chapter 10 Flashcards
probability distribution
summarises the information regarding risky investments and the different returns they may earn and their likelihood of occuring. it assigns a probability pR, that each possible return, R, will occur.
return of a security
indicates the percentage increase in the value of an investment per dollar initially invested in the security. it makes different securities comparable.
expected return
a weighted average of the possible returns, where the weights correspond to the probabilities.
volatility
the standard deviation of a return in finance terms.
variance
the expected squared deviation from the mean.
standard deviation
the square root of the variance. it quantifies the difference in variability.
realised return
the return that actually occurs over a particular time period of all the possible returns.
average annual return
the average of the realised returns for each year during some historical period.
standard error
the estimation of error of a statistical estimate. it is the standard deviation of the estimated value of the mean of the actual distribution around its true value. so, it is the standard deviation of the average return.
95% confidence interval
a reasonable range of the true expected value. it means that the average return will be within two standard errors of the true expected return approximately 95% of the time.
excess return
the difference between the average return for the investment and the average return for Treasury bills, which are a risk-free investment and measure the average risk premium investors earned for bearing the risk of the investment.
independent/firm-specific/idiosyncratic/unique/diversifiable risk
risk that is perfectly correlated. it causes fluctuations in a stock’s return due to firm-specific news. it is averaged out and diversified when many stocks are combined in a large portfolio.
common/systematic/undiversifiable/market risk
risks that share no correlation. it causes fluctuations in a stock’s return due to market-wide news. it affects all firms and therefore the entire portfolio and cannot be diversified.
firm-specific news
good or bad news about the company itself.
market-wide news
news about the economy as a whole and therefore it affects all stocks.
risk premium
the difference between the market portfolio’s expected return and the risk-free interest rate. it is determined by the security’s systematic risk.
efficient portfolio
a portfolio that contains only systematic risk. changes in the price of the portfolio will reflect systematic shocks to the economy. it cannot be diversified further, meaning risk cannot be reduced without lowering expected return. an efficient portfolio should be a large portfolio containing many different stocks, because diversification improves with the number of stocks.
market portfolio
a portfolio of all stocks and securities traded in the capital market. it is a natural candidate for an efficient portfolio.
beta
the sensitivity of the security’s return to the return of the market portfolio/market-wide risk factors. it is the expected % change in return given a 1% change in the return of the market portfolio. it is related to how sensitive its underlying revenues and cash flows are due to general economic conditions.
market risk premium
the reward investors expect to earn for holding a portfolio with a beta of one, the market portfolio.
Capital Asset Pricing Model (CAPM)
a method for estimating the cost of capital.
diversification
the averaging out of independent risks in a large portfolio.
