Chapter 22

Estimating Risk and

Return on Assets
What is
It is the possibility
that an unfavorable
event will occur.
 Risk -Return
Relationship

Higher the Risk.

Higher the Return.
the percentage that an event 0 1
will occur.

Outcome Probability
Win .6 60%
Lose .4 40%
the listing of all possible outcomes in 1 100%
which the probability on each event
are also listed.
 Based on past outcomes.
or
Based on “educated guesses” about the
likelihood that an event will have a
particular future outcome.

Variables can assume limited or finite

or number of values.
Variables can assume unlimited or infinite
number of values.

Difference between the highest and

lowest possible outcome.
 Formula:
𝑛

𝑟Ƹ = ෍ 𝑤𝑖 𝑟𝑖Ƹ
𝑖=1
The weighted average Where:
𝑤𝑖 = 𝑝𝑟𝑜𝑝𝑜𝑟𝑡𝑖𝑜𝑛 𝑜𝑓 𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 𝑖𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝑖𝑛 𝑎𝑠𝑠𝑒𝑡, 𝑖
of the expected returns 𝑟Ƹ = 𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑟𝑒𝑡𝑢𝑟𝑛 𝑜𝑓 𝑎𝑠𝑠𝑒𝑡, 𝑖
from the individual 𝑛 = 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑎𝑠𝑠𝑒𝑡𝑠 𝑖𝑛 𝑎 𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜

assets in a portfolio
To calculate Standard Deviation:
1. Compute the Expected Value (𝑟). Ƹ
2. Subtract (𝑟)Ƹ from each possible return to
obtain the deviations (𝑟𝑖 − 𝑟).Ƹ
3. Square each deviation (𝑟𝑖 − 𝑟)Ƹ 2.
4. Multiply each (𝑟𝑖 − 𝑟)Ƹ 2 by its probability
of occurrence, and then add. The result
would be called Variance (𝜎 2 ). a statistical measure
5. Take the square root of the variance. of the variability of a
probability
Note: The smaller the standard deviation, the tighter the
probability distribution, the smaller the range of returns, and the
distribution around its
lower risk. expected value.
The standardize measure of the risk per unit of return.

Formula:
𝑆𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝐷𝑒𝑣𝑖𝑎𝑡𝑖𝑜𝑛 (𝜎)
𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑅𝑒𝑡𝑢𝑟𝑛
 the variability of return of the
portfolio as a whole.

investing in more than one type of asset in

order to reduce risk.

measure the amount of risk reduction

achieved through diversification.

𝒑 = +𝟏. 𝟎 Perfectly Positively Correlated

𝒑 = −𝟏. 𝟎 Perfectly Negatively Correlated

𝒑= 𝟎 Uncorrelated or Independent
Formula:

𝜎𝑝 = 𝑤12 𝜎12 + 𝑤22 𝜎22 + 2𝑤1 𝑤2 𝑝1,2 𝜎1 𝜎2

Where:
𝑤1 = 𝑝𝑟𝑜𝑝𝑜𝑟𝑡𝑖𝑜𝑛 𝑖𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝑖𝑛 𝑎𝑠𝑠𝑒𝑡 1
𝑤2 = 𝑝𝑟𝑜𝑝𝑜𝑟𝑡𝑖𝑜𝑛 𝑖𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝑖𝑛 𝑎𝑠𝑠𝑒𝑡 2
𝜎1 = 𝑠𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝑑𝑒𝑣𝑖𝑎𝑡𝑖𝑜𝑛 𝑜𝑓 𝑎𝑠𝑠𝑒𝑡 1
𝜎2 = 𝑠𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝑑𝑒𝑣𝑖𝑎𝑡𝑖𝑜𝑛 𝑜𝑓 𝑎𝑠𝑠𝑒𝑡 2
𝑝1,2 = 𝑐𝑜𝑟𝑟𝑒𝑙𝑎𝑡𝑖𝑜𝑛 𝑐𝑜𝑒𝑓𝑓𝑖𝑐𝑖𝑒𝑛𝑡 𝑏𝑒𝑡𝑤𝑒𝑒𝑛 𝑎𝑠𝑠𝑒𝑡 1 & 2
 the actual amount of compensation demanded.

Classification of Decision Makers:

1. Risk-adverse – are those that require higher rates of return on
higher-risk securities.
2. Risk-neutral – are those willing to pay the expected value.
3. Risk-takers – are those willing to pay more than the expected
value.