Chp 8: Risk And Rates Of Return(Key Concepts)

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Risk

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The chance that some unfavorable event will occur.

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Stand-Alone Risk

Back 2

The risk an investor would face if he or she held only one asset.

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Probability distributions

Back 3

Listings of possible outcomes or events with a probability(chance of occurrence) assigned to each outcome.

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Expected Rate of return

Back 4

The rate of return expected to be realized from investments; the weighted average of the probability distribution of possible results.

Expected ending value-cost/cost

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Standard Deviation

Back 5

A statistical measure of the variability of a set of observations.

Used to quantify the tightness of a probability distribution.

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Coefficient of Variation(CV)

Back 6

The standardized measure of the risk per unit of return; calculated as the standard deviation divided by the expected return.

Standard Deviation/Expected Return

Most useful when the expected returns of two alternative investments are not the same.

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Risk Aversion

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Risk-averse investors dislike risk and require higher rates of return as an inducement to buy riskier securities.

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Risk Premium(RP)

Back 8

The difference between the expected rate of return on a given risky asset and that on a less risky asset.

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Capital Asset Pricing Model(CAPM)

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A model based on the proposition that 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.

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Expected return on a portfolio

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The weighted average of the expected returns on the assets held in the portfolio.

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Realized Rates of return

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Returns that were actually earned during some past period. Actual returns usually turn out to be different from expected returns except for riskless assets.

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Correlation

Back 12

The tendency of two variables to move together.

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Correlation coefficient

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A measure of the degree of relationship between two variables.

Measures the tendency of two variables to move together.

In reality, most stocks are positively correlated, but not perfectly; studies demonstrate it to be an average of 0.30 positive correlation.

Thus, combining stocks into portfolios reduces risk, but does not completely eliminate it.

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Diversifiable Risk(Company specific or unsystematic risk)

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That part of a security's risk associated with random events; it can be eliminated by proper diversification.

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Market Risk(nondiversifiable, systematic, or beta risk)

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The risk that remains in a portfolio after diversification has eliminated all company specific risk.

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Market Portfolio

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A portfolio consisting of all stocks.

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Relevant Risk

Back 17

The risk that remains once a stock is in a diversified portfolio is its contribution to the portfolio's market risk.

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Beta Coefficient, b

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A metric that shows the extent to which a given stock's return move up and down with the stock market. Beta measures market risk.

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Average Stock's Beta, bA

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By definition bA=1 because an average-risk stock is one that tends to move up and down in step with the general market.

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Market Risk Premium, RPm

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The additional return over the risk-free rate needed to compensate investors for assuming an average amount of risk.

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Security Market Line(SML) Equation

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An equation that shows the relationship between risk as measured by beta and the required rates of return on individual securities.