Chapter 2 Vocabulary

Question 1

Risk means

Answer 1

Uncertainty

Question 2

The tendency for a particular measure of performance, such as percentage rate of return, to revert to its historical average return

Answer 2

Reversion to the mean

Question 3

Three parts of the efficient capital markets hypothesis

Answer 3

The stock market is brutally efficient
Current stock prices reflect all publicly available information
Stock prices react completely, correctly and almost instantaneously to incorporate the receipt of new information

Question 4

States that the changes in stock prices are random

Answer 4

The Random Walk Hypothesis

Question 5

Theory about the pricing of assets and the trade-off between the risk of an asset and the expected returns associated with the asset (used in the pricing of risky securities)

Answer 5

Capital asset pricing model

Question 6

A measure if the volatility, or systematic risk of a security or a portfolio in comparison to the market as a whole

Answer 6

Beta (beta coefficient)

Question 7

The difference between the expected return on a portfolio and the risk-free rate

Answer 7

Market risk premium

Question 8

This means that an investor prefers less risk to more risk

Answer 8

Risk-averse

Question 9

An investor who shows no particular concern about risk because the pain of losing a dollar is equal to the pleasure associated with winning a dollar

Answer 9

Risk neutral

Question 10

An investor who enjoys taking risks, the pleasure of winning a thousand dollars exceeds the pain of losing a thousand dollars

Answer 10

Risk taker

Question 11

Market capitalization

Answer 11

Current stock price * Number of shares outstanding

Question 12

The goal of creating shareholder value is to

Answer 12

Maximize the marker value of the existing owners equity

Question 13

Which strategic financial decision involves short-term assets and short term liabilities

Answer 13

Working capital management

Question 14

Which strategic financial decision involves long term assets

Answer 14

Capital budgeting (investing)

Question 15

Which strategic financial decision involves long term debt (shareholders equity)

Answer 15

Capital structure (financing)

Question 16

The process of planning and managing a firm’s long term investments in projects and ventures

Answer 16

Capital budgeting

Question 17

The goal of the capital budgeting decision is to

Answer 17

Maximize the net present value of the investments that are financed by the firm’s capital budget

Question 18

The goal of working capital management is to

Answer 18

Minimize the cost of maintaining the net working capital position of the company

Question 19

Refers to s firm’s specific mixture of long term debt and equity that it uses to finance its operations and investments

Answer 19

Capital structure

Question 20

The goal relating to capital structure is to

Answer 20

Minimize the weighted average cost of capital of the company

Question 21

To spread your wealth among a number of different investments and asset classes

Answer 21

Diversification

Question 22

Achieving the highest return for each level of risk is known as investing efficiently. A like created from the risk-reward graph, compromised of optimal portfolios

Answer 22

Efficient frontier

Question 23

The two types of risk

Answer 23

Unsystematic

Systematic

Question 24

Total risk equals

Answer 24

Systematic risk + unsystematic risk

Question 25

The risk inherent to the entire market or entire market segment (measured by beta)

Answer 25

Systematic risk (undiversifiable or market risk)

Question 26

Risk that affects a very small number of assets. Specific to a company.

Answer 26

Unsystematic risk

Question 27

Diversification reduces what kind of risk

Answer 27

Unsystematic risk

Question 28

Model that estimates the rate of return an investor should expect to receive on a risky asset

Answer 28

CAPM (capital asset pricing model)

Question 29

When an investment pays interest only on the original principal

Answer 29

Simple average

Question 30

When an investment earns interest on both the original principal and the accumulated interest

Answer 30

Compound interest

Question 31

The idea that money available at the present time is worth more than the same amount in the future

Answer 31

Time value of money

Question 32

The amount that a future sum of money is worth today given a specified rate of return

Answer 32

Present value

Question 33

The value of an asset or cash at a specified date in the future that is equivalent in value to a specified sum today

Answer 33

Future value

Question 34

The ability of an asset to generate earning which are then reinvested in order to generate their own earnings. Generating earnings from previous earnings

Answer 34

Compounding

Question 35

The process of going from an expected future value to a present value, or multiplying by a number less than 1.0 over a number of time periods

Answer 35

Discounting

Question 36

A theory on how risk-averse investors can construct portfolios in order to optimize market risk for expected returns, emphasizing that risk is an inherent part of higher reward

Answer 36

Modern portfolio theory

Question 37

Is to reduce risk by diversifying the portfolio

Answer 37

Asset allocation