In a world of uncertainty, we cannot tell 100% certain what could happen. Thus, we must speak in terms of expected events. The expected rate of return of an investment, therefore, is stated as the weighted average of all possible events where those events are tied to the probability that each will occur. When dealing with investment, we also need to know how risky is an investment, i.e. the prospect that we experience actual returns that are different from expected return.
a. Given the information on the table below, calculate expected rate of return and standard deviation of stock returns of iLight Inc. Explain the meaning of the numbers you’ve obtained from the calculations.
Demand for the company’s products Probability of this demand occurs Rate of return if this demand occurs Weak 0.1 -30%
Below average 0.2 -5%
Average 0.4 12%
Above average 0.2 17%
Strong 0.1 25%
b. Assuming returns of the stock follow a normal distribution, draw the probability distribution of its returns. Explain the graph.