Question

Anthony is a new investor and has been closely watching a company by the name of CLS Ltd., a pharmaceutical company aiming to develop a coronavirus vaccine.

Anthony believes the following returns are possible in 2020 and has attached a probability to each potential outcome:

Probability	Possible Return
.20	230.00%
.30	100.00%
.30	5.00%
.20	-100.00%

a) Calculate the Expected Return for CLS Ltd. in 2020.

Show formula, calculation and a concluding statement in your response.

b) Calculate the Risk (Standard Deviation) for CLS Ltd. in 2020.

Show formula, calculation and a concluding statement in your response.

c) Anthony is considering investing all his savings in buying shares in CLS Ltd. Explain to Anthony why he should not do this by referring to the risk/return trade-off. What action can Anthony take to reduce some of the risk?

d) Explain what the standard deviation actually measures in Finance. Include in your answer an explanation of what a high and low value for the standard deviation means.

Answer 1

(a): Expected return = (0.20*230%) + (0.30*100%) + (0.3*5%) + (0.2*-100%)

= 57.50%

(b): standard deviation =[ 0.2*(230%-57.50%)^2 + 0.3*(100%-57.50%)^2 + 0.3*(5%-57.5%)^2 + 0.2*(-100%-57.50%)]^0.5

= 110.82% (or 1.11082)

(c ): Anthony should not invest all his savings in buying shares in CLS Ltd because of the principle of risk/return trade-off which is that higher risk is associated with greater probability of higher return and lower risk with a greater probability of smaller return. Putting all his savings in buying shares in CLS will not help Anthony to optimize risk-return. Secondly as Anthony will have entire exposure to CLS he will not be able to reduce his total risk by taking advantage of diversifiable risk (or unsystematic risk).

(d): In finance standard deviation tells about volatility. The higher the volatility the higher is the risk. Thus high standard deviation indicates high levels of volatility and thus high risks. On the other hand low standard deviation indicates low levels of volatility and thus low risks.