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The expected return from investing in a security over some future holding period is an estimate of
the future outcome of this security.
Although the Expected Return is an estimate of an investors expectations of the future,
it can be estimated using either ex ante (forward looking) or ex post (historical) data.
If the expected return is equal to or greater than the required return, purchase the
security.
Regardless of how the individual returns are calculated, the Expected Return of a
Portfolio is the weighted sum of the individual returns from the securities making up the
portfolio:
N
E ( R ) P wn E ( R ) n
n 1
Ex ante expected return calculations are based on probabilities of the future states of nature and
the expected return in each state of nature. Sum over all states of nature, the product of the
probability of a state of nature and the return projected in that state.
State
Ps
Good 30%
Average 50%
Poor 20%
Rs
20%
15%
-4%
Ps * Rs
0.3(0.2)
+0.5(0.15)
+0.2(-0.04)
E ( R ) Ps R s
s 1
12.70%
Ex post expected return calculations are based on historical data. Add the historical returns and
then divide by the number of observations.
Year
2002
2003
2004
2005
2006
T
E ( R ) Rt T
t 1
Rt
15%
20%
9%
10%
5%
11.80%
Rs
20%
15%
-4%
Ps * Rs
(Rs E(R))2 * Ps
0.3(0.2)
0.3(0.2-0.127)2
+0.5(0.15) +0.5(0.15-0.127)2
+0.2(-0.04) +0.2(-0.04-0.127)2
12.70%
0.0074
Mean
Variance
S
8.63%
Standard
Deviation
2 [ R s E ( R)] 2 Ps
s 1
Population
data
Sample
data
Rt
15%
20%
9%
10%
5%
= Sum/5
11.80%
Mean
(Rt E(R))2
(0.15-0.118)2
(0.2-0.118)2
(0.09-0.118)2
(0.1-0.118)2
(0.05-0.118)2
=Sum/5
0.0027
Population
Variance
5.19%
Population
Std Dev
E ( R)) 2 (T )
t 1
( Rt E ( R )) 2 (T 1)
t 1
(R
(Rt E(R))2
(0.15-0.118)2
(0.2-0.118)2
(0.09-0.118)2
(0.1-0.118)2
(0.05-0.118)2
=Sum/4
0.0034
Sample
Variance
5.81%
Sample
Std Dev
Variance of a Portfolio: p
Ex ante variance of a portfolio if portfolio returns for each state of nature and probabilities of
the states of nature are known:
S
P2 [ R P ,s E ( R P )]2 PP ,s
s 1
Ex post variance of a portfolio if portfolio returns for each historical time period are known:
E ( R P )) 2 (T )
(R
P2
t 1
P ,t
The variance of a portfolio (ex ante or ex post) can be calculated using the weights and
covariances of the assets making up the portfolio:
P2
P2 w 2j
j 1
2
j
w
j 1 k 1
wk j k
w
j 1 k 1, k j
wk
jk
The variance of a portfolio is not equal to the weighted sum of the individual asset
variances unless all the assets are perfectly positively correlated with each other.
N
2
2
P wi i
i 1
Covariance: ij
Covariance is an absolute measure of the extent to which two variables tend to covary or move
together.
Correlation Coefficient: ij
The correlation coefficient is a standardized statistical measure of the extent to which two
variables are associated ranging from perfect positive correlation (i,j = +1.0) to perfect negative
correlation (i,j = -1.0).
Ex ante
State
PS
RX,S
RY,S
PS * (RX,S E(RS)) * (RY,S E(RS))
Good
30% 20%
38%
0.3(0.2-0.127)(0.38-0.174)
Average 50% 15%
16%
+0.5(0.15-0.127)(0.16-0.174)
Poor
20% -4%
-10%
+0.2(-0.04-0.127)(-0.1-0.174)
Mean
12.70% 17.40%
Variance
0.0074 0.0278
Std Dev
8.63% 16.69%
Covariance
0.0135
Correlation
0.9380
ij
S
i j
i j Ps ( Ri s E ( R ) i )( R j s E ( R ) j )
i j
s 1
Ex post
Year
2002
2003
2004
2005
2006
Mean
RX,t
15%
20%
9%
10%
5%
11.80%
RY,t
(RX,t E(RX)) (RY,t E(RY))
18%
(0.15-0.118)(0.18-0.144)
15%
(0.2-0.118)(0.15-0.144)
35%
(0.09-0.118)(0.35-0.144)
9%
(0.1-0.118)(0.09-0.144)
-5%
(0.05-0.118)(-0.05-0.144)
14.40%
Population
Variance
0.0027
0.0169
Std Dev
5.19%
12.99%
Sum / 5
Covariance
0.0020
Correlation
0.2978
Sample
Variance
0.0034
0.0211
Std Dev
5.81%
14.52%
Sum / (5-1)
Covariance
0.0025
Correlation
0.2978
Population data
T
i j ( Rit E ( R ) i )( R j t E ( R ) j ) T
t 1
T
Sample data
i j ( Ri t E ( R ) i )( R j t E ( R ) j ) T 1
t 1
Beta: i
Beta is a measure of volatility, or relative systematic risk, for single assets or portfolios.
iM
2
M
iM i
M
Historical beta is usually estimated by regressing the excess asset returns for the company
or portfolio (y-variable: Ri - Rf) against the excess market returns (x-variable: Rm - Rf)
i.e., through the use of a characteristic line.
