Measuring Risk with Variation. Which Game do you want to play?

Game 1.
You start by investing $100. Then two coins are flipped.
For each head that comes up your starting balace will be increased by 20%
For each tail that comes up your starting balacne will be reduced by 10%
The game plays infinitely.
Game 2.
You start by investing $100. Then two coins are flipped.
For each head that comes up your starting balace will be increased by 35%
For each tail that comes up your starting balacne will be reduced by 25%
The game plays infinitely.

Possible cases. Probability rate of return (%) Possible cases. Probability rate of return (%)
1. Head + Head 0.25 40 =20+20 1. Head + Head 0.25 70 =35+35
2. Head + Tail 0.25 10 =20-10 2. Head + Tail 0.25 10 =35-25
3. Tail + Head 0.25 10 =-10+20 3. Tail + Head 0.25 10 =-25+35
4. Tail + Tail 0.25 -20 =-10-10 4. Tail + Tail 0.25 -50 =-25-25
Expected rate of return (%) 10 =AVERAGE(D11:D14) Expected rate of return (%) 10 =AVERAGE(I11:I14)
Standard Deviation (%) 21.21 =STDEV.P(D11:D14) Standard Deviation (%) 42.43 =STDEV.P(I11:I14)

Range of Expected rate of return Range of Expected rate of return

Highest 31.21 =D16+D15 Highest 52.43 =I16+I15
Lowest -11.21 =D15-D16 Lowest -32.43 =I15-I16
Expected Rate of Return with the Same probability

A stock’s returns for the past three years are 10%, -15%, and 35%. What is the expected rate of return on year 4?

Year Realized return

1 10%
2 -15%
3 35%
Expected rate of return (Average) = 10.0% =AVERAGE(D9:D11)

A Hult student’s GPAs in University for the past four years are 2.8, 3.2, 4.0. What is the expected GPA of year 4?

Year Realized grade

1 2.80
2 3.20
3 4.00
Expected grade (Average) = 3.33 =AVERAGE(D19:D21)

Expected Rate of Return with probability

An investment has a 30% chance of producing a 25% return (strong economic growth), a 50% chance of producing a 10% return
(moderate growth), and a 20% chance of producing a -15% return (Econonmic recession). What is its expected return? What is its
standard deviation?

Possible Case Probability Return(%) Prob x Return (%)

Strong 0.30 25.00 7.50
Moderate 0.50 10.00 5.00
Recession 0.20 -15.00 -3.00
Expected Rate of Return (%) 9.50 =SUM(E32:E34) Sum of Prob x Return
9.50 =SUMPRODUCT(C32:C34,D32:D34)

A Hult student has a 25% chance of producing a 4.0 grade (if 8hours study per day individually), a 50% chance of producing a 3.6 grade
(if 4hours study per day individually), and a 25% chance of producing a 2.4 grade (if 1hour study per day individually). What is its
expected grade? What is its standard deviation?

Possible Case Probability Grade Prob x Grade

8 hours / day 0.25 4.00 1.00
4 hours / day 0.50 3.60 1.80
1 hours /day 0.25 2.40 0.60
Expected Grade of the Hult student 3.40 =SUM(E44:E46) Sum of Prob x Grade
Short cut 3.40 =SUMPRODUCT(C44:C46,D44:D46)
Standard Deviation with the same probability

A stock’s returns for the past three years are 10%, -15%, and 35%. What is the historical average return?
What is the standard deviation?

Year Realized return

1 10%
2 -15%
3 35%
Expected rate of return (Average) 10.0% =AVERAGE(D9:D11)
Standard deviation 20.4% =STDEV.P(D9:D11)
Expected Rate of Return at highest (%) 30%
Expected Rate of Return at lowest (%) -10%

A Hult student’s GPAs in University for the past four years are 2.8, 3.2, 4.0, and 3.5. What is the historical
average GPA? What is the standard deviation?

