# FINA601 Lecture Notes - Lecture 3: Capital Asset Pricing Model, Squared Deviations From The Mean, Standard Deviation

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**preview**shows pages 1-3. to view the full**18 pages of the document.**Week 3 Lecture 3 – Chapter 11: Return and Risk: The Capital Asset Pricing Model (CAPM)

Expected Return, Variance, and Covariance (11.1)

Expected Return

• This is the return that an individual expects a stock to earn over the next period. Of

course, because this is only an expectation, the actual return may be either higher or

lower – An individual’s expectation may simply be the average return per period a

security has earned in the past

Variance and Standard Deviation

• There are many ways to assess the volatility of a security’s return. One of the most

common is variance, which is a measure of the squared deviations of a security’s

return from its expected – Standard Deviation is the square root of the variance

Variance Formula:

Standard Deviation (Risk) Formula:

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Covariance and Correlation

• Returns on individual securities are related to one another – Covariance is a statistic

measuring the interrelationship between two securities. Alternatively, this relationship

can be restated in terms of the correlation between the two securities – Covariance

and Correlation are building blocks to an understanding of the beta coefficient

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Expected Return, Variance, and Covariance: Example

• Consider the following two risky asset world. There is a 1/3 chance of each state of

the economy, and the only assets are a stock fund and a bond fund

Expected Return and Variance

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