Lecture 04
Principles of Finance
Portfolio Theory
1
Probability Distribution of Returns
? Returns on investment are uncertain (risky)
? We model uncertainty of future returns using
? Expected return: the return you expect to receive on
average
? Volatility (standard deviation): degree of dispersion of
future returns
The larger a stock’s volatility, the wider the range of possible outcomes and the larger the probabilities of those returns at the extreme of the range
2
Distribution of Returns on Two Stocks 3.53.0Probability Density 2.5NORMCOVOLCO2.01.51.00.50.0-100%-50%0%Return 500% 3
Expected Return
~E?R????iRi??1R1??2R2????nRni?1n
~E?R?: Expected rate of return for investment ?i: Probability of occurrence of ith state Ri: Estimated rate of return for that state
n: Number of possible states
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