Year Realized grade

1 2.80
2 3.20
3 4.00
4 3.50
Expected grade (Average) 3.38 =AVERAGE(D22:D25)
Standard deviation 0.44 =STDEV.P(D22:D25)
Expected Grade at highest 3.81
Expected Grade at lowest 2.94
Expected Rate of Return with probabilities

An investment has a 30% chance of producing a 25% return (strong economic growth), a 50% chance of producing a 10% return (moderate growth), and a 20%
chance of producing a -15% return (Econonmic recession). What is its expected return? What is its standard deviation?

Deviation from the Expected

Deviation^2 (%%)
Possible Case Probability Return (%) Prob x Return (%) Return (%): Deviation^2 (%%)
x Probability
Return - Expected Return

Strong 0.3 25.00 7.50 15.50 240.25 72.075

Moderate 0.5 10.00 5.00 0.50 0.25 0.125

Recession 0.2 -15.00 -3.00 -24.50 600.25 120.05

Expected Rate of Return (%) 9.50 =SUM(E9:E11) of Prob x Return

Variance (%%) 192.25 =SUM(H9:H11) of Deviation^2 x Prob
Standard Deviation (%) 13.87 =SQRT(E13) of Variance
Expected Rate of Return at highest (%) 23.37
Expected Rate of Return at lowest (%) -4.37

A Hult student has a 25% chance of producing a 4.0 grade (if 8hours study per day individually), a 50% chance of producing a 3.6 grade (if 4hours study per day
individually), and a 25% chance of producing a 2.4 grade (if 1hour study per day individually). What is its expected grade? What is its standard deviation?

Deviation from the

Deviation^2 x
Possible Case Probability Grade Prob x Grade Expected Grade: Deviation^2
Probability
Grade - Expected Grade
8 hours / day 0.25 4.00 1.00 0.60 0.36 0.09
4 hours / day 0.5 3.60 1.80 0.20 0.04 0.02

1 hours /day 0.25 2.40 0.60 -1.00 1.00 0.25

Expected Grade the Hult student 3.40 =SUM(E23:E25) of Prob x Grade

Variance (grade x grade) 0.36 =SUM(H23:H25) of Deviation^2 x Prob
Standard Deviation (grade) 0.60 =SQRT(E27) of Variance
Expected Grade at highest 4.00
Expected Grade at lowest 2.80
 Correlation & Diversification of Portfolio

Stock A's returns for the past five years have been 10%, −15%, 35%, 10%, and −20%. Stock B's returns 15%, -1%, 28%, 40%, and -20%. Stock C's returns -1%, 35%, -2%,-
2%,32%. What are the execpected return and SD of the Portfolio A and B, correlation A and B? What are the execpected return and SD of the Portfolio A and C, correlation A
and C? What does the correlation mean? Assume two stock in the portfolio have the same weight of investment.

Year Stock A Stock B Portfolio A&B Year Stock A Stock C Portfolio A&C
1 10% 15% 13% Average of A & B 1 10% -1% 5% Average of A & C
2 -15% -1% -8% Average of A & B 2 -15% 35% 10% Average of A & C
3 35% 28% 32% Average of A & B 3 35% -2% 17% Average of A & C
4 10% 40% 25% Average of A & B 4 10% -2% 4% Average of A & C
5 -20% -20% -20% Average of A & B 5 -20% 32% 6% Average of A & C
Expected return 4.0% 12.4% 8.4% Average of Portfolio A&B Expected return 4.0% 12.4% 8.4% =AVERAGE(J10:J14)
Standard deviation 19.8% 21.2% 19.6% =STDEV.P(E10:E14) Standard deviation 19.8% 17.3% 4.8% =STDEV.P(J10:J14)
Correlation A and B 0.81 =CORREL(C10:C14,D10:D14) Correlation A and C -0.88 =CORREL(H10:H14,I10:I14)

