Corporate Finance: Risk, Return, Bonds, and Stock Valuation

Comprehensive vocabulary flashcards covering optimal portfolio choice, the Capital Asset Pricing Model (CAPM), capital market risk and return history, bond valuation, and equity valuation models.

Probability Distribution

A specification that assigns a probability $p_R$ to each possible return $R$ that an asset or investment may realize.

Expected (Mean) Return

The probability-weighted average of all possible returns: $E[R] = \sum_{R} p_R \times R$.

Volatility (Standard Deviation)

The square root of the variance ($SD(R) = \sqrt{Var(R)}$), measuring the total risk or dispersion of returns in the same percentage units as the return itself.

Realized Return

The actual total return earned on an investment over a specific time horizon, equal to the dividend yield plus the capital gain rate: $R_{t+1} = \frac{Div_{t+1}}{P_t} + \frac{P_{t+1} - P_t}{P_t}$.

Standard Error (SE)

The standard deviation of an estimated average return around its true expected value ($SE = \frac{SD}{\sqrt{T}}$), quantifying sample estimation error.

Excess Return

The difference between an investment's average return and the return on a risk-free asset (such as Treasury bills), quantifying the historical risk premium.

Common Risk

A risk that is perfectly correlated across securities and affects all market assets simultaneously, preventing it from being eliminated via diversification.

Independent Risk

A firm-specific, uncorrelated risk that affects only a single company or asset and can be completely eliminated by holding a large portfolio.

Diversification

The reduction of risk that occurs by combining multiple assets into a portfolio, thereby averaging out independent, firm-specific risks.

Systematic Risk

Market-wide risk caused by macroeconomic events that affects all firms; it cannot be diversified away and determines the required risk premium.

Diversifiable Risk

Firm-specific, unique, or idiosyncratic risk that can be eliminated costlessly through diversification, earning a risk premium of zero in competitive markets.

Portfolio Weight ($x_i$)

The fraction of a portfolio's total dollar value invested in asset $i$ ($x_i = \frac{\text{Value of investment } i}{\text{Total value of portfolio}}$), where all weights sum to $1.0$ ($100\%$).

Covariance

A statistical measure of the degree to which two asset returns comove, calculated as the expected product of their deviations from their means: $Cov(R_i, R_j) = E[(R_i - E[R_i])(R_j - E[R_j])]$.

Correlation Coefficient Spectrum

A standardized measure of common movement between two assets ranging from $-1$ (perfectly negatively correlated, always moving oppositely) through $0$ (uncorrelated) to $+1$ (perfectly positively correlated, always moving together).

Efficient Frontier

The northwest boundary of attainable investment combinations displaying the set of portfolios that provide the highest possible expected return for any given level of volatility.

Short Position (Short Sale)

A transaction in which an investor sells a security they do not own by borrowing it, expecting to buy it back later at a lower price; represented by a negative portfolio weight.

Levered Portfolio

A portfolio created by borrowing cash at the risk-free rate (buying on margin) to invest more than $100\%$ ($x > 1$) of initial wealth into a risky portfolio.

Sharpe Ratio

The ratio of an asset's or portfolio's excess return to its volatility, measuring reward per unit of total risk: $\frac{E[R_P] - r_f}{SD(R_P)}$.

Tangent Portfolio

The optimal portfolio of risky securities located at the point of tangency between the risk-free rate line and the efficient frontier, possessing the highest possible Sharpe ratio.

Homogeneous Expectations

A central assumption of the CAPM that all market participants share identical estimates regarding future expected returns, volatilities, and correlations for all assets.

Capital Market Line (CML)

The linear efficient frontier formed by combining the risk-free asset with the market portfolio of all risky assets.

Beta ($\beta$)

A measure of an asset's systematic risk sensitivity, indicating the expected percentage change in its excess return per $1\%$ change in the market portfolio's excess return: $\beta_i = \frac{Cov(R_i, R_{Mkt})}{Var(R_{Mkt})}$.

Security Market Line (SML)

The graphical depiction of the CAPM showing the linear relationship between systematic risk ($\beta$) and expected return: $E[R_i] = r_f + \beta_i(E[R_{Mkt}] - r_f)$.

Face Value (Par Value)

The notional principal amount of a bond used to compute interest payments and paid to the investor at maturity, typically standard at $\$1{,}000$.

Coupon Rate

The annualized percentage of a bond's face value that determines the dollar amount of periodic interest payments: $CPN = \frac{\text{Coupon Rate} \times \text{Face Value}}{\text{Number of Coupon Payments per Year}}$.

Zero-Coupon Bond

A pure discount debt security that pays no regular interest coupons and is sold at a discount below face value, returning only the face value at maturity.

Yield to Maturity (YTM)

The single discount rate that equates the present value of all remaining promised bond cash flows to the bond's current market price.

Premium Bond

A bond that trades at a market price exceeding its face value, which occurs when its coupon rate is higher than its yield to maturity.

Discount Bond

A bond that trades at a market price below its face value, which occurs when its coupon rate is lower than its yield to maturity.

Duration

A metric measuring the sensitivity of a bond's market price to changes in market interest rates; longer durations reflect greater interest rate risk.

Credit Spread (Default Spread)

The yield difference between a credit-risky corporate bond and a default-free government Treasury security of equivalent maturity.

Bond Credit Rating Grades

Creditworthiness classifications assigned by rating agencies (Fitch, S&P, Moody's), divided into Investment Grade (Aaa/AAA down to Baa/BBB) and Speculative Grade/Junk (Ba/BB and below).

Sovereign Bonds

Government debt securities issued by sovereign national entities, which may be subject to default and inflation risks.

Dividend Yield

The ratio of a stock's expected annual cash dividend per share to its current stock price: $\frac{Div_1}{P_0}$.

Equity Cost of Capital ($r_E$)

The expected rate of return required by equity investors to compensate for holding a stock with a given level of risk.

Dividend-Discount Model (DDM)

A stock valuation method where a share's price is equal to the present value of all expected future dividends: $P_0 = \sum_{n=1}^{\infty} \frac{Div_n}{(1 + r_E)^n}$.

Constant Dividend Growth Model

A valuation formula equating stock price to the next expected dividend divided by the equity cost of capital minus the constant growth rate: $P_0 = \frac{Div_1}{r_E - g}$.

Retention Rate

The fraction of net earnings reinvested into the firm rather than paid out as dividends ($1 - \text{Dividend Payout Rate}$), which determines earnings growth: $g = \text{Retention Rate} \times \text{Return on New Investment}$.

Total Payout Model

An equity valuation method that discounts total cash payouts (dividends plus share repurchases) at the equity cost of capital to find total equity value, which is then divided by total shares outstanding.

Free Cash Flow (FCF)

Cash flow generated by operations available for distribution to all capital providers (debt and equity), computed as $EBIT \times (1 - \tau_c) + \text{Depreciation} - \text{CapEx} - \Delta NWC$.

Enterprise Value (EV)

The total market value of a firm's underlying core business, equal to the present value of its future free cash flows, or $\text{Market Value of Equity} + \text{Debt} - \text{Cash}$.

Method of Comparables

A relative valuation technique that estimates a firm's equity or enterprise value by applying benchmark market multiples (such as P/E or EV/EBITDA) of peer companies.

Efficient Markets Hypothesis (EMH)

The proposition that security prices in competitive financial markets instantaneously and fully reflect all available information, ensuring that securities are fairly priced.