MATH1WRITEUP
MATH1WRITEUP
MATH1WRITEUP
obtain a sense of variability, investors use scenario analysis to end up with several possible
alternative outcomes, or simply different states of nature to the returns, namely pessimistic, most
likely, and optimistic. The values assigned to these states of nature will be their probability or
chance of occurring and must sum up to 100%.
Applying this, the expected return, r, is the average return that an investment is expected
to produce over time. For an investment that has j different possible returns, the expected return
is as follows:
where rj=return for the jth outcome; Prj= probability of occurrence of the jth outcome; and n=
number of outcomes considered.
Consequently, if all of the outcomes are known and the probabilities equal, the expected
value of the return is simply their arithmetic average:
After computing for the expected values of the returns, calculating for the standard
deviation will be the next step. The following is the formula for standard deviation of returns, r:
Likewise, in the occasion that the full range of possible investment outcomes and their
probabilities is known, the following formula will be applicable:
.
2. One-Period Valuation Model
This approach depicts one of the simplest possible scenario to understand stock
valuation: You buy a stock, hold it for one period to get a dividend, then sell the
stock. This can be translated as
where Div1=the dividend paid at the end of year 1; ke=rs; and P1=the price at the
end of the first period.
.
Applications
References
http://www.investopedia.com/articles/08/risk.asp
http://www.investopedia.com/terms/r/risk.asp
http://www.investopedia.com/terms/s/standarddeviation.asp
http://www.investopedia.com/terms/r/return.asp
http://davidmlane.com/hyperstat/A40397.html
http://www.investopedia.com/walkthrough/fund-guide/uit-hedge-fund-reit/hf/standard-deviationvalue-at-risk.aspx
Principles of Managerial Finance, 13th edition by Lawrence J. Gitman and Chad J. Zutter 2012
Prentice Hall Pearson Education
The Economics of Money, Banking, and Financial Markets, 9th edition by Frederic S. Mishkin
2010 Addison Wesley Pearson Education