Graph. Correlation A&B Graph. Correlation A&C

Chart Title Chart Title

0.5 0.4
0.4 0.35
0.3
0.3
0.25
0.2
0.2
0.1
0.15
0 0.1
-0.3 -0.2 -0.1 0 0.1 0.2 0.3 0.4
-0.1 0.05
-0.2 0
-0.3 -0.2 -0.1 -0.05 0 0.1 0.2 0.3 0.4
-0.3
Beta
eBay's beta
Graph eBay
Monthly Rate of Return Market Stock 15.00%
Month Nasdaq eBay
May 1.87% -1.32%
June -1.48% 5.53%
10.00%
July 3.73% 5.05%
August -1.55% 2.04%
September 2.33% -7.29%
5.00%
October 2.48% 4.53% f(x) = 0.781757237400134 x + 0.0070523494139955
November -0.44% 2.26%
December -3.11% -5.56%
0.00%
January 5.51% 9.26% -4.00% -3.00% -2.00% -1.00% 0.00% 1.00% 2.00% 3.00% 4.00% 5.00% 6.00%
February -1.76% -0.40%
March 0.87% 1.01%
-5.00%
April 2.01% 1.53%
Expected Monthly rate of return 0.87% 1.39%
Standard Deviation 2.46% 4.45%
Beta 1.00 0.78 -10.00%

Beta = Slope = Rise / Run =SLOPE(D7:D18,C7:C18)

slope of Characteristic line: =SLOPE(C7:C18,C7:C18)
eBay’s returns are 0.782 times as volatile on average as those of the overall market.

What is the Hult student's beta

Grade School Student

Year School Avg. Grade
Elementary 1 3.40 3.80 Grade
2 3.45 3.90 4.25
3 3.60 4.00
4 3.50 3.80 f(x) = 2.01673703256936 x − 3.49794933655006
5 3.25 3.10 3.75
Middle 6 3.40 3.90
7 3.38 3.60
8 3.56 3.70
3.25
High 9 3.25 3.65
10 3.20 3.30
11 3.50 2.80
12 3.30 1.90 2.75

Univ. 1 3.30 2.40

2 3.40 3.20
3 3.56 3.50 2.25
4 3.75 4.00
Expected Grade 3.43 3.41
Standard Deviation 0.14 0.57 1.75
2.50 2.70 2.90 3.10 3.30 3.50 3.70 3.90
Beta 1.00 2.02
=SLOPE(C31:C46,C31:C46) =SLOPE(D31:D46,C31:C46)
Required Rate of Return on an Equity. Capital Asset Pricing Model (CAPM)

Apple has a beta of 1.4. Assume that the risk-free rate is 2.5% and that the market risk premium is 7.3%. What is the stock’s
required rate of return?

Beta 1.4 Required Rate of Return on a stock (i)

Risk-free rate 2.5% = Risk free rate + Equity Risk Premium
= Risk free rate + Market risk premium x Beta of a stock (i)
Market Risk Premium 7.3%
Required rate of return on the stock 12.72% = Risk free rate + (Market Rate of Return – Risk free rate) x Beta of a stock (i)
= Rf + (Rm – Rf) Bi

Google has a beta of 0.95. Assume that the historical average T-bill rate is 2.5% and that the historical S&P500 market return
is 9.8%. What is the stock’s required rate of return?

Beta 0.95 Required Rate of Return on a stock (i)

Risk-free rate 2.5% = Risk free rate + Risk Premium of a stock (i)
= Risk free rate + Market risk premium x Beta of a stock (i)
Market return (S&P 500) 9.8%
Required rate of return on the stock 9.44% = Risk free rate + (Market Rate of Return – Risk free rate) x Beta of a stock (i)
= Rf + (Rm – Rf) Bi

I have invested in Apple stocks of $60,000 and invested in Google stocks of $ 40,000. What is the required rate of the return
on my investment portfolio? Assume that the historical average T-bill rate is 2.5% and that the historical S&P500 market
return is 9.8%.

Stock Investment Beta Weight Beta x Weight

Apple 60,000 1.40 0.6 0.84
Google 40,000 0.95 0.4 0.38
Total 100,000 Portfolio beta = 1.22 =SUM(F29:F30) of Beta x Weight

Portfolio Beta 1.22 Required Rate of Return on a stock (i)

Risk-free rate 2.5% = Risk free rate + Risk Premium of a stock (i)
= Risk free rate + Market risk premium x Beta of a stock (i)
Market return (S&P 500) 9.8%
Required rate of return on the pf = 11.4% = Risk free rate + (Market Rate of Return – Risk free rate) x Beta of a stock (i)
= Rf + (Rm – Rf) Bi