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HANDOUT 4.1
This Handout 4.1 discusses the core ideas of the classic approach to returns as random
variables. It provides just an overview. The more detailed discussion of the probabilistic
treatment of returns can be found in Further Reading for Week 4.
INTRODUCTION
In real life, many factors affect returns on investments. It is reasonable to treat these returns
as random variables. In this case, we have to talk about expected returns and the probability
distribution of returns.
Generally, normal distribution serves as a good approximation. In this case, any return is
characterized by its mean value and the standard deviation from the mean.
It is important to be able to calculate the means and standard deviations for a group of
returns. The corresponding values depend upon correlation between those returns.
Variance
Covariance
(2) (y) ( y)
(3) E ( x y) ~
x~
y
(7) s 2 (a x + b y) = a 2s x2 + b 2s y2 + 2abs xy
2
Principles of Corporate Finance – A Tale of Value Week 4
Stock X Y
Weight 60% 40%
E(R) 12% 15%
30% 20%
Stock X Y Z
Weight wx wy wz
E(R) Rx Ry Rz
x y z
E ( R) w x R x w y R y w z R z ( w x w y w z 1)