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Return Return Distribution Expected Return Risk Variance of Return

Lecture 1.3: Risk-Return Characteristics of


Securities
Investment Analysis
Fall, 2012
Anisha Ghosh
Tepper School of Business
Carnegie Mellon University
November 1, 2012
Return Return Distribution Expected Return Risk Variance of Return
Return
Return: is the growth in the value of an investment over a particular
span of time
r
t +1
=
P
t +1
+ d
t +1
P
t
1
P
t
: purchase price
P
t +1
: price next period
d
t +1
: cash ow next period
Looking forward through time, the return is random.
Return Return Distribution Expected Return Risk Variance of Return
Return
Return: is the growth in the value of an investment over a particular
span of time
r
t +1
=
P
t +1
+ d
t +1
P
t
1
P
t
: purchase price
P
t +1
: price next period
d
t +1
: cash ow next period
Looking forward through time, the return is random.
Return Return Distribution Expected Return Risk Variance of Return
Return Distribution
The existence of risk the investor can no longer associate a single
number or payoff with investment in any asset.
Return Distribution
A return distribution is the set of possible payoffs from investment in an
asset along with their associated probability of occurrence.
Two summary measures are typically used to capture the relevant
information about a return distribution: Expected Return and Variance
of Return
Return Return Distribution Expected Return Risk Variance of Return
Return Distribution
The existence of risk the investor can no longer associate a single
number or payoff with investment in any asset.
Return Distribution
A return distribution is the set of possible payoffs from investment in an
asset along with their associated probability of occurrence.
Two summary measures are typically used to capture the relevant
information about a return distribution: Expected Return and Variance
of Return
Return Return Distribution Expected Return Risk Variance of Return
Return Distribution
The existence of risk the investor can no longer associate a single
number or payoff with investment in any asset.
Return Distribution
A return distribution is the set of possible payoffs from investment in an
asset along with their associated probability of occurrence.
Two summary measures are typically used to capture the relevant
information about a return distribution: Expected Return and Variance
of Return
Return Return Distribution Expected Return Risk Variance of Return
Expected Return
Denition
The Expected Return of an asset is the probability-weighted sum of the
different possible outcomes or payoffs from investing in the asset.
If P
ij
is the probability of the j th return on the i th asset, R
ij
, then
expected return is
E (R
i
) =
M

j =1
P
ij
R
ij
If the M outcomes are equally likely, the expected return is
E (R
i
) =
1
M
M

j =1
R
ij
The expected return refers to the "average value" of the return.
Return Return Distribution Expected Return Risk Variance of Return
Expected Return
Denition
The Expected Return of an asset is the probability-weighted sum of the
different possible outcomes or payoffs from investing in the asset.
If P
ij
is the probability of the j th return on the i th asset, R
ij
, then
expected return is
E (R
i
) =
M

j =1
P
ij
R
ij
If the M outcomes are equally likely, the expected return is
E (R
i
) =
1
M
M

j =1
R
ij
The expected return refers to the "average value" of the return.
Return Return Distribution Expected Return Risk Variance of Return
Expected Return
Denition
The Expected Return of an asset is the probability-weighted sum of the
different possible outcomes or payoffs from investing in the asset.
If P
ij
is the probability of the j th return on the i th asset, R
ij
, then
expected return is
E (R
i
) =
M

j =1
P
ij
R
ij
If the M outcomes are equally likely, the expected return is
E (R
i
) =
1
M
M

j =1
R
ij
The expected return refers to the "average value" of the return.
Return Return Distribution Expected Return Risk Variance of Return
Expected Return
Denition
The Expected Return of an asset is the probability-weighted sum of the
different possible outcomes or payoffs from investing in the asset.
If P
ij
is the probability of the j th return on the i th asset, R
ij
, then
expected return is
E (R
i
) =
M

j =1
P
ij
R
ij
If the M outcomes are equally likely, the expected return is
E (R
i
) =
1
M
M

