BNFN444 - Risk and Return Part I (Chapter 2)

Risk Aversion

A risk-averse investor dislikes risk and requires a high rate of return as an inducement to buy riskier securities.

Portfolio

A group of individual assets held in combination. An asset that would be relatively risky if held in isolation may have little or no risk if held in a well-diversified portfolio.

Market Risk

That part of security’s (or project’s) total risk that cannot be eliminated by diversification; measured by the beta coefficient and often called beta risk. In the context of project analysis, it is the risk of the project as viewed by a well-diversified stockholder who owns many different stocks, which is the project’s impact on the firm’s beta coefficient.

Expected rate of return, required rate of return

The rate of return expected on a portfolio given it current price and expected future cash flows.

Capital Asset Pricing Model (CAPM)

A model based on the proposition that any stock’s required rate of return is equal to the risk-free rate of return plus a risk premium reflecting only the risk remaining after diversification.

Risk

Exposure to the chance of an unfavorable event.

Stand-alone Risk

The risk an investor would take by holding only one asset. In the context of project analysis, it is the risk a company would have if the company had only one project and it is caused by variability in a project’s cash flows. The standard deviation is used often tot measure stand-alone risk.

Discrete Probability Distribution

Probability distribution having a finite number of outcomes. Often presented as a listing, chart, or graph showing all possible outcomes with a probability assigned to each outcome. This listing of outcomes and probabilities is a probability density function.

Expected Rate of Return

The rate of return expected on a stock given its current price and expected future cash flows. If the stock is in equilibrium, the required rate of return will equal the expected rate of return.

Continuous Probability Distributions

Probability distribution having an infinite number of possible outcomes. Often shown as a graph with outcomes on the x-axis having values that might range from negative infinity to positive infinity (although many probability distributions do not have an infinite range of possible outcomes). The values on the y-axis are a continuous curve that begin with a value of zero (or tangent to zero), are always positive, and end with a value of zero (or tangent to zero). Also, the area under this curve must be equal to 100% (this is a probability density function). Sometimes shown with cumulative probabilities on the y-axis (i.e., the probability that an outcome will be less than or equal to the value on the x-axis; this is a cumulative density function).

Normal Distribution

A widely used continuous probability distribution that resembles a bell-shaped curve.

Average Return

The average return from a sample periods of past actual returns.

Diversification

The reduction in risk due to holding a portfolio of assets that are not perfectly correlated.

Correlation Coefficient

A standardized measure of how tow random variables covary. A correlation coefficient (p) of +1.0 means that the tow variables move up and down in perfect synchronization, whereas a coefficient of -1.0 means the variables always move in opposite directions. A correlation coefficient of zero suggests that the two variables always move in opposite directions. A correlation coefficient of zero suggests that the two variables are not related to one another; that is, they are independent.

Correlation

The tendency of two variables to move together.

Market Portfolio

A portfolio consisting of all shares of all stocks.

Diversifiable Risk

Refers to that part of a security’s total risk associated with random events not affecting the market as a whole. This risk can be eliminated by proper diversification. Also known as company-specific risk.

Relevant Risk

An asset’s contribution to a well-diversified portfolio’s risk.

Beta Coefficient (b)

A measure of the amount of risk that an individual Stock i contributes to a well-diversified portfolio.

Equity Premium

RP_M ; Expected market return minus the risk-free rate; also called market risk premium or equity risk premium.

Equity Risk Premium

RP_M ; Expected market return minus the risk-free rate; also called market risk premium or equity premium.

Market Equilibrium

The condition under which the intrinsic value of a security is equal to its price; also, when a security’s expected return is equal it its required return. Also known as equilibrium.

Equilibrium

The condition under which the intrinsic value of a security is equal to its price; also, when a security’s expected return is equal to its required return. Also known as market equilibrium.

Efficient Markets Hypothesis (EMH)

States (1) that stocks are always in equilibrium and (2) that it is impossible for an investor to consistently “beat the market’ by getting a higher return than is justified by the stock’s risk. The EMH assumes that all important information regarding a stock is reflected in the price of that stock.

Technical Analysts

Stock analyst who believe that past trends or patterns in stock prices can be used to predict future stock prices.

Fama-French Three-factor Model

Includes one factor for the excess market return (the market return minus the risk-free rate), a second factor for size (defined as the return on a portfolio of small firms minus the return on a portfolio of big firms), and a third factor for the book-to-market effect (defined as the return on a portfolio of firms with a high book-to-market ratio minus the return on a portfolio of firms with low book-to-market ratio).

Behavioral Finance

A field of study that analyzes investor behavior as a result of psychological traits. It does not assume that investors necessarily behave rationally and instead focuses on irrational, but predictable, financial decisions.

Anchoring Bias

Occurs when predictions of future events are influenced too heavily by recent events.

Herding

Occurs when groups of investors emulate other successful investors and chase asset classes that are doing well. Also occurs when analysts go along with other analysts rather than state their true opinions.

Loss Aversion

A behavioral phenomenon occurring when investors dislike a loss more than they like a gain of the same amount. For example, an investor dislikes a loss of $100 more than a gain go $100.