1 = n Pi [ Ri − E ( Ri )]2 ∑ i= 1 1-7 Risk of Expected Return Standard Deviation (σ): It is the square root of the variance and measures the total risk – σ= – n − E ( Ri )]2 ∑ Pi [ Ri i= 1 Coefficient of Variation (CV): It measures the risk per unit of expected return and is a relative measure of risk. Standard Deviation of Return Expected Rate of Return =σ E (R) CV = 1-8 ...
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Expected Rates of Return - Expected Rates of Return • •...

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