Pricing Risk
Expected return and return = The expected return is the profit or loss that an investor anticipates on an investment that has known historical rates of return (RoR). It is calculated by multiplying potential outcomes by the chances of them occurring and then totaling these results.
Expected Return=WA×RA+WB×RB+WC×RC
where:
WA = Weight of security
ARA = Expected return of security
AWB = Weight of security
BRB = Expected return of security
BWC = Weight of security
CRC = Expected return of security C
For example, if an investment has a 50% chance of gaining 20% and a 50% chance of losing 10%, the expected return would be 5% = (50% x 20% + 50% x -10% = 5%)
Variance Realized versus expected return
Empirical distribution of returns
the risk return tradeoff = The risk-return tradeoff states that the potential return rises with an increase in risk. Using this principle, individuals associate low levels of uncertainty with low potential returns, and high levels of uncertainty or risk with high potential returns. According to the risk-return tradeoff, invested money can render higher profits only if the investor will accept a higher possibility of losses.
Systematic versus Idiosyncratic risk and Diversification
The CAPM in practice = The Capital Asset Pricing Model (CAPM) describes the relationship between systematic risk and expected return for assets, particularly stocks. CAPM is widely used throughout finance for pricing risky securities and generating expected returns for assets given the risk of those assets and cost of capital.
The formula for calculating the expected return of an asset given its risk is as follows:
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