BNFN444 - Risk and Return Part II (Chapter 3)

Efficient Portfolio

Provides that highest expected return for any specified level of risk. The efficient portfolio also provides the lowest degree of risk for any specified level of expected return.

Capital Market Line (CML)

Show the relationship between the expected return and standard deviation for the set of optimal portfolios.

Historical Beta

Beta as estimated using historical data for the past returns on the stock and market portfolio. Often estimated by a regression with the stock’s returns (or return in excess of the risk-free) on the y-axis and the market’s return (or excess returns) on the x-axis.

Adjusted Beta

Adjustment to historical beta that reflects knowledge of then distribution of true betas (i.e., average beta is equal to 1). If estimated beta is greater than 1, then adjusted beta is between 1 and the estimated beta; if the estimated beta is less than 1, the adjusted beta is less 1, the adjusted beta is between the estimated beta and 1.

Fundamental Beta

Incorporates adjustments to historical beta that address impact of current variables such as operating leverage, financial leverage, and sales volatility.

Feasible Set

Represents all portfolios that can be constructed from a given set of stocks; also known as the attainable set.

Attainable Set

Represents all portfolios that can be constructed from a given set of stocks; also known as the feasible set.

Efficient Set

The set of efficient portfolios out of the full set of potential portfolios. On a graph, the efficient set constitutes the boundary line of the set of potential portfolios. Also called the efficient frontier.

Efficient Frontier

The set of efficient portfolios out the full set of potential portfolios. On a graph, the efficient frontier constitutes the boundary line of the set of potential portfolios. Also called the efficient set.

Indifference Curve

The risk-return trade-off function for a particular investor; reflects that investor’s attitude toward risk. An investor would be indifferent between any pair of assets on the same indifference curve. In risk-return space, the greater the slop of the indifference curve, the greater is the investor’s risk aversion.

Risk Premium

the additional expected return on a higher risk investment relative to a lower risk investment. A higher expected return is required by investors as compensation for bearing higher risk.

Optimal Portfolio

The point at which the efficient set of portfolios—the efficient frontier—is just tangent to the investor’s indifference curve. This point marks the highest level of satisfaction an investor can attain given the set of potential portfolios.

Risk-free Asset

An asset with a zero probability of default. It is denoted as r_RF . It is often proxied by the yield on a short-term U.S. Treasury security.

Characteristic Line

Obtained by regressing the historical returns on a particular stock against the historical returns on the general stock market. The slope of the characteristic line the stock’s beta, which measures the amount by which the stock’s expected return increase for a given increase in the expected return on the market.

Market Model

A regression with a stock’s returns on the y-axis and the market’s returns on the x-axis.

Jensen’s Alpha

Measures the vertical distance of a portfolio’s return about or below the Security Market Line; first suggested by Professor Michael Jensen, it became popular because of its ease of calculation. It measures the average return that cannot be explained by the CAPM.

Sharpe’s reward-to-variability ratio

Asset’s average return (in excess of the risk-free rate) divided by its standard deviation. Measure the return per unit of risk as defined by standard deviation.

Treynor’s reward-to-volatility ratio

Asset’s average return (in excess of the risk-free rate) divided by its beta. Measure the return per unit of risk as defined by beta.

Arbitrage Pricing Theory (APT)

An approach to measuring the equilibrium risk-return relationship for a given stock as a function of multiple factors, rather than the single factor (the market return) used by the CAPM. The APT is based on complex mathematical and statistical theory, and it can account for several factors (such as GNP and the level of inflation) in determining the required return for a paricular stock.