Investment Part II

Expected Risk and Return (+class exercise 1 )

Expected Risk and Return calculation

The use of Probability analysis to calculate expected risk and return instead of the historical data. The look in the future is based on a number of uneven scenarios (i.e.. 3,5,7 ), they show the probability of optimistic (good) , most likely (normal) and pessimistic (bad )outcomes. The probabilities add up to 1 (100%).

Expected return for one single asset

Expected risk for one single asset

The expected risk ( standard deviation)

Expected risk for one single asset (cont.)

Risk Measurement for a Single Asset: Coefficient of Variation

The coefficient of variation, CV, is a measure of relative dispersion that is useful in comparing risks of assets with differing expected returns.

Coefficient of Variation (cont.)

The coefficient of variation(CV) combines both risk and return to evaluate the asset.

How to create Probabilities?

The Probabilities in real life are not given but must be estimated. We can use the historical data to create the Probabilities. The basic idea is to cut the range(max-min) of historical returns into bins and to estimate the probability of each return with the use of a histogram.(EXCEL) Example class age groups

Steps using Excel (class exercise1(

1. Convert prices to total return 2. Copy Paste Special Values for the total return column. 3. To remove the outliers, go to Charts Line Chart Remove any total return that exceeds + 20% or -20% (step 2must be done before this step ) 4. Tools Data analysis Descriptive Statistics Summary Statistics (input range =highlight total return column). 5. Calculate the length of bin = Range / # of bins.(Rule of thumb: number of bins is equal to square root of number of observations)

Steps using Excel (cont.)

6. To construct a bin, start with the minimum then add the length of bin ( fix the length of bin using F4) and drag down until you reach the maximum. 7. Copy Paste Special Values for the bins next to the original column of the total return (sheet1) 8. Tools Data analysis Histogram, input range =TR and bins= the bins input chart output.(Important Note: exclude the minimum and the maximum ) 9. Insert the minimum and the maximum in your bins. 10. Calculate the probabilities by dividing frequency of each bin by the total frequency.

Steps using Excel (cont.)

11. Calculate the outcome (end of bin + beginning of bin) / 2). 12. Create a new column ,multiply each outcome by its assigned probability. The expected return is the summation of the column( x). 13. Create a new column ,here subtract the expected return (x)from each individual outcome(x)( Note: fix the expected return using F4). 14. Create a new column where you square (x - x ). 15. Create a new column where you multiply (x - x) by probability for each cell. The sum of this column is the expected variance .

Steps using Excel (cont.)

16. Get the square root of the expected variance = the expected risk. 17. The coefficient of variation is the expected standard deviation divided by the expected return. 18. Right-click on the chart custom type Smooth line in order to get the probability distribution. 19. UNIFIED BIN FOR MORE THAN ONE STOCK