Risk and return
Before understanding the concept of Risk and Return in Financial Management, understanding the two-concept Risk and return individually is necessary.
Capital Asset Pricing Model
Capital asset pricing model, also known as CAPM, shows the relationship between the expected return of the investment and the market at risk. This concept is basically used particularly in the case of stocks or shares. It is also used across finance for pricing assets that have higher risk identity and for evaluating the expected returns for the assets given the risk of those assets and also the cost of capital.
Charlie has made an investment in the stock market. Initially, he believes that the economy is “Good.” So he believes that each day the value of his investment goes up with probability 80% and goes down with probability 20%. Assume the probability of “up” or “down” on each day is independent.
1. According to Charlie's initial belief, what is the probability of having 5 straight days on which his investment goes up?
2. After doing some research and reading some news, Charlie starts to wonder if maybe his initial belief about the economy was too optimistic. He still thinks the economy is “Good” with 70% confidence, but acknowledges a 20% chance that the economy is “OK” and a 10% chance that the economy is “Bad.” Charlie believes that in an “OK” economy, each day the value of his investment goes up with probability 60% or goes down with probability 40%. He believes that in a “Bad” economy, each day the value of his investment goes up with probability 10% or goes down with probability 90%. Over the next 5 days, Charlie observes his investment goes up, down, up, down, down. After these observations, what does Charlie now believe is the probability that the economy is “Good?
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