Term
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Definition
| amount received by an investor as compensation for taking on the risk of the investment |
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Term
| return on investment (ROI) |
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Definition
ROI = income / average invested capital
ROI = net income / total assets
DuPont ROI = profit margin * asset turnover |
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Term
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Definition
| interest generated by an investment either disbursed periodically in the form of cash or rolled into the investment principal |
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Term
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Definition
| risk faced by all firms; caused by changes in the economy as a whole. Only risk associated with a well-diversified portfolio (in which 20-30 securities are held). |
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Term
| unsystematic/unique/diversifiable risk |
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Definition
| risk inherent in a particular investment |
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Term
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Definition
| borrower will default on loan; credit-rating agencies |
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Term
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Definition
| security cannot be sold or short notice for its market value |
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Term
| maturity/interest rate risk |
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Definition
| security will fluctuate in value between time issue and maturity date |
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Term
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Definition
| purchasing power will be lost during term of loan |
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Term
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Definition
| probability of loss from government action |
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Term
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Definition
| fluctuation in relative value of foreign currency |
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Term
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Definition
fluctuations in EBIT or in operating income when the firm uses no debt
Depends on demand, sales price, input price variability and operating leverage.
Excludes financial risk- risk to shareholders from the use of financial leverage. |
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Term
| (non-investment risk) financial risk |
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Definition
| risk to shareholders from the use of financial leverage. |
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Term
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Definition
| utility of gain does not outweigh the disutility of a potential loss of the same amount. |
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Term
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Definition
| utility of gain equals the disutility of a potential loss of the same amount; expected value approach |
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Term
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Definition
| utility of gain exceeds the disutility of a potential loss of the same amount |
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Term
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Definition
| excess of investment's expected rate of return over the risk-free rate (rM - rRF) |
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Term
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Definition
| rate of return = (amount received – amount invested) / amount invested |
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Term
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Definition
safest investment; backed by T-bills
rRF = rRF + IP (only inflation risk occurs with T-bills) |
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Term
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Definition
| return that takes into account all the investment risks that relate to a specific security |
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Term
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Definition
| last in priority in company liquidation, but can receive excess profits |
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Term
| convertible preferred stock |
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Definition
| convertible into common shares |
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Term
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Definition
| above common shareholders in terms of liquidation, but returns capped by the BOD |
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Term
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Definition
| pay a return only if the issuer is profitable |
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Term
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Definition
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Term
| first and second mortgage bonds |
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Definition
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Term
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Definition
| backed by full faith and credit of U.S. government |
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Term
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Definition
| set of all possible outcomes of a decision, with a probability assigned to each outcome |
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Term
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Definition
| probability distribution in which outcomes are limited |
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Term
| expected rate of return (R-bar) |
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Definition
average of the possible outcomes weighted according to their probabilities
R-bar = possible rate of return (Ri) * probability |
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Term
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Definition
| chance that the actual ROI will differ from the expected return. Measure risk with SD of distribution of return. |
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Term
| standard deviation (SD) formula |
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Definition
square root of (Ri - R)2 * probability)
Ri = possible rate of return
R = expected rate of return
square root of variance |
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Term
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Definition
| measures tightness of distribution and riskiness of the investment; the smaller the SD, the tighter the probability distribution and the lower the risk |
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Term
| coefficient of variation (CV) |
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Definition
| used to determine the best investment in terms of the risk-return tradeoff; useful when rates of return and SDs differ. Measures risk per unit of return. |
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Term
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Definition
| CV = st. dev. / expected rate of return. Lower CV = better risk-return tradeoff. |
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Term
| goal of portfolio management |
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Definition
| Construct a basket of securities to generate a reasonable return without the risks of holding a single security (diversification). Diversification also reduces aggregate volatility. |
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Term
| coefficient of correlation (r) |
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Definition
measures the degree to which any two variables (two stocks) are related.
Normal r value for two randomly selected stocks is .5 - .7. |
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Term
| perfect positive correlation |
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Definition
| 1.0; the two stocks always move together. No specific/diversifiable risk is eliminated. |
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Term
| perfect negative correlation |
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Definition
| -1.0; the two stocks always move away from each other. All specific/diversifiable risk is eliminated. |
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Term
| capital asset pricing model (CAPM) |
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Definition
CAPM quantifies the required return on an equity security by relating the security's level of risk to the average return available in the market.
Investor must be compensated for time value of money and risk. |
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Term
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Definition
Required rate of return = rRF + (rM – rRF)b
risk-free rate = rRF
market return = rM
market risk premium (rM – rRF)
beta (b) |
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Term
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Definition
measure of the systematic/market risk or volatility of the individual security in comparison to the market (diversified portfolio) (b)
beta of market = 1.
beta of T-securities = 0.
beta > 1 = systematically riskier than the market. |
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Term
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Definition
| The market risk premium varies in direct proportion to beta. Therefore, all investments (securities) must lie on the security market line. |
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Term
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Definition
| investment transaction in which the parties' gain or loss is derived from some other economic event (some underlying asset price) |
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Term
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Definition
| process of using offsetting commitments to minimize or avoid the impact of adverse price movements. Entity takes a position in the financial instrument that is almost perfectly correlated with the original asset but in the opposite direction. |
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Term
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Definition
| entity owns the asset, so benefits when asset rises in value |
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Term
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Definition
| entity sells asset it does not own, anticipating a decline in value (asset is borrowed) |
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Term
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Definition
| holder buys the right to demand that the seller (writer) buy or sell an underlying asset on or before a specified future date. Buyer holds rights and seller holds obligations. Buyer pays fee for these rights. |
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Term
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Definition
| gives buyer right to purchase underlying at a fixed price |
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Term
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Definition
| gives buyer right to sell the underlying at a fixed price |
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Term
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Definition
| asset subject to being bought or sold under option terms |
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Term
| When can an option be exercised? |
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Definition
| On or before the expiration date. |
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Term
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Definition
| intrinsic value + time premium |
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Term
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Definition
| price at which the holder can purchase (call option) or sell (put option) the asset underlying the option contract |
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Term
| intrinsic value of a call option |
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Definition
amount by which exercise price is less than the current price of the underlying
positive intrinsic value = in-the-money
intrinsic value of $0= out-of-the-money |
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Term
| intrinsic value of a put option |
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Definition
amount by which exercise price is greater than the current price of the underlying
positive intrinsic value = in-the-money
intrinsic value of $0= out-of-the-money |
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Term
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Definition
| the more time that exists between the writing of an option and its expiration, the riskier any investment is. Buyer can only lose the option premium. |
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Term
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Definition
| Two parties agree that, at a set future date, one will perform and the other will pay a specified price for the performance. No option for nonperformance exists. |
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Term
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Definition
Commitment to buy or sell an asset at a fixed price during a specified future period; counterparty is unknown.
Futures are actively traded. |
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Term
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Definition
| market price is posted and netted to each person's account at the close of every business day |
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