Chapter 5-7

Question 1

effective annual rate (EAR)

Answer 1

Interest rate annualized using compound rather than simple interest.

Question 2

annual percentage rate (APR)

Answer 2

Interest rate is annualized using simple rather than compound interest.

Question 3

nominal interest rate

Answer 3

The interest rate in terms of nominal (not adjusted for purchasing power) dollars.

Question 4

real interest rate

Question 5

dividend yield

Answer 5

The annual dividend payment expressed as a percent of the stock price.

Question 6

mean return

Answer 6

Another term for expected return.

Question 7

variance

Answer 7

A measure of the dispersion of a random vari- able. Equals the expected value of the squared deviation from the mean.

Question 8

standard deviation

Answer 8

Square root of the variance.

Question 9

risk-free rate

Answer 9

The interest rate that can be earned with certainty, commonly taken to be the rate on short-term Treasury bills.

Question 10

risk premium

Answer 10

An expected return in excess of that on risk- free securities. The premium provides compensation for the
risk of an investment.

Question 11

excess return

Answer 11

The probability-weighted average of the possible outcomes.

Question 12

normal distribution

Answer 12

Bell-shaped probability distribution that characterizes many natural phenomena.

Question 13

event tree

Answer 13

Depicts all possible sequences of events.

Question 14

skew

Answer 14

Measure of the asymmetry of a probability distribution.

Question 15

kurtosis

Answer 15

Measure of the fatness of the tails of a probability distribution. Indicates probability of observing extreme high or low values.

Question 16

tail risk

Answer 16

Risk of extreme events in the far tail of the prob- ability distribution

Question 17

value at risk (VaR)

Answer 17

Measure of downside risk. The loss that will be incurred in the event of an extreme adverse price change with some given, typically low, probability.

Question 18

expected shortfall (ES)

Answer 18

The expected loss on a security conditional on returns being in the left tail of the probability distribution.

Question 19

conditional tail expectation
(CTE)

Answer 19

Expectation of a random variable conditional on its falling below some threshold value. Often used as a measure of downside risk.

Question 20

lower partial standard deviation (LPSD)

Answer 20

Standard deviation computed using only the portion of the return distribution below a threshold such as the risk-free rate or the sample average.

Question 21

Sortino ratio

Answer 21

Excess return divided by lower partial standard deviation.

Question 22

lognormal distribution

Answer 22

The probability distribution that characterizes a variable whose log has a normal (bell- shaped) distribution.

Question 23

risk premium

Answer 23

An expected return in excess of that on risk- free securities. The premium provides compensation for the
risk of an investment.

Question 24

fair game

Answer 24

An investment prospect that has a zero risk
premium.

Question 25

risk averse

Answer 25

An investor who will consider risky portfo- lios only if they provide compensation for risk via a risk premium.

Question 25

utility

Answer 25

The measure of the welfare or satisfaction of an investor.

Question 26

certainty equivalent rate

Answer 26

The certain return providing the same utility as a risky portfolio.

Question 27

risk neutral

Answer 27

An investor who finds the level of risk irrelevant and considers only the expected return of risk prospects.

Question 28

risk lover

Answer 28

An investor who is willing to accept lower expected returns on prospects with higher amounts of risk.

Question 29

mean-variance (M-V) criterion

Answer 29

The selection of portfolios based on the means and variances of their returns. The choice of the highest expected return portfolio for a given level of variance or the lowest variance portfolio for a given expected return.

Question 30

indifference curve

Answer 30

A curve connecting all portfolios with the same utility according to their means and standard deviations

Question 31

complete portfolio

Answer 31

The entire portfolio, including risky and risk-free assets.

Question 32

risk-free asset

Answer 32

An asset with a certain rate of return; often taken to be short-term T-bills.

Question 32

capital allocation line (CAL)

Answer 32

A graph showing all feasible risk–return combinations of a risky and risk-free asset.

Question 33

reward-to-volatility or Sharpe ratio

Answer 33

Ratio of excess return to portfolio standard deviation.

Question 33

passive strategy

Answer 33

A portfolio decision that avoids any direct or indirect security analysis. See passive management.

Question 33

capital market line (CML)

Answer 33

The capital allocation line that results when using the market index as the risky portfolio.

Question 34

diversification

Answer 34

Spreading a portfolio over many investments to avoid excessive exposure to any one source of risk.

Question 35

insurance principle

Answer 35

The law of averages. The average outcome for many independent trials of an experiment will approach the expected value of the experiment.

Question 36

market risk

Answer 36

Risk factors common to the whole economy; also called systematic or nondiversifiable risk.

Question 37

systematic risk

Answer 37

Risk of breakdown in the financial system, particularly due to spillover effects from one market into others.

Question 38

nondiversifiable risk

Answer 38

Risk factors common to the whole economy; also called market risk or systematic risk.

Question 39

unique risk

Answer 39

Nonmarket or firm-specific risk factors that can be eliminated by diversification. Also called firm- specific risk, nonsystematic risk, or diversifiable risk.

Question 40

firm-specific risk

Answer 40

Nonmarket or firm-specific risk factors that can be eliminated by diversification. Also called unique risk, nonsystematic risk, or diversifiable risk.

Question 41

nonsystematic risk

Answer 41

Nonmarket or firm-specific risk factors that can be eliminated by diversification. Also called unique risk, firm-specific risk, or diversifiable risk. Systematic risk refers to risk factors common to the entire economy.

Question 42

diversifiable risk

Answer 42

Nonmarket or firm-specific risk factors that can be eliminated by diversification. Also called unique risk, firm-specific risk, or nonsystematic risk. Nondiversifi- able risk refers to systematic or market risk.

Question 43

minimum-variance portfolio

Answer 43

The portfolio of risky assets with lowest possible variance.

Question 44

portfolio opportunity set

Answer 44

The expected return–standard deviation pairs of all portfolios that can be constructed from a given set of assets.

Question 45

optimal risky portfolio

Answer 45

An investor’s best combination of risky assets; the combination that maximizes the Sharpe ratio.

Question 46

minimum-variance frontier

Answer 46

Graph of the lowest possible portfolio standard deviation corresponding to each value of portfolio expected return.

Question 47

efficient frontier of risky assets

Answer 47

The portion of the minimum- variance frontier that lies above the global minimum-variance portfolio.

Question 48

input list

Answer 48

List of parameters such as expected returns, variances, and covariances necessary to determine the optimal risky portfolio.

Question 49

separation property

Answer 49

The property that portfolio choice can be separated into two independent tasks: (1) determination of the optimal risky portfolio, which is a purely technical problem, and (2) the personal choice of the best mix of the risky portfolio and the risk-free asset

Question 50

risk pooling

Answer 50

Adding uncorrelated, risky investments to the portfolio

Question 51

risk sharing

Answer 51

Spreading risk across many investors so that each investor bears only a fraction of the total risk.