Expected Return State of Probability Return Economy (P) Orl. Utility Orl. Tech Recession.20 4% -10% Normal.50 10% 14% Boom.30 14% 30% For each firm, the.

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Presentation transcript:

Expected Return State of Probability Return Economy (P) Orl. Utility Orl. Tech Recession.20 4% -10% Normal.50 10% 14% Boom.30 14% 30% For each firm, the expected return on the stock is just a weighted average:

Expected Return State of Probability Return Economy (P) Orl. Utility Orl. Tech Recession.20 4% -10% Normal.50 10% 14% Boom.30 14% 30% For each firm, the expected return on the stock is just a weighted average: k = P(k 1 )*k 1 + P(k 2 )*k P(k n )*kn

Expected Return State of Probability Return Economy (P) Orl. Utility Orl. Tech Recession.20 4% -10% Normal.50 10% 14% Boom.30 14% 30% k = P(k 1 )*k 1 + P(k 2 )*k P(k n )*kn k (OU) =.2 (4%) +.5 (10%) +.3 (14%) = 10%

Expected Return State of Probability Return Economy (P) Orl. Utility Orl. Tech Recession.20 4% -10% Normal.50 10% 14% Boom.30 14% 30% k = P(k 1 )*k 1 + P(k 2 )*k P(k n )*kn k (OI) =.2 (-10%)+.5 (14%) +.3 (30%) = 14%

Based only on your expected return calculations, which stock would you prefer?

RISK? Have you considered

What is Risk? n n Uncertainty in the distribution of possible outcomes. Company A return

What is Risk? n n Uncertainty in the distribution of possible outcomes. Company B return Company A return

How do we Measure Risk? n n A more scientific approach is to examine the stock’s STANDARD DEVIATION of returns. n n Standard deviation is a measure of the dispersion of possible outcomes. n n The greater the standard deviation, the greater the uncertainty, and therefore, the greater the RISK.

Standard Deviation n i=1 = (k i - k) P(k i ) 2  

Orlando Utility, Inc. = (k i - k) P(k i ) 2   n i=1

Orlando Utility, Inc. ( 4% - 10%) 2 (.2) = 7.2 Orlando Utility, Inc. ( 4% - 10%) 2 (.2) = 7.2 n i=1 = (k i - k) P(k i ) 2   n i=1

Orlando Utility, Inc. ( 4% - 10%) 2 (.2) = 7.2 (10% - 10%) 2 (.5) = 0 Orlando Utility, Inc. ( 4% - 10%) 2 (.2) = 7.2 (10% - 10%) 2 (.5) = 0 = (k i - k) P(k i ) 2   n i=1

Orlando Utility, Inc. ( 4% - 10%) 2 (.2) = 7.2 (10% - 10%) 2 (.5) = 0 (14% - 10%) 2 (.3) = 4.8 Orlando Utility, Inc. ( 4% - 10%) 2 (.2) = 7.2 (10% - 10%) 2 (.5) = 0 (14% - 10%) 2 (.3) = 4.8 = (k i - k) P(k i ) 2   n i=1

Orlando Utility, Inc. ( 4% - 10%) 2 (.2) = 7.2 (10% - 10%) 2 (.5) = 0 (14% - 10%) 2 (.3) = 4.8 Variance = 12 Orlando Utility, Inc. ( 4% - 10%) 2 (.2) = 7.2 (10% - 10%) 2 (.5) = 0 (14% - 10%) 2 (.3) = 4.8 Variance = 12 = (k i - k) P(k i ) 2   n i=1

Orlando Utility, Inc. ( 4% - 10%) 2 (.2) = 7.2 (10% - 10%) 2 (.5) = 0 (14% - 10%) 2 (.3) = 4.8 Variance = 12 Stand. dev. = 12 = 3.46% Orlando Utility, Inc. ( 4% - 10%) 2 (.2) = 7.2 (10% - 10%) 2 (.5) = 0 (14% - 10%) 2 (.3) = 4.8 Variance = 12 Stand. dev. = 12 = 3.46% = (k i - k) P(k i ) 2   n i=1

Orlando Technology, Inc. = (k i - k) P(k i ) 2   n i=1

Orlando Technology, Inc. (-10% - 14%) 2 (.2) = = (k i - k) P(k i ) 2   n i=1

Orlando Technology, Inc. (-10% - 14%) 2 (.2) = (14% - 14%) 2 (.5) = 0 = (k i - k) P(k i ) 2   n i=1

Orlando Technology, Inc. (-10% - 14%) 2 (.2) = (14% - 14%) 2 (.5) = 0 (30% - 14%) 2 (.3) = 76.8 = (k i - k) P(k i ) 2   n i=1

Orlando Technology, Inc. (-10% - 14%) 2 (.2) = (14% - 14%) 2 (.5) = 0 (30% - 14%) 2 (.3) = 76.8 Variance = 192 = (k i - k) P(k i ) 2   n i=1

Orlando Technology, Inc. (-10% - 14%) 2 (.2) = (14% - 14%) 2 (.5) = 0 (30% - 14%) 2 (.3) = 76.8 Variance = 192 Stand. dev. = 192 = 13.86% = (k i - k) P(k i ) 2   n i=1

n Which stock would you prefer? n How would you decide?

Orlando Orlando UtilityTechnology Expected Return 10% 14% Standard Deviation 3.46% 13.86% Orlando Orlando UtilityTechnology Expected Return 10% 14% Standard Deviation 3.46% 13.86% SummarySummary

It depends on your tolerance for risk! Remember there’s a tradeoff between risk and return. Return Risk