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Unit 2: Risk and Return




          estimated. An investor may expect the TR (total return) on a particular security to be 10% for the  Notes
          coming year, but in truth this is only a "point estimate."

          Probability Distributions

          To deal with the uncertainty of returns, investors need to think explicitly  about a security's
          distribution of probable TRs In other words, investors need to keep in mind that, although they
          may expect a security to return 10%, for example, this is only a one-point estimate of the entire
          range of possibilities. Given that investors must deal with the uncertain future, a number of
          possible returns can, and will, occur.
          In the case of a Treasury bond paying a fixed rate of interest, the interest payment will be made
          with 100 per cent certainty, barring a financial collapse of the economy.  The probability of
          occurrence is 1.0, because no other outcome is possible.  With the possibility of two or more
          outcomes, which is the norm for common stocks, each possible likely outcome must be considered
          and a probability of its occurrence assessed. The result of considering these outcomes and their
          probabilities together is a probability distribution consisting of the specification of the likely
          returns that may occur and the probabilities associated with these likely returns.

          Probabilities represent the likelihood  of various outcomes and are typically  expressed as a
          decimal (sometimes fractions are used). The sum of the probabilities of all possible outcomes
          must be 1.0, because they must completely describe all the (perceived) likely occurrences. How
          are these probabilities and associated outcomes obtained? In the final analysis, investing  for
          some future  period involves  uncertainty, and therefore subjective  estimates. Although past
          occurrences (frequencies) may be relied on heavily to estimate the probabilities, the past must
          be modified for  any changes expected in the future.  Probability distributions  can be  either
          discrete or continuous. With a discrete probability distribution, a probability is assigned to each
          possible  outcome. With a continuous probability distribution, an infinite number of possible
          outcomes exists. The most familiar continuous distribution is the normal distribution depicted
          by the well-known bell-shaped curve often used in statistics. It is a two-parameter distribution
          in that the mean and the variance fully describe it.
          To describe  the  single-most  likely outcome from a  particular probability distribution, it is
          necessary to calculate its expected value. The expected value is the average of all possible return
          outcomes, where  each outcome is weighted by its  respective probability of occurrence. For
          investors, this can be described as the expected return.
          We have mentioned that it's important for investors to be able to quantify and measure risk.
          To calculate the total risk associated with the expected return, the variance or standard deviation
          is used. This is a measure of the spread or dispersion in the probability distribution; that is, a
          measurement  of the dispersion of a random  variable around  its mean.  Without going  into
          further details, just be aware that the larger this dispersion, the larger the variance or standard
          deviation. Since variance, volatility and risk can, in this context, be used synonymously, remember
          that the larger the standard deviation, the more uncertain the outcome.
          Calculating a standard  deviation using probability distributions  involves making subjective
          estimates of the probabilities and the likely returns. However, we cannot avoid such estimates
          because future returns are uncertain. The prices of securities are based on investors' expectations
          about the future. The relevant standard deviation in this situation is the ex ante standard deviation
          and not the ex post based on realized returns.

          Although standard deviations based on realized returns are often used as proxies  for ex ante
          standard deviations, investors should be careful to remember that the past cannot always be
          extrapolated into the future without modifications. Ex post standard deviations may be convenient,
          but they are subject to errors. One important point about the estimation of standard deviation is




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