Term
| What are the characteristics of a perfect market? |
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Definition
- No costs of trading or enforcing contracts
- Investors have identical information
- No taxes
- No restrictions on the buying or selling of securities
- Purchases and sales of securities do not affect the market price of the securities.
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Term
| When returns follow a normal distribution, the risk can be completely described by: |
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Definition
- the expected (mean) return AND the variance or standard deviation of returns
Note that the larger the standard deviation of the probability distribution of returns, the greater the risk or uncertainty of returns over a single period. |
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Term
What will a cumulative probability distribution table provide?
What are the required inputs for a cumulative probability distribution table? |
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Definition
the percentage of the outcomes that are expected to be less than (to the left of) any value we choose.
Required inputs are the mean and volatility of the distribution and the target return. |
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Term
| How do you calculate standardised return? |
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Definition
| standardised return = (mean return - target return) / standard deviations of returns |
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Term
High level formula for the correlation coefficient:
What does the correlation coefficient measure? |
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Definition
CorrAB = Cov(RA, RB) / σBσA
The correlation coefficient is a standardised measure of how two random variables move together. It takes on values from -1 to +1. |
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Term
| Define diversifiable risk: |
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Definition
| volatility of a single securities returns that is uncorrelated with the volatility of the market portfolio. |
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Term
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Definition
| The part of an individual security's risk that arises because of the positive covariance of that security's returns with overall market returns. |
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Term
what is beta?
How do you calculate beta? |
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Definition
beta is a standardised measure of systematic risk
it's calculated as the covariance of the returns on security or portfolio i, with the returns on the market portfolio, Cov(Ri,Rm), divided by the variance of the returns on the market portfolio: σ2m
Betai = Cov(Ri,Rm) / σ2m
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Term
| Is there any added expected return for bearing non systematic risk? |
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Definition
| No - this risk is diversifiable risk and can be avoided by efficient diversification |
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Term
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Definition
| The Security market Line says that for each unit of market risk (beta), investors can expect to receive a premium over the risk-free rate equal to the market risk premium. |
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Term
What is the market risk premium?
How can you calculate it? |
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Definition
Market risk premium is the difference between the risk-free rate and the expected return on the market.
This is denoted by E(Rm)-RF |
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Term
| For any single security or portfolio of securities i, the expected return in equilibrium is: |
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Definition
| E(Ri) = RF + Betai[E(Rm - RF) |
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