Explain how the statistical concepts of mean and standard ...

[Engineer]

Explain how the statistical concepts of mean and standard deviation apply to the financial ideas of risk and return.
 
  What will be an ideal response?

Question 2

You are considering buying a share of stock in a firm that has the following two possible payoffs with the corresponding probability of occurring. The stock has a purchase price of 15.00.
 
  You forecast that there is a 30 chance that the stock will sell for 30.00 at the end of one year. The alternative expectation is that there is a 70 chance that the stock will sell for 10.00 at the end of one year. What is the expected percentage return on this stock, and what is the return variance?
  A) 6.67, 9.17
  B) 1.00, 93.50
  C) 6.67, 37.33
  D) 84.00, 9.67

[cloud]

Answer to Question 1

Answer: One common definition of risk is that it is the probability of getting a return different from what you expect. Calculating an average rate of return gives you a reasonable expectation. Then calculating the standard deviation lets you apply the normal curve probabilities around that expectation. So, for example, if you calculate a 10 expected rate of return and a 5 standard deviation, then you can estimate a 34 probability of making a return of between 10 and 15, or a 16 probability of making more than 15, or an 84 chance of making less than 15.

Answer to Question 2

Answer: C
Explanation: C) Expected payoff =  Expected payoffi  probabilityi = .30  30.00 + .70  10 = 16.00.
E(r) = = = 6.67
Variance = (0.30)(1.00 - 0.0667)2 + (0.70)(-0.333 - 0.0677)2 = 0.377, or 37.33.

[Engineer]

Excellent

[bulacsom]

Thanks for the timely response, appreciate it