Expected return is the mean, or average, of the probability distribution of possible future returns.
To calculate expected return, compute the weighted average of possible returns
where = Expected return V i = Possible value of return during period i P i = Probability (%) of V occurring during period i V i x P i )
Expected Return Calculation Example: You are evaluating Zumwalt Corporation’s common stock. You estimate the following returns given different states of the economy = – 0.5% = 1.0% = 4.0% = 6.0% k = 10.5% Expected rate of return on the stock is 10.5% State of Economy Probability Return Economic Downturn .10 –5% Zero Growth .20 5% Moderate Growth .40 10% High Growth .30 20% 1.00
Measurement of Investment Risk Example: You evaluate two investments: Zumwalt (10.5%) Corporation’s common stock and a one year Government Note paying a guaranteed 6%. Link to Society for Risk Analysis There is risk in owning Zumwalt stock, no risk in owning the T-bills 100% Return Probability of Return T-Note 6% Return 10% Probability of Return Zumwalt Corp 5% 20% 30% 40% 10% 20% – 5%
Investors adjust their required rates of return to compensate for risk.
Security Market Line where: K j = required rate of return on the j th security K RF = risk free rate of return (T-Bill) K M = required rate of return on the market B j = Beta for the j th security The Capital Asset Pricing Model
The CAPM measures required rate of return for investments, given the degree of market risk as measured by beta.