US RPA 2 Module 3 Lecture Notes

A set of vocabulary flashcards covering the key terms and concepts of portfolio risk and the Capital Asset Pricing Model from Module 3.

Probability distributions

All possible outcomes for a security and the likelihoods of these outcomes

Variance/standard deviation with expected data

Measures of the dispersion of a set of data points around the mean

Portfolio expected return

A weighted average of the expected returns of the individual security expected returns in the portfolio

Risk reduction—the insurance principle

The concept that risk can be reduced by diversifying investments

Diversification

Adding securities to a portfolio to reduce firm-specific risk

Marginal risk reduction

A decrease in risk achieved by adding one more security to a portfolio

Random diversification

Adding securities to a portfolio without regard to their risk characteristics

Efficient diversification

Adding securities to a portfolio with consideration of their risk characteristics and correlations

Correlation coefficient

Statistical measure of the degree to which two securities are associated (between $-1$ and $1$).

Covariance

The measure of how two securities move together over time

Portfolio risk in two-security case

Influenced by their correlation

Number of securities impact on portfolio risk

Having more securities in a portfolio generally reduces the overall risk

Portfolio of two securities

The simplest possible case to see what happens in the portfolio risk equation. Determined by variance of each security, covariance between securities, and portfolio weights for each security.

Portfolio of greater than two securities

Large, complex calculations must be done on a computer

Formula for determining the unique covariances for a set of n securities

Shows portfolio risk is a function of the weighted risk of each individual security and the weighted covariances among all pairs of securities.

Capital Asset Pricing Model (CAPM)

Model used to determine the expected return on an asset based on its risk relative to the market

Beta

Measure of a security's risk in relation to the market

Risk-free rate

Return on an investment with no risk of financial loss

Required rate of return

The minimum expected rate of return on an asset required by an investor to invest in that asset. Risk-free rate + risk premium

Security market line (SML)

Graphical representation of the CAPM, showing the relationship between risk and expected return