Chapter 5-7 Flashcards
effective annual rate (EAR)
Interest rate annualized using compound rather than simple interest.
annual percentage rate (APR)
Interest rate is annualized using simple rather than compound interest.
nominal interest rate
The interest rate in terms of nominal (not adjusted for purchasing power) dollars.
real interest rate
dividend yield
The annual dividend payment expressed as a percent of the stock price.
mean return
Another term for expected return.
variance
A measure of the dispersion of a random vari- able. Equals the expected value of the squared deviation from the mean.
standard deviation
Square root of the variance.
risk-free rate
The interest rate that can be earned with certainty, commonly taken to be the rate on short-term Treasury bills.
risk premium
An expected return in excess of that on risk- free securities. The premium provides compensation for the
risk of an investment.
excess return
The probability-weighted average of the possible outcomes.
normal distribution
Bell-shaped probability distribution that characterizes many natural phenomena.
event tree
Depicts all possible sequences of events.
skew
Measure of the asymmetry of a probability distribution.
kurtosis
Measure of the fatness of the tails of a probability distribution. Indicates probability of observing extreme high or low values.
tail risk
Risk of extreme events in the far tail of the prob- ability distribution
value at risk (VaR)
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.
expected shortfall (ES)
The expected loss on a security conditional on returns being in the left tail of the probability distribution.
conditional tail expectation
(CTE)
Expectation of a random variable conditional on its falling below some threshold value. Often used as a measure of downside risk.
lower partial standard deviation (LPSD)
Standard deviation computed using only the portion of the return distribution below a threshold such as the risk-free rate or the sample average.
Sortino ratio
Excess return divided by lower partial standard deviation.
lognormal distribution
The probability distribution that characterizes a variable whose log has a normal (bell- shaped) distribution.
risk premium
An expected return in excess of that on risk- free securities. The premium provides compensation for the
risk of an investment.
fair game
An investment prospect that has a zero risk
premium.
risk averse
An investor who will consider risky portfo- lios only if they provide compensation for risk via a risk premium.
utility
The measure of the welfare or satisfaction of an investor.
certainty equivalent rate
The certain return providing the same utility as a risky portfolio.
risk neutral
An investor who finds the level of risk irrelevant and considers only the expected return of risk prospects.
risk lover
An investor who is willing to accept lower expected returns on prospects with higher amounts of risk.
mean-variance (M-V)
criterion
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.
indifference curve
A curve connecting all portfolios with the
same utility according to their means and standard deviations
complete portfolio
The entire portfolio, including risky and risk-free assets.
risk-free asset
An asset with a certain rate of return; often taken to be short-term T-bills.
capital allocation line (CAL)
A graph showing all feasible risk–return combinations of a risky and risk-free asset.
reward-to-volatility or Sharpe
ratio
Ratio of excess return to portfolio standard deviation.
passive strategy
A portfolio decision that avoids any direct or indirect security analysis. See passive management.
capital market line (CML)
The capital allocation line that results when using the market index as the risky portfolio.
diversification
Spreading a portfolio over many investments to avoid excessive exposure to any one source of risk.
insurance principle
The law of averages. The average outcome for many independent trials of an experiment will approach the expected value of the experiment.
market risk
Risk factors common to the whole economy; also called systematic or nondiversifiable risk.
systematic risk
Risk of breakdown in the financial system, particularly due to spillover effects from one market into others.
nondiversifiable risk
Risk factors common to the whole economy; also called market risk or systematic risk.
unique risk
Nonmarket or firm-specific risk factors
that can be eliminated by diversification. Also called firm- specific risk, nonsystematic risk, or diversifiable risk.
firm-specific risk
Nonmarket or firm-specific risk factors that can be eliminated by diversification. Also called unique risk, nonsystematic risk, or diversifiable risk.
nonsystematic risk
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.
diversifiable risk
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.
minimum-variance
portfolio
The portfolio of risky assets with lowest possible variance.
portfolio opportunity set
The expected return–standard deviation pairs of all portfolios that can be constructed from a given set of assets.
optimal risky portfolio
An investor’s best combination of risky assets; the combination that maximizes the Sharpe ratio.
minimum-variance frontier
Graph of the lowest possible portfolio standard deviation corresponding to each value of portfolio expected return.
efficient frontier of risky assets
The portion of the minimum- variance frontier that lies above the global minimum-variance portfolio.
input list
List of parameters such as expected returns, variances, and covariances necessary to determine the optimal risky portfolio.
separation property
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
risk pooling
Adding uncorrelated, risky investments to the portfolio
risk sharing
Spreading risk across many investors so that each investor bears only a fraction of the total risk.
