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Lecture 3

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

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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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