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Lecture 6

ADM2350 Lecture 6: Untitled6

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Anna Dodonova

Chapter 7: RISK, RETURN, AND THE CAPITAL ASSET PRICING MODEL Percentage return Return = capital gain (loss) return + income yield(if any) P1− P 0 CF 1 CF 1 P 1 P 0 Return = + = P 0 P0 P0 e.g, A stock had an initial price of $58 per share, paid a dividend of $1.25 per share during the year, and had an ending price of $75. The percentage total return R = [$1.25 + ($75 - 58)]/$58 = 31.47% —> CF (cash flow) is the dividend here —> the initial price (P0) is 58 and the ending price (P1) os 75 —> Main principal: Investors like higher return and do not like higher risk! Probability Distributions —> Probability distributions are used to describe the certainty of returns by listing all possible returns and their probabilities. —> Graphically, the tighter (i.e., more peaked) the probability distribution, the more likely it is that the actual returns will be close to the expected value. —> The tighter the probability distribution, the lower the risk assigned to a stock. Expected return = The weighted average of outcomes Standard deviation = A measure of the tightness of a probability distribution giving an idea of how far above or below the expected value the actual value is likely to be —> EQ calculate the expected return and SD of the stocks Coefficient of Variation (CV) = shows the risk per unit of return and captures the effects of both risk and return, help us to decide in which assets we want to invest CV = Standard deviation / expected return CVMicro = 65.84% / 15% = 4.39 CVBig = 19.36% / 15% = 1.29 Expected Return and Risk for Portfolios —> portfolio = a collect
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