j =1
R
ij
The expected return refers to the "average value" of the return.
Return Return Distribution Expected Return Risk Variance of Return
Example
Return Return Distribution Expected Return Risk Variance of Return
Risk
Several factors affect the risk associated with investing in a instrument:
The maturity (in general, the longer the maturity the more risky it
is)
The risk characteristic and creditworthiness of the issuer or
guarantor
The nature and priority of the claims the investment has on
income and assets
The liquidity of the instrument and the type of market in which it is
traded
measures of risk such as the variability of returns should be related
to the above factors.
The variance is a widely used measure of risk.
Return Return Distribution Expected Return Risk Variance of Return
Risk
Several factors affect the risk associated with investing in a instrument:
The maturity (in general, the longer the maturity the more risky it
is)
The risk characteristic and creditworthiness of the issuer or
guarantor
The nature and priority of the claims the investment has on
income and assets
The liquidity of the instrument and the type of market in which it is
traded
measures of risk such as the variability of returns should be related
to the above factors.
The variance is a widely used measure of risk.
Return Return Distribution Expected Return Risk Variance of Return
Risk
Several factors affect the risk associated with investing in a instrument:
The maturity (in general, the longer the maturity the more risky it
is)
The risk characteristic and creditworthiness of the issuer or
guarantor
The nature and priority of the claims the investment has on
income and assets
The liquidity of the instrument and the type of market in which it is
traded
measures of risk such as the variability of returns should be related
to the above factors.
The variance is a widely used measure of risk.
Return Return Distribution Expected Return Risk Variance of Return
Variance of Return
Denition
The variance of return on an asset is the probability-weighted sum of
the squared deviations of the different possible payoffs from its mean.
The formula for the variance of the return on asset i is

2
i
=
M

j =1
P
ij
(R
ij
E (R
i
))
2
If the M outcomes are equally likely, the variance of the return is

2
i
=
1
M
M

j =1
(R
ij
E (R
i
))
2
The variance is a measure of the dispersion of the return distribution,
i.e. a measure of how much the outcomes differ from the average.
Standard deviation: is the square root of the variance
Return Return Distribution Expected Return Risk Variance of Return
Variance of Return
Denition
The variance of return on an asset is the probability-weighted sum of
the squared deviations of the different possible payoffs from its mean.
The formula for the variance of the return on asset i is

2
i
=
M

j =1
P
ij
(R
ij
E (R
i
))
2
If the M outcomes are equally likely, the variance of the return is

2
i
=
1
M
M

j =1
(R
ij
E (R
i
))
2
The variance is a measure of the dispersion of the return distribution,
i.e. a measure of how much the outcomes differ from the average.
Standard deviation: is the square root of the variance
Return Return Distribution Expected Return Risk Variance of Return
Variance of Return
Denition
The variance of return on an asset is the probability-weighted sum of
the squared deviations of the different possible payoffs from its mean.
The formula for the variance of the return on asset i is

2
i
=
M

j =1
P
ij
(R
ij
E (R
i
))
2
If the M outcomes are equally likely, the variance of the return is

2
i
=
1
M
M

j =1
(R
ij
E (R
i
))
2
The variance is a measure of the dispersion of the return distribution,
i.e. a measure of how much the outcomes differ from the average.
Standard deviation: is the square root of the variance
Return Return Distribution Expected Return Risk Variance of Return
Variance of Return
Denition
The variance of return on an asset is the probability-weighted sum of
the squared deviations of the different possible payoffs from its mean.
The formula for the variance of the return on asset i is

2
i
=
M

j =1
P
ij
(R
ij
E (R
i
))
2
If the M outcomes are equally likely, the variance of the return is

2
i
=
1
M
M

j =1
(R
ij
E (R
i
))
2
The variance is a measure of the dispersion of the return distribution,
i.e. a measure of how much the outcomes differ from the average.
Standard deviation: is the square root of the variance
Return Return Distribution Expected Return Risk Variance of Return
Variance of Return
Denition
The variance of return on an asset is the probability-weighted sum of
the squared deviations of the different possible payoffs from its mean.
The formula for the variance of the return on asset i is

2
i
=
M

j =1
P
ij
(R
ij
E (R
i
))
2
If the M outcomes are equally likely, the variance of the return is

2
i
=
1
M
M

j =1
(R
ij
E (R
i
))
2
The variance is a measure of the dispersion of the return distribution,
i.e. a measure of how much the outcomes differ from the average.
Standard deviation: is the square root of the variance
Return Return Distribution Expected Return Risk Variance of Return
Example
Return Return Distribution Expected Return Risk Variance of Return
Rates of returns vs time
Treasury bond returns are more variable than T-bills due to the longer
maturity of the former
Common stocks are even more variable because the issuer has a
higher risk and because the claim on income and earnings are more
junior in nature
Return Return Distribution Expected Return Risk Variance of Return
Rates of returns vs time
Treasury bond returns are more variable than T-bills due to the longer
maturity of the former
Common stocks are even more variable because the issuer has a
higher risk and because the claim on income and earnings are more
junior in nature
Return Return Distribution Expected Return Risk Variance of Return
Rates of returns vs time
Treasury bond returns are more variable than T-bills due to the longer
maturity of the former
Common stocks are even more variable because the issuer has a
higher risk and because the claim on income and earnings are more
junior in nature
Return Return Distribution Expected Return Risk Variance of Return
Return and Risk
Return and risk for selected types of securities in percent per year