CHAPTER 22

ESTIMATING RISK AND RETURN ON ASSETS

RISK is the variability of an asset’s future returns.

PROBABILITY AND PROBABILITY DISTRIBUTION

Probability is the percentage chance that an event will occur and range between o to 1.
If all possible events or outcomes are listed, and the probability is assigned to each
event, the listing is called probability distribution.

Example : For the election forecast, the following probability distribution could be set up.
Outcome Probability
Win 0.6 60%
Lose 0.4 40%
1.0 100%

Expected Value or Expected rate of return on investment is the weighted average of all
possible returns from an investment, with the weights being the probability of each
return.
 Objective Probability Distribution based on past outcomes of similar events.
 Subjective Probability Distribution based on opinions or educated guesses about the
likelihood that an event will have a particular future outcome.
 Discrete Probability Distribution is an arrangement of the probabilities associated
with the values of a variable that can assume a limited/finite number of values.
 Continuous Probability Distribution is an arrangement of probabilities associated
with the values of a variable that can assume an infinite number of possible values.

Exercise 1: Assume that 2 investment prospects are available to Mr. Martin who has a
P100, 000 funds. He is considering the following:
a. Investment in ABC Products Inc., a manufacturer and distributor of computer
terminals and equipment for a rapidly growing data transmission industry, or
b. Investment in PENELCO which supplies an essential service.

The rate of return probability distributions for the two companies are as follows:

ABC PRODUCTS, INC.

Probability of
State of Rate of Return Expected Rate
this State
Economy (%) of Return (%)
Occurring
Boom .30 100
Normal .40 15
Recession .30 (70)
Expected Value of Outcome

PENELCO
Probability of
State of Rate of Return Expected Rate
this State
Economy (%) of Return (%)
Occurring
Boom .30 20
Normal .40 15
Recession .30 10
Expected Value of Outcome

EXPECTED PORTFOLIO RETURNS (Fp)

- Weighted average of the expected returns from the individual assets in the
portfolio.
n
F p=∑ wi f i
i =1
 where: wi = proportion of portfolio invested in asset
fi = expected returnof asset
n = number of assets in the portfolio

Exercise 2: DEF Properties is evaluating two opportunities, each having the same initial
investment. The project’s risk and return characteristics are shown below:
Project A Project B
Expected Return 0.10 0.20
Proportion invested in each 0.50 0.50
project

What is the expected return portfolio combining Project A and project B?

STANDARD DEVIATION
- A statistical measure of the variability of a probability distribution around its
expected value.
- It is calculated as follows:
1. Compute the expected value (f)
2. Subtract (f) fromeach possible return to obtain the deviations (ri – f)
3. Square each deviation (ri – f)2
4. Multiply each squared deciation by its probability of occurrence, pi(ri – f)2, and
then add. The result is called the variance (σ2), which is the standard deviation
squared.
5. Take the square root of the variance to get the standard deviation.
where: pi = probability of outcome
ri = return of value of outcome
n = number of possible outcomes

Exercise: Using the data of ABC Products, Inc. and PENELCO above. Compute the
standard deviation.

QUIZ NO. 2
1. The following projections are available for three alternative investments in equity
stocks.
Probability of Rate of Return if State Occurs
State of
State of
Economy Stock A StockB Stock C
Economy
Boom .40 10% 15% 20%
Recession .60 8% 4% 0%

Required:
1. What would be the expected return on a portfolio with equal amounts invested
in each of the three stocks? (Portfolio 1)
2. What would be the expected return if half of the portfolio were in A, with the
remainder equally divided between B and C? (Portfolio 2)
3. Compute for the Standard Deviation using expected Portfolio 1 and Portfolio 2.
QUIZ NO. 1
A dealer in luxury yachts may order 0, 1, or 2 yachts for this season’s inventory. The cost
of carrying each excess yacht is P50,000, and the gain for each yacht sold is Php
200,000.
a. Compute for the expected value of each decision.
b. What is the expected value with perfect information?
c. What is the expected value of perfect information?

QUIZ NO. 1
A dealer in luxury yachts may order 0, 1, or 2 yachts for this season’s inventory. The cost
of carrying each excess yacht is P50,000, and the gain for each yacht sold is Php
200,000.
a. Compute for the expected value of each decision.
b. What is the expected value with perfect information?
c. What is the expected value of perfect information?

QUIZ NO. 1
A dealer in luxury yachts may order 0, 1, or 2 yachts for this season’s inventory. The cost
of carrying each excess yacht is P50,000, and the gain for each yacht sold is Php
200,000.
a. Compute for the expected value of each decision.
b. What is the expected value with perfect information?
c. What is the expected value of perfect information?

QUIZ NO. 1
A dealer in luxury yachts may order 0, 1, or 2 yachts for this season’s inventory. The cost
of carrying each excess yacht is P50,000, and the gain for each yacht sold is Php
200,000.
a. Compute for the expected value of each decision.
b. What is the expected value with perfect information?
c. What is the expected value of perfect information?

QUIZ NO. 1
A dealer in luxury yachts may order 0, 1, or 2 yachts for this season’s inventory. The cost
of carrying each excess yacht is P50,000, and the gain for each yacht sold is Php
200,000.
a. Compute for the expected value of each decision.
b. What is the expected value with perfect information?
c. What is the expected value of perfect information?

QUIZ NO. 1
A dealer in luxury yachts may order 0, 1, or 2 yachts for this season’s inventory. The cost
of carrying each excess yacht is P50,000, and the gain for each yacht sold is Php
200,000.
a. Compute for the expected value of each decision.
b. What is the expected value with perfect information?
c. What is the expected value of perfect information?

QUIZ NO. 1
A dealer in luxury yachts may order 0, 1, or 2 yachts for this season’s inventory. The cost
of carrying each excess yacht is P50,000, and the gain for each yacht sold is Php
200,000.
a. Compute for the expected value of each decision.
b. What is the expected value with perfect information?
c. What is the expected value of perfect information?