FINC 318 - Risk and Rates of Return Flashcards

Vocabulary flashcards covering key terms and concepts from lecture notes on Risk and Rates of Return (FINC 318).

Holding Period Return (HPR)

The total percentage return earned on an investment over the duration it is held, calculated as dollar profit or loss divided by the original cost.

Dollar Profit or Loss

The absolute monetary return on an investment, calculated as ending value plus distributions minus original cost.

Annual Percentage Rate (APR)

The simple annual rate of return on an investment, calculated as $\text{APR} = \frac{\text{HPR}}{n}$, where $n$ is the number of years.

Effective Annual Rate (EAR)

The compounded annual rate of return on an investment, calculated as $\text{EAR} = (1 + \text{HPR})^{1/n} - 1$, where $n$ is the number of years.

Risk Aversion

The behavioral assumption that investors dislike risk and require higher expected rates of return to compensate for holding riskier securities.

Risk-Free Rate ($R_f$)

The rate of return earned on a completely riskless asset, typically represented in financial analysis by U.S. Treasury bills.

Risk Premium

The excess return earned on a risky asset over the risk-free rate, serving as compensation to investors for bearing risk.

Variance ($\text{VAR}(R)$ or $\sigma^2$)

A statistical measure of return dispersion or variability calculated from historical returns as $\text{VAR}(R) = \sigma^2 = \frac{\sum_{i=1}^T (R_i - \bar{R})^2}{T - 1}$.

Standard Deviation ($\text{SD}(R)$ or $\sigma$)

The square root of return variance, measuring an asset's volatility in the same unit percentage as the expected or average return.

Expected Rate of Return ($\hat{r}$)

The weighted average rate of return expected from an investment, calculated as the sum of each potential return multiplied by its probability of occurrence: $\hat{r} = \sum_{i=1}^N P_i r_i$.

Coefficient of Variation (CV)

A standardized measure of stand-alone risk relative to expected return, calculated as $\text{CV} = \frac{\sigma}{\hat{r}}$.

Sharpe Ratio

A metric measuring stand-alone excess return per unit of total risk, defined as $\text{Sharpe Ratio} = \frac{\text{Asset Return} - R_f}{\sigma}$.

Portfolio Expected Return

The weighted average expected return of all individual securities contained within a portfolio, expressed as $E(R_p) = \sum_{j=1}^m w_j E(R_j)$.

Market Risk (Systematic Risk)

Non-diversifiable risk caused by economy-wide factors—such as changes in GDP, inflation, or interest rates—that impact a large number of assets.

Diversifiable Risk (Unsystematic Risk)

Company-specific or industry-specific risk that can be eliminated by combining assets into a well-diversified portfolio.

Total Risk

The overall risk of an asset when held alone, equal to the sum of systematic risk and unsystematic risk ($\text{Total risk} = \text{Market risk} + \text{Diversifiable risk}$).

Diversification

An investment strategy of combining varied assets to reduce portfolio risk by leveraging low or negative return correlations across assets.

Correlation Coefficient

A metric ranging from $-1$ to $1$ that measures the direction and strength of linear co-movement between two security returns.

Beta Coefficient ($\beta$)

A measure of a stock's systematic risk relative to the overall market portfolio, where a beta of $1.0$ indicates average market risk.

Capital Asset Pricing Model (CAPM)

A model defining the relationship between systematic risk and expected return, given by $E(R_A) = R_f + (E(R_M) - R_f)\beta_A$.

Market Risk Premium ($\text{RPM}$)

The additional expected return required by investors above the risk-free rate to bear average market risk ($E(R_M) - R_f$).

Security Market Line (SML)

The graphical representation of CAPM displaying the linear relationship between expected return and systematic risk (Beta).