Thursday, November 26, 2009


Expected Return and Risk

Instead of using historical data for calculating return and risk, we may use forecast ed data. Suppose you are considering buying one share of sunshine industries which has market price of 522.50$ today. The company pays dividend of 5$ per share. You want to hold the share for one year. What is the expected rate of return? This will depend on the dividend on the dividend per share you would actually receive and the market price at which you could sell the share. You do not know both the outcomes. The outcomes may depend on the economic conditions, the performance of the company and other factors. You will have to think of the outcomes of dividend and the share price under possible economic scenarios to arrive at a judgment about the expected return.

Expected Rate of Return

You can put the information summaries the range of returns under the possible states of economic conditions along with probabilities together to calculate the expected rate of return. The expected rate of return is the sum of the product of each outcome and its associated probability.

Risk Preference

The information about the expected return and standard deviation helps an investor to make decision about investments. This depends on the investor’s risk preference. Generally investors would prefer investments with higher rates of return and lower standard deviation. According to the economic principle of diminishing marginal utility, as a person gets more and more wealth his utility for additional wealth increases at a declining rate.

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