Essentials of Investments: CAPM & Asset Pricing Exam Review

A set of flashcards covering key concepts and definitions from the lecture on CAPM and Asset Pricing.

CAPM

Capital Asset Pricing Model; a formula used to determine the required rate of return on an investment based on its systematic risk.

E(ri)

Expected return of a security, calculated using the formula E(ri) = rf + βi[E(rM) − rf].

rf

Risk-free rate; the return on an investment with zero risk, often represented by the yield on short-term U.S. Treasury bills.

Market risk premium

The additional return over the risk-free rate required by investors for taking on the higher risk of equity investing.

Beta (β)

Measure of a security's sensitivity to market movements; used to determine systematic risk in the CAPM formula.

Systematic risk

Risk inherent to the entire market or market segment, which cannot be eliminated through diversification.

Unsystematic risk

Risk specific to a single asset or small group of assets that can be reduced through diversification.

Security Market Line (SML)

A graphical representation of the CAPM that illustrates the relationship between systematic risk (beta) and expected return for securities.

Alpha (α)

A measure of the performance of an investment relative to a market index or benchmark, representing excess return.

Jensen's Alpha

A risk-adjusted performance measure that calculates the excess return of a portfolio over the expected return predicted by CAPM.

WACC

Weighted Average Cost of Capital; the average rate that a company is expected to pay to its security holders to finance its assets.

Fama-French Model

A multi-factor model that expands on CAPM by including size and value factors to explain stock returns.

Adjusted Beta

A modified version of beta that accounts for mean reversion, calculated as (2/3)Raw Beta + (1/3)1.0.

Risk Decomposition

The separation of total risk into systematic and unsystematic risk components, typically represented by the equation σ²(ri) = β²σ²M + σ²(εi).