Chapter 25: Portfolio Theory and Asset Pricing Models

Market Model

a regression with a stock's returns on the y axis and the market's returns on the x axis

Sharpe's Reward-to-Variability Ratio

Asset's average return (in excess of the risk free rate) divided by its standard deviation. Measures the return per unit of risk defined by standard deviation.

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 is the stock's beta, which measures the amount by which the stock's expected return increases for a given increase in the expected return on the market

Adjusted Betas

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

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 (market return) used by CAPM. -Can account for several factors (GNP & level of inflation) in determining the required return for a particular stock

Risk-Free Asset

an asset with a zero probability of default. Although nothing is truly risk free, most investors consider a short term US treasury security to be a risk free asset -The Capital Asset Pricing Model (CAPM) describes the relationship between market risk and required rates of return.

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. -Stock i's beta coefficient, bi, is a measure of the stock's market risk. Beta measures the variability of a security's returns relative to the stock market.

Historical Betas

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

Fundamental Beta

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

Jensen's Alpha

measures the vertical distance of a portfolio's return above or below the security market line. Measures the return that cannot be explained by CAPM.

Efficient Portfolio

provides the highest return for any specified level of risk. Provided the lowest degree of risk for any specific level of expected return

Feasible Set

represents all portfolio that can be constructed from a given set of stocks, also called Attainable set

Efficient Set

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

Capital Market Line (CML)

shows the relationship between the expected return and standard deviation for the set of optimal portfolios r^p = rRF + [(r^M - rRF)/σM] σP

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

Indifference Curve

the risk return trade off function for a particular investor, it reflect 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 slope of the indifference curve, the greater the investor's risk aversion