# study material on finance 29

May 14th, 2015
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At the end of the lesson, students should be able to: calculate expected returns

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Taylors UniversityDual Degree ProgramIntroductionto FinanceTopic 8Risk & Return1Acknowledgement Ross et al, 2008, Essentials of Corporate Finance, 6 th Ed, McGraw-Hill1-211-2Learning OutcomesAt the end of the lesson, students should beable to:calculate expected returnsexplain the impact of diversificationdescribe systematic risk principleexplain security market linediscuss the risk-return trade-off21-311-3Chapter Outline Expected Returns and Variances Portfolios Announcements, Surprises, and ExpectedReturns Risk: Systematic and Unsystematic Diversification and Portfolio Risk Systematic Risk and Beta The Security Market Line (SML) The SML and the Cost of Capital: A Preview31-411-4Expected Returns Expected returns are based on theprobabilities of possible outcomes In this context, expected meansaverage if the process is repeatedmany times The expected return does not evenhave to be a possible returnnE ( R ) pi Rii 141-511-5Example: Expected Returns Suppose you have predicted the following returns for stocksC and T in three possible states of nature. What are theexpected returns?StateProbabilityBoom0.3Normal0.5Recession???C0.150.100.02T0.250.200.01 E(RC)= .3(.15) + .5(.10) + .2(.02) = .099 = 9.9% E(RT) = .3(.25) + .5(.20) + .2(.01) = .177 = 17.7%Refer Notes for Risk Premium5Variance and StandardDe

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