Risk and Return Part 2 (Chapter 7)

Vocabulary practice flashcards covering variance calculation, portfolio diversification, systematic and unsystematic risk, beta, the Capital Asset Pricing Model (CAPM), and the Security Market Line (SML) from Chapter 7: Risk and Return Part 2.

Population Variance ($\sigma_{pop}^2$)

The variance calculated when all observations in a population are available and observations share equal probability ($\frac{1}{N}$), given by $\sigma_{pop}^2 = \frac{1}{N} \sum_{i=1}^{N} (X_i - \bar{X})^2$.

Sample Variance ($\sigma_{sample}^2$)

The variance calculated when only a sample of observations is available, dividing by degrees of freedom ($N - 1$): $\sigma_{sample}^2 = \frac{1}{N - 1} \sum_{i=1}^{N} (X_i - \bar{X})^2$.

Diversification

A strategy designed to reduce risk by spreading an investment portfolio across many relatively low-correlated assets, introduced by Markowitz (1959) in 'Portfolio Selection'.

Portfolio Return ($r_{portfolio}$)

The total return generated by a portfolio, calculated as the weighted sum of the returns of its individual assets: $r_{portfolio} = \sum_{i=1}^{N} w_i r_i$.

Idiosyncratic Risk

Risk that stems from firm-specific or asset-specific events and uncertainties; also referred to as diversifiable risk or firm-specific risk.

Systematic Risk

Economy-wide sources of uncertainty that affect the overall stock market and cannot be diversified away; also referred to as non-diversifiable risk or market risk.

Well-Diversified Portfolio

A portfolio whose specific (idiosyncratic) risk has been eliminated through diversification across numerous assets, leaving only systematic risk.

Market Portfolio

The most well-diversified portfolio possible that an investor constructs to capture the maximum diversification benefit.

Beta ($\beta$)

A measure of the sensitivity of an asset's return to the return on the market portfolio, serving as the relevant risk metric for a well-diversified portfolio and roughly expressed as $\beta_i = \frac{\Delta r_i}{\Delta r_{market}}$.

Portfolio Beta ($\beta_{portfolio}$)

The weighted average of the betas of the individual securities comprising a portfolio, calculated as $\beta_{portfolio} = \sum_{i=1}^{N} w_i \beta_i$.

Capital Asset Pricing Model (CAPM)

A financial model defining the trade-off between risk and required return for a well-diversified investor, calculated as $E(r_i) = r_f + \beta (E(r_m) - r_f)$, where expected return depends on compensation for waiting ($r_f$) plus an asset-specific risk premium.

Security Market Line (SML)

A graphical representation of the Capital Asset Pricing Model (CAPM) displaying expected return as a function of beta ($\beta$), used to evaluate an equity's risk-to-return tradeoff relative to the risk-free rate ($r_f$) and market return ($r_m$).

Undervalued Security (CAPM Context)

A stock whose predicted or expected return exceeds its CAPM-required return, indicating it offers excess return for its level of systematic risk.

Overvalued Security (CAPM Context)

A stock whose predicted return is lower than its required rate of return under the CAPM, meaning it provides inadequate compensation for its market risk.