The beta of a portfolio is Port wi i .
Prob
30%
50%
20%
Mean
Variance
Std Dev
Beta
5.00%
0
0.00%
0.00
RF,Mkt
Covariance
Correlation
0
0
Mkt,x
0.0027
0.8520
11.00%
0.0013
3.61%
1.00
12.70%
0.0074
8.63%
2.04
17.40%
0.0278
16.69%
4.54
x,RF
Mkt,y
0.0059
0.9807
x,y
0.0135
0.9380
0
0
12.19%
0.0052
7.21%
1.92
y,RF
0
0
RF,Mkt
0.0001
0.4396
4.80%
0.0001
0.75%
0.07
10.40%
0.0020
4.50%
1
11.80%
0.0027
5.19%
0.83
14.40%
0.0169
12.99%
0.64
11.06%
0.0021
4.64%
0.79
Mkt,x
0.0017
0.7226
x,RF
0.0003
0.8647
Mkt,y
0.0013
0.2232
x,y
0.0020
0.2978
y,RF
0.0005
0.5227
RF,Mkt
0.0002
0.4396
4.80%
0.0001
0.84%
0.07
10.40%
0.0025
5.03%
1
11.80%
0.0034
5.81%
0.83
14.40%
0.0211
14.52%
0.64
11.06%
0.0027
5.18%
0.79
Mkt,x
0.0021
0.7226
x,RF
0.0004
0.8647
Mkt,y
0.0016
0.2232
x,y
0.0025
0.2978
y,RF
0.0006
0.5227
Ex Ante
Variance/Covariance Matrix (4x4)
0
0
0
0
0 0.0013 0.0027
0.0059
0 0.0027 0.0074
0.0135
0 0.0059 0.0135
0.0278
Weights*Var/Covar matrix (1x4)
0.0000 0.0025 0.0060
0.0120
Weights (4x1)
10%
40%
30%
20%
Weights (4x1)
10%
40%
30%
20%
0.0052
7.21%
Weights (4x1)
10%
40%
30%
20%
Weights (4x1)
10%
40%
30%
20%
0.0021
4.64%
Weights (4x1)
10%
40%
30%
20%
Weights (4x1)
10%
40%
30%
20%
0.0027
5.18%
Annualizing Values
To annualize returns and standard deviations from periodic returns and standard deviations use the
following set of equations which assumes compounding.
Rannual 1 RPeriodic
annual
2
Periodic
1 RPeriodic
2 m
1 RPeriodic
2m
1.1196%
4.3532%
Annual w/
compounding
14.2928%
17.1313%
Annual w/o
compounding
13.4352%
15.0799%
Note: Without the compounding effects, the annualized equations would be m times the periodic
average return for the mean Rannual m * R Periodic and the square root of m times the periodic
*
(1 RFree , F ) (1 RReal, F ) [1 E ( I F )]
E ( RM ) R Free
Realized Return
The actual return that the investor earns on the investment. A key calculation for realized return is
holding period return (or total return).
Holding Period Return: Percentage measure relating all cash flows on a security for a given time
period to its purchase price.
Holding Period Return
The return over a specified holding period.
Ending Value
HPR
1
Beginning Value
HPR
Beginning Value
(1 / T )
Cash Inflows
Selling price
Cash Inflows
Selling price
1
Purchase price
Purchase price Annual HPR Purchase price Purchase price
Return Relative: The total return for an investment for a given time period stated on the basis of a
starting point of 1.
Cash Inflows
Selling price
1 T
R ( Rt ) T
t 1
(1 TR )
t 1
1/ T
RRt 1
t1
T
1/ T
When return variability exists, the arithmetic average will always be larger than the
geometric mean and this difference grows as return variability increases.
The geometric average return is approximately equal to the arithmetic average return less
one-half the variance (i.e., G R 2 2 ).
The arithmetic mean is a better measure of average performance over single periods and
the geometric mean is a better measure of the change in wealth over multiple periods.
An alternative for projecting future performance over multiple time periods consists of a
weighted average of the Arithmetic and Geometric Means
R 1 H T G H T
Where T is the number of used in the historical mean calculations and H is the number of
years in the forecasted period.