Chapter 5

Risk and return:

Past and prologue

Characteristics of Probability Distributions

1) Mean: most likely value 2) Variance or standard deviation: volatility 3) Skewness: symmetry * If a distribution is approximately normal, the distribution is described by characteristics 1 and 2

Figure 5.2 Rates of Return on Stocks, Bonds and Bills

Normal Distribution

s.d.

s.d.

r
Symmetric distribution

Skewed Distribution: Large Negative Returns Possible

Median

Negative

Positive

Skewed Distribution: Large Positive Returns Possible

Median

Negative

Positive

Measuring Mean: Expected Returns

Expected returns

E (r ) P( s )r ( s )
s

s different scenarios p(s) = probability of a scenario r(s) = return if a scenario occurs

Expected Returns

Using subjective probabilities for the coming year: State of economy Probability poor 0.2 normal 0.5 great 0.3

Return -10% 8% 25%

E(R) = 0.2 (-10%) + 0.5 (8%) + 0.3 (25%) = 9.5%

Measuring Variance & Standard deviation

measures the uncertainty of possible outcomes

Variance P( s)[r (s) E (r )] s

2

st.deviation Variance
Using Our Example:

Scenario poor normal great

P(s) 0.2 0.5 0.3

r(s) -10% 8% 25%

Variance = [.2*(-10 9.5) 2 + .5*(8 9.5)2 + .3*(25 - 9.5)2]

Variance = 76.05 + 1.125 + 72.075 = 149.25

Standard deviation = [ 149.25] 1/2 = 12.22%

Example
State of economy boom normal growth recession probability 0.25 0.50 0.25 return 44% 14% -16%

What is the expected return and standard deviation for this stock?

Historical Returns and Risk Aversion

Risk premium or Excess returns: ri - rf

What is the relationship between risk aversion, risk premium, and the risk-return tradeoff ?

Do you think the pattern of returns and standard deviations of small and large stocks (also bonds and T-bills) over the past 75-80 years is consistent with risk aversion and the risk-return tradeoff ?

Annual Holding Period Returns From Table 5.2 of Text

Figure 5.2 Rates of Return on Stocks, Bonds and Bills

Figure 5.1 Frequency Distributions of Holding Period Returns

Figure 5.3 Normal Distribution with Mean of 12.25% and St Dev of 20.50%