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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

(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

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