Investments Chapter 6

capital allocation line

a graph created by investors to measure the risk of risky and risk-free assets. The graph displays the return to be made by taking on a certain level of risk. Its slope is known as the "reward-to-variability ratio".

sharpe ratio

a measure that indicates the average return minus the risk-free return divided by the standard deviation of return on an investment.

single factor model

a model of security returns that acknowledges only one common factor. The single factor is usually the market return.

minimum variance portfolio

a portfolio of individually risky assets that, when taken together, result in the lowest possible risk level for the rate of expected return.

security characteristic line (SCL)

a regression line, plotting performance of a particular security or portfolio against that of the market portfolio at every point in time.

passive benchmark

a standard against which the performance of a security, mutual fund or investment manager can be measured

preferred complete portfolio

an efficient portfolio most preferred by an investor because its risk/reward characteristics approximate the investor's utility function. A portfolio that maximizes an investor's preferences with respect to return and risk.

optimal risky portfolio

best combination of risky assets to be mixed with safe assets to form the complete portfolio

firm-specific or residual risk

component of return variance that is independent of the market factor

correlation coefficient

covariance divided by the product of the standard deviations of the returns on each fund; ranges from -1 to +1, complete diversification at -1 and no diversification at +1.

optimal portfolio

efficient portfolio most preferred by an investor because its risk/reward characteristics approximate the investor's utility function. A portfolio that maximizes an investor's preferences with respect to return and risk.

markowitz set

efficient set of the entire investment opportunity set

efficient frontier

graph representing a set of portfolios that maximizes expected return at each level of portfolio risk

mean-variance criterion

markowitz efficiency; portfolios are "efficient" if they offer the highest expected return for a given level of risk. inefficient portfolios are dominated by efficient portfolios

index model

model that relates stock returns to returns on both a broad market index and firm-specific factors

security characteristic line

plot of a security's predicted excess return from the excess return of the market

active portfolio

portfolio formed by optimally combining analyzed stocks

weighted average

portfolio returns; an average in which each quantity to be averaged is assigned a weight. These weightings determine the relative importance of each quantity on the average.

excess return

rate of return in excess of the risk-free rate

information ratio

ratio of alpha to the standard deviation of the residual

unique risk

risk that cannot be eliminated by diversification; firm-specific risk, nonsystematic risk, diversifiable risk; beta; there is a single "factor" that moves all stocks (market), and cannot diversify the market factor away

market risk

risk that remains after diversification; risk that is attributable to marketwide risk sources; systematic or nondiversifiable risk; each security has risk due to characteristics that are unique to that security; when combine stocks/assets, firm specific risks cancel each other out

beta

sensitivity of a security's returns to the market factor; equals standard deviation if risk has been fully diversified

investment opportunity set

set of available portfolio risk-return combinations

single index model

simple asset pricing model to measure both the risk and the return of a stock.

total risk

standard deviation of the portfolio = non-diversifiable risk + diversifiable risk

alpha

stock's expected return beyond that induced by the market index; its expected excess return when the market's excess return is zero

complete portfolio

the entire portfolio, including risky and risk-free assets.

covariance

the extent to which the returns on the two assets vary either in tandem or in opposition; portfolio risk depends on this between the returns of the assets in the portfolio

low risk of the portfolio is due to...

the inverse relationship between the performances of the stock and bond funds

separation property

the property that implies portfolio choice can be separated into two independent tasks: (1) determination of the optimal risky portfolio, which is a purely technical problem, and (2) the personal choice of the best mix of the risky portfolio and the risk-free asset

risk free rate

the theoretical rate of return of an investment with no risk of financial loss.

diversification

total risk can be reduced by combining stocks/assets into a portfolio. random up moves are cancelled out to some degree against random down moves

rate of return on a portfolio

weighted average of returns on the component securities, with the investment proportions as weights

expected rate of return on a portfolio

weighted average of the expected returns on the component securities, with the portfolio proportions as weights