lecture 3: meaning and measurement of risk and return pt.1

Question 1

holding-period return

Answer 1

-historical/realised rate of return
-payoff during holding period
-equation:price end of period (+dividend)- price end of period

Question 2

holding period rate of return

Answer 2

equation: (price end of period +dividend)-price beginning of period)/(price beginning of period)

Question 3

expected return and expected cash flow equation

Answer 3

-expected return an investment generates come in the form of cash flows
-cash flows measure returns (not investments)

expected cash flows: weighted average of possible cash flow returns - weights are probabilities of occurrence
-expected cash flow= sum of (cash flow in state 1X probability of state 1)

Question 4

probability payoffs (expected return equation 2)

Answer 4

-expected return is the expected future return on a risky asset
-equation: sum(probability of outcome x expected return of outcome

Question 5

expected return summary

Answer 5

-expected return= expected future return on a risky asset
-calculate expected return by multiply expected return in a particular state of the economy by probability of state occuring

Question 6

measuring expected return

Answer 6

-sum of probability of state occuring x cash flow from investment
-probability x expected percentage returns (cash flow/investment)

Question 7

risk defined

Answer 7

potential variability in future cash flows
-the wider the range of possible future outcomes the riskier the asset

Question 8

standard deviation

Answer 8

-measures volatility/risk
-variance: weighted average difference of each return from expected return

Question 9

example table of how to calculate variance

Answer 9

-have expected return from probabilityx expected percentage returns
-state
-prob of state
return
-return from expected return (take away expected from actual return)
-squared return deviation from expected return (4^2)
-product (5x2)
-add up to get variance

Question 10

portfolio and portfolio weight

Answer 10

portfolio: group of assets (such as equities/bonds) held by an investor
portfolio weight: percentage of a portfolio’s total value that is in a particular asset

Question 11

portfolio expected returns

Answer 11

-if both weighted equally:
expected return 1 x 0.5 + expected return 2 x 0.5

Question 12

portfolio expected return with unknown weights (example)

Answer 12

-equity A has expected return of 5%, equity B has expected return of 15%, want a portfolio expected return of 10%
-we know 0.1=Wax0.05 + Wb x 0.15
-weight of B= 1- weight of A
-so: 0.1=Wax0.05 + 1-Wax0.15
-solve for Wa
-Wa=0.5 therefore, Wb=0.5

Question 13

portfolio variance (example)

Answer 13

-expected return on portfolio is 0.225
-state of economy
-probability of state occurring
-portfolio return if state occurs
-squared deviation from expected return (portfolio if occurs - return all squared)
-product (2 x 4)

Question 14

portfolio summary

Answer 14

-portfolio= group of assets such as equities and bonds held by an investor
-portfolio weight: percentage of a portfolios vtotal value that is in a particular asset
-expected return is weighted average of expected return of indivudal constituents
-vairance is less that weighted average of variance on its individual constituent