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**preview**shows half of the first page. to view the full**3 pages of the document.**Topic 10- Risk, Return, Portfolios, Diversification and the CAPM

Forward looking expected returns

- Expected returns depend upon possible outcomes weighted by their probabilities

Elements of the equation

E(RA)=Expected Return

pi=probability of i

RAi=rate of return

This equation appears complicated but it is actually relatively straightforward

In simple terms it is: E(RA)= Probability 1 x Return 1 + Probability 2 x Return 2 ……

Example to show this

State

Probability of state of

economy

Rate of return

Boom

0.14

0.18

Normal

0.75

0.11

Recession

0.11

-0.06

What is the future expected rate of return?

E(RA)=Probability 1 x Return 1 + Probability 2 x Return 2 + Probability 3 x Return 3

0.14 x 0.18 + 0.75 x 0.11 + 0.11 x -0.06 = 0.1011

0.1011 x 100 = 10.11

Another example to reinforce the point

Suppose there are three possible future states of the world, and you have predicted the

following returns for stocks BDA and CEC in these states. What are the expected returns

on the stocks?

State

Probability

BDA return

CEC Return

Boom

0.3

0.15

0.25

Normal

0.5

0.10

0.20

Recession

0.2

0.02

0.01

E(RBDA)=0.3 x 0.15 + 0.5 x 0.10 + 0.2 x 0.02

= 0.099

0.099 x 100 = 9.9%

E(RCEC)=0.3 x 0.25 + 0.5 x 0.20 + 0.2 x 0.01

= 0.177

0.177 x 100 = 17.7%

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