Overview of Capital Asset Pricing Model (CAPM)

These flashcards cover key concepts relating to the Capital Asset Pricing Model (CAPM) and associated financial principles, providing definitions important for understanding investment strategies and risk management.

Capital Asset Pricing Model (CAPM)

A model that describes the relationship between systematic risk and expected return for assets, commonly used to price risky securities.

Expected Return

The anticipated return on an investment, reflecting the return an investor expects to receive based on historical data and market conditions.

Beta (β)

A measure of a security's sensitivity to market movements, indicating how much the price of the asset is expected to change in relation to changes in the overall market.

Sharpe Ratio

A measure of risk-adjusted return, calculated as the difference between the return of the asset and the risk-free rate divided by the asset's standard deviation.

Capital Allocation Line (CAL)

A line that represents the risk-return profiles of different combinations of risky and risk-free assets.

Risk Aversion

The preference of investors to choose lower-risk investments over higher-risk investments, reflecting their willingness to accept risk for potential return.

Capital Market Line (CML)

A special case of the Capital Allocation Line, representing the relationship between expected return and risk for portfolios that optimally combine risk-free assets and the market portfolio.

Equity Risk Premium

The additional return that investing in the stock market provides over a risk-free rate, often used to assess the attractiveness of equity markets.

Efficient Frontier

A curve that represents the set of optimal portfolios that offer the highest expected return for a given level of risk.

Security Market Line (SML)

A graphical representation of the CAPM, illustrating the relationship between expected return and beta for individual securities.

Passive Investing

An investment strategy that aims to replicate the performance of a market index, avoiding active stock selection.

Mean-Beta Relationship

A principle stating that the relationship between an asset's return and its market risk is reflected in its beta, with a portfolio's beta being the weighted average of the individual assets' betas.

Survivorship Bias

The bias that occurs when only the surviving members of a dataset are considered, which can lead to an overestimation of performance indicators.

Risk-Free Rate ($R_f$)

The theoretical rate of return of an investment with zero risk, often represented by the return on short-term government securities like T-bills.

Market Portfolio

A theoretical portfolio consisting of all risky assets in the market, with each asset weighted in proportion to its total market capitalization.

Systematic Risk (Market Risk)

The undiversifiable risk inherent to the entire market or market segment, affecting a large number of assets. It is measured by Beta.

Unsystematic Risk (Specific Risk)

The diversifiable risk unique to a specific company or industry, which can be reduced or eliminated through diversification.

Alpha (α)

A measure of an investment's performance relative to a benchmark index, representing the excess return generated by active management beyond what would be expected given the risk level.