Risk and Return in Portfolio: Chapter 8

Vocabulary flashcards covering concepts of stand-alone risk, portfolio risk, diversifiable versus market risk, CAPM, and related statistical metrics.

Risk

The chance that some unfavorable event will occur.

Stand-alone risk

The risk an investor would face if he or she held only one asset; it is especially important for small businesses.

Probability distribution

A listing of possible outcomes or events with a probability (chance of occurrence) assigned to each outcome.

Expected rate of return ($\hat{r}$)

The rate of return expected to be realized from an investment; calculated as the weighted average of the probability distribution of possible results, or as

$\frac{\text{expected ending value} - \text{cost}}{\text{cost}}$.

Standard deviation

A statistical measure of the variability of a set of observations, where a lower standard deviation indicates lower risk.

Coefficient of variation (CV)

The standardized measure of the risk per unit of return, calculated as the standard deviation divided by the expected return.

Sharpe ratio

A measure of stand-alone risk that compares an asset's realized excess return to its standard deviation over a specified period, calculated as

$$\text{return}-\text{risk-free rate}$$

A higher ratio indicates better performance.

Risk aversion

The characteristic of investors who dislike risk and require higher rates of return as an inducement to buy riskier securities.

Risk premium (RP)

The difference between the expected rate of return on a given risky asset and that on a less risky asset.

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 that reflects only the risk remaining after diversification.

Expected return on a portfolio ($\hat{r}_p$)

The weighted average of the expected returns on the assets held in the portfolio, calculated as $\hat{r}_p = W_1 \hat{r}_1 + W_2 \hat{r}_2 + \dots + W_N \hat{r}_N$.

Realized rate of return ($\bar{r}$)

Returns that were actually earned during some past period; actual returns usually turn out to be different from expected returns ($\hat{r}$) except for riskless assets.

Correlation

The tendency of two variables to move together.

Correlation coefficient

A measure of the degree of relationship between two variables.

Diversifiable risk

That part of a security's risk associated with random events that can be eliminated by proper diversification; also known as company-specific or unsystematic risk.

Market risk

The risk that remains in a portfolio after diversification has eliminated all company-specific risk; also known as nondiversifiable, systematic, or beta risk.

Market portfolio

A portfolio consisting of all stocks.

Relevant risk

The risk that remains once a stock is in a diversified portfolio, representing its contribution to the portfolio's market risk; measured by the extent to which the stock moves up or down with the market.

Average stock's beta ($b_A$)

A beta value equal to $1$ ($b_A = 1$), characteristic of an average-risk stock that tends to move up and down in steps with the general market.

Market risk premium ($RP_M$)

The additional return over the risk-free rate needed to compensate investors for assuming an average amount of risk.

Risk premium for stock $i$ ($RP_i$)

The risk premium specific to a stock, calculated as $RP_i = (RP_M) b_i$.