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FA - Chapter 8
Risk and Rates of Return
21
Business
Undergraduate 2
04/17/2011

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Term
Risk
Definition
The chance that some unfavorable event will occur.
Term
Stand-Alone Risk
Definition
The risk an investor would face if he or she held only one asset.
Term
Probability Distribution
Definition
A listing of possible outcomes or events with a probability (chance of occurrence) assigned to each outcome.
Term
Expected Rate of Return, (r hat)
Definition
The rate of return expected to be realized from an investment; the weighted average of the probability distribution of possible results.
Term
Standard Deviation, (sigma)
Definition
A statistical measure of the variability of a set of observations.
Term
Coefficient of Variation, (CV)
Definition
The standardized measure of the risk per unit of return; calculated as the standard deviation divided by the expected return.
Term
Risk Aversion
Definition
Risk-averse investors dislike risk and require higher rates of return as an inducement to buy riskier securities.
Term
Risk Premium (RP)
Definition
The difference between the expected rate of return on a given risky asset and that on a less risky asset.
Term
Capital Asset Pricing Model (CAPM)
Definition
A model based on the proposition than any stock's required rate of return is equal to the risk-free rate of return plus a risk premium that reflects only the risk remaining after diversification.
Term
Expected Return on a Portfolio, (r hat p)
Definition
The weighted average of the expected returns on the assets held in the portfolio.
Term
Realized Rate of Return, (r bar)
Definition
The return that was actually earned during some past period. The actual return (r bar) usually turns out to be different from the expected return (r hat) except for riskless assets.
Term
Correlation
Definition
The tendency of two variables to move together.
Term
Correlation Coefficient, (p)
Definition
A measure of the degree of relationship between two variables.
Term
Diversifiable Risk
Definition
That part of a security's risk associated with random events; it can be eliminated by proper diversification. This risk is also known as company-specific, or unsystematic, risk.
Term
Market Risk
Definition
The risk that remains in a portfolio after diversification has eliminated all company-specific risk. This risk is also known as non-diversifiable or systematic or beta risk.
Term
Relevant Risk
Definition
The risk that remains once a stock is in a diversified portfolio is its contribution to the portfolio's market risk. It is measured by the extent to which the stock moves up or down with the market.
Term
Market Portfolio
Definition
A portfolio consisting of all stocks.
Term
Beta Coefficient, (b)
Definition
A metric that shows that extent to which a given stock's returns move up and down with the stock market. Beta thus measures market risk.
Term
Average Stock's Beta, (b A)
Definition
By definition, b A = 1 because an average-risk stock is one that tends to move up and down in step with the general market.
Term
Market Risk Premium, RP M
Definition
The additional return over the risk-free rate needed to compensate investors for assuming an average amount of risk.
Term
Security Market Line (SML) Equation
Definition
An equation that shows the relationship between risk as measured by beta and the required rates of return on individual securities.
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