Expected and Unexpected Returns

To begin, for concreteness, we consider the return on the stock of a company called Flyers. What will determine this stock's return in, say, the coming year?

The return on any stock traded in a financial market is composed of two parts. First, the normal, or expected, return from the stock is the part of the return that shareholders in the market predict or expect. This return depends on the information shareholders have that bears on the stock, and it is based on the market's understanding today of the important factors that will influence the stock in the coming year.

The second part of the return on the stock is the uncertain, or risky, part. This is the portion that comes from unexpected information revealed within the year. A list of all possible sources of such information would be endless, but here are a few examples:

News about Flyers research

Government figures released on gross domestic product (GDP)

The results from the latest arms control talks

The news that Flyers's sales figures are higher than expected

A sudden, unexpected drop in interest rates

Based on this discussion, one way to express the return on Flyers stock in the coming year would be:

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Ross et al.: Fundamentals I V. Risk and Return I 13. Return, Risk, and the I I © The McGraw-Hill of Corporate Finance, Sixth Security Market Line Companies, 2002

Edition, Alternate Edition

424 PART FIVE Risk and Return

Total return = Expected return + Unexpected return R = E(R) + U

where R stands for the actual total return in the year, E(R) stands for the expected part of the return, and U stands for the unexpected part of the return. What this says is that the actual return, R, differs from the expected return, E(R), because of surprises that occur during the year. In any given year, the unexpected return will be positive or negative, but, through time, the average value of U will be zero. This simply means that on average, the actual return equals the expected return.

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