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

4