Chapter 8: Risk and Rates of Return

probability distributions

Listings of possible outcomes or events with a probability (chance of occurrence) assigned to each outcome.

Perceived Risk

No investment should be undertaken unless the expected rate of return is high enough to compensate for the _________ _____.

realized rates of return

Returns that were actually earned during some past period. Actual returns usually turn out to be different from expected returns except for riskless assets.

Risk-Adversion

Risk-averse investors dislike risk and require higher rates of return as an inducement to buy riskier securities.

diversifiable risk

That part of a security's risk associated with random events; it can be eliminated by proper diversification. This risk is also known as company-specific, or unsystematic, risk.

market risk premium

The additional return over the risk-free rate needed to compensate investors for assuming an average amount of risk.

Risk

The chance that some unfavorable event will occur.

risk premium (RP)

The difference between the expected rate of return on a given risky asset and that on a less risky asset.

expected rate of return

The rate of return expected to be realized from an investment; the weighted average of the probability distribution of possible results.

stand-alone risk

The risk an investor would face if he or she held only one asset.

market risk

The risk that remains in a portfolio after diversification has eliminated all company-specific risk. This risk is also known as nondiversifiable or systematic or beta risk.

relevant risk

The risk that remains once a stock is in a diversified portfolio is its contribution to the portfolio's market risk. It is measured by the extent to which the stock moves up or down with the market.

coefficient of variation (CV)

The standardized measure of the risk per unit of return; calculated as the standard deviation divided by the expected return.

correlation

The tendency of two variables to move together.

expected return on a portfolio

The weighted average of the expected returns on the assets held in the portfolio.

CV

shows the risk per unit of return, and it provides a more meaningful risk measure when the expected returns on two alternatives are not the same.

lower

the tighter the probability distribution, the ______ the risk

security market line (SML) equation

An equation that shows the relationship between risk as measured by beta and the required rates of return on individual securities.

average stock's beta

By definition, because an average-risk stock is one that tends to move up and down in step with the general market.

capital asset pricing model (CAPM)

A model based on the proposition that any stock's required rate of return is equal to the risk-free rate of return plus a risk premium that reflects only the risk remaining after diversification.

market portfolio

A portfolio consisting of all stocks.

standard deviation

A statistical measure of the variability of a set of observations.

correlation coefficient

A measure of the degree of relationship between two variables.

beta coefficient

A metric that shows the extent to which a given stock's returns move up and down with the stock market. Beta measures market risk.