Finance Ch 5 - Risk and Return
beta coefficient (B)
A relative measure of non-diversifiable risk. an index of this degree of movement of an asset's return in response to a change in the market return.
equation for the rate of return earned on any asset over period t.
Rt = (Ct + Pt + Pt-1) / (Pt-1)
US Treasury Bill (T-Bill)
Short term IOU issued by the US Treasury. Considered to be the risk-free asset.
portfolio
a collection or group of assets
range
a measure of an asset's risk, found by subtracting the return associated with the worst outcome from the return associated with the best outcome.
efficient portfolio
a portfolio that maximizes return for a given level of risk or minimizes risk for a given level of return.
correlation
a statistical measure of the relationship between any two series of numbers representing data of any kind.
risk-averse
attitude toward risk in which an increased return would be required for an increase in risk
negative beta (0 to -2)
beta that moves in the opposite direction of the market
positive beta (0 to 2)
beta that moves in the same direction as the market
diversifying a portfolio
can be done by adding more assets to the portfolio
risk
chance of financial loss, or more formally, t he variability of returns associated with a given asset.
business risk
chance that the firm will be unable to cover its operating costs. level of risk is driven by the firm's revenue stability and the structure of its operating costs.
perfectly negatively correlated
describes two negatively correlated series that have a correlation coefficient of -1.
perfectly positively correlated
describes two positively correlated series that have a correlation coefficient of 1.
negatively correlated
describes two series that move in opposite directions
positively correlated
describes two series that move in the same direction
exchange rate risk
exposure of future expected cash flows to fluctuations in the currency exchange rate. the greater the chance of undesirable exchange rate fluctuations, the greater the risk of the cash flows and therefore the lower the value of the firm or investment.
coefficient of variation (CV)
measure of relative dispersion that is useful in comparing the risks of assets with differing expected returns.
correlation coefficient
measure of the degree of correlation between two series.
standard deviation
most common statistical idicator of an asset's risk; it measures the dispersion around the expected value.
capital asset pricing model (CAPM)
the basic thery that links risk and return for all assets
event risk
the chance that a totally unexpected event will have a significant effect on the value of the firm o a specific investment. these events are not frequent and only affect a small group of people.
liquidity risk
the chance that an investment cannot be easily liquidated at a resonable price. liquidity is significantly affected by the size and depth of the market in which an investment is customarily traded.
interest rate risk
the chance that changes in interest rates will adversely affect the value of an investment. most investments lose value when the interest rate rises and increase in value when it falls.
purchasing-power risk
the chance that changing price levels caused by inflation or deflation in the economy will adversely affect the firm's or investment's cash flows and value.
financial risk
the chance that the firm will be unable to cover its financial obligations. level is driven by the predictability of the firm's operating cash flows and its fixed-cost financial obligations.
market risk
the chance that the value of an investment will decline because of market factors that are independent of the investment (such as economical, political, and social events). in general, the more a given investment's value responds to the market, the greater its risk, the less it responds, the smaller its risk.
tax risk
the chance that unfavorable changes in tax laws will occur.
total risk
the combination of a security's nondiversifiable risk and diversifiable risk
expected value of return (r)
the most likely return on a given asset.
diversifiable risk
the portion of an asset's risk that is attributable to firm-specific, random causes; can be eliminated t hrough diversification. also, called unsystematic risk.
nondiversifiable risk
the relevant portion of an asset's risk attributable to market factors that affect all firms; cannot be eliminated through diversification. also called systematic risk.
Risk free rate of return (Rf)
the required return on a risk-free asset, typically a 3-month US Treasury Bill.
market return
the return on the market portfolio of all