Principles of Investments: Comprehensive Exam Review

Vocabulary practice flashcards covering core concepts of investment environments, market microstructure, portfolio risk and return, CAPM, diversification, and equity valuation.

Real Assets

Tangible, physical assets—such as land, buildings, machinery, and equipment—that are used directly to produce goods and services.

Financial Assets

Claims on real assets or the income they generate that convey contractual rights, such as ownership equity or creditor rights; examples include stocks, bonds, derivatives, and cash.

Weak-Form Market Efficiency

The hypothesis that stock prices fully reflect all historical market information, including past prices and trading volume, meaning technical analysis cannot generate excess returns.

Semi-Strong Form Market Efficiency

The hypothesis that stock prices reflect all publicly available information, including past market data and current public news or financial reports.

Strong-Form Market Efficiency

The hypothesis that stock prices reflect all existing information, both public and private (insider) information.

Passive Management

An investment strategy that holds a highly diversified portfolio to track market performance, without attempting to time the market or pick undervalued securities.

Active Management

An investment strategy that attempts to outperform the market by actively timing market movements and selecting mispriced or undervalued securities.

Primary Market

The financial market where newly issued securities are sold to investors for the first time, and the issuing corporation receives the sales proceeds.

Secondary Market

The market where existing, previously issued securities are traded among investors (e.g., NYSE, NASDAQ), with no proceeds going to the original corporate issuer.

Dealer Market

A security market structure where dealers quote prices to buy and sell securities directly from and into their own inventory (e.g., NASDAQ).

Auction Market

A centralized trading venue where all buy and sell orders converge and are directly matched against one another through an exchange (e.g., NYSE).

Standardized Bid-Ask Spread

A measure of liquidity and trading cost relative to price, calculated as: $\frac{\text{Ask Price} - \text{Bid Price}}{\text{Ask Price}}$

Initial Margin

The mandatory minimum percentage of the total purchase price that an investor must contribute using their own equity when buying securities on margin or short selling.

Maintenance Margin

The minimum proportion of equity an investor must maintain in a margin account relative to the market value of the position before triggering a margin call.

Long Margin Call Price

The price level to which a purchased stock can drop before triggering a margin call, determined using the equation: $\frac{(\text{Shares} \times P) - \text{Amount Borrowed}}{\text{Shares} \times P} = \text{Maintenance Margin}$

Short Margin Call Price

The price level to which a shorted stock can rise before triggering a margin call, determined using the equation: $\frac{\text{Sale Proceeds} + \text{Initial Equity} - (\text{Shares} \times P)}{\text{Shares} \times P} = \text{Maintenance Margin}$

Fisher Equation

The exact relationship used to convert nominal interest rate ($R$) and inflation rate ($i$) into real return ($r$): $1 + r = \frac{1 + R}{1 + i}$

Real After-Tax Rate of Return

The real increase in purchasing power after accounting for tax liability ($t$) on nominal return ($R$) and inflation ($i$): $1 + r_{\text{After-Tax}} = \frac{1 + R(1 - t)}{1 + i}$

Holding Period Return (HPR)

The total percentage return realized over a specific holding timeframe, accounting for capital gains and dividends: $\text{HPR} = \frac{P_1 - P_0 + D}{P_0}$

Annualized Holding Period Return

The equivalent annual compounded return over a holding period of $n$ years: $\text{Annualized HPR} = (1 + \text{HPR})^{\frac{1}{n}} - 1$

Geometric Mean Return

The compound average growth rate per period used to report historical performance: $R_G = [(1 + R_1)(1 + R_2) \cdots (1 + R_n)]^{\frac{1}{n}} - 1$

Arithmetic Mean Return

The simple uncompounded average of past returns ($\bar{R} = \frac{\sum R_t}{n}$), used primarily to forecast expected future returns.

Sharpe Ratio

A measure of risk-adjusted return (reward-to-volatility) defined as average excess return divided by standard deviation: $\text{Sharpe Ratio} = \frac{\bar{R} - r_f}{\text{SD}}$

Capital Allocation Line (CAL)

A graph depicting all available risk-return combinations formed by combining a risk-free asset with a specific risky portfolio, where the line's slope is the portfolio's Sharpe ratio.

Capital Market Line (CML)

The optimal Capital Allocation Line tangent to the efficient frontier at the Market Portfolio ($M$), offering the highest Sharpe ratio possible.

Market Risk (Systematic Risk)

Macroeconomic or non-diversifiable risk stemming from aggregate market factors (such as interest rates or GDP changes) that cannot be eliminated by diversification.

Firm-Specific Risk (Unique Risk)

Nonsystematic, diversifiable risk that affects an individual firm or industry (such as CEO resignation or product recalls) and can be reduced to zero through diversification.

Statman Diversification Limit

Empirical evidence showing that holding a single stock carries an average standard deviation of $49.2\%$, which rapidly drops as more stocks are added until reaching the non-diversifiable limit of $19.2\%$.

Covariance of Returns

A statistic measuring how two asset returns move together: $\text{Cov}(r_D, r_E) = \frac{\sum (r_{D,t} - \bar{r}_D)(r_{E,t} - \bar{r}_E)}{T - 1} = \rho(r_D, r_E) \sigma_D \sigma_E$

Correlation Coefficient ($\rho$)

A standardized measure of co-movement between two security returns ranging between $-1.0$ and $+1.0$, where $\rho = -1.0$ maximizes diversification and $\rho = +1.0$ offers no risk reduction.

Capital Asset Pricing Model (CAPM)

An equilibrium model establishing that the expected return on a security equals the risk-free rate plus a premium based only on systematic risk: $E(R_i) = r_f + \beta_i [E(R_M) - r_f]$

Beta ($\beta$)

The sensitivity of an individual asset's return to movements in the market portfolio, measuring non-diversifiable systematic risk: $\beta_i = \frac{\text{Cov}(r_i, r_M)}{\sigma_M^2}$

Security Market Line (SML)

The graphical depiction of CAPM showing expected return plotted against systematic risk ($\beta$), with an intercept at $r_f$ and a slope equal to the market risk premium $[E(R_M) - r_f]$.

Treynor Ratio

A risk-adjusted performance measure defined as expected excess return per unit of systematic risk: $\text{Treynor Ratio} = \frac{E(R_i) - r_f}{\beta_i}$

Characteristic Line

The linear regression of a security's excess return against the market portfolio's excess return ($R_i - r_f = a_0 + b_i (R_M - r_f) + e_i$), whose slope ($b_i$) estimates the security's beta.

Constant Growth Dividend Discount Model (Gordon Model)

A stock valuation model for companies with dividends growing at a steady perpetual rate $g$: $V_0 = \frac{D_0 (1 + g)}{k - g} = \frac{D_1}{k - g}$

Internal Dividend Growth Rate ($g$)

The sustainable growth rate of a firm's dividends derived from retained earnings: $g = \text{ROE} \times b$

Plowback (Retention) Ratio ($b$)

The fraction of a firm's earnings retained and reinvested into operations rather than distributed as dividends: $b = 1 - \text{dividend payout ratio}$

Price-to-Earnings (P/E) Ratio

A relative valuation ratio calculated as current stock price divided by annual earnings per share ($\text{P/E} = \frac{P}{\text{EPS}}$), indicating the dollar amount investors pay per dollar of current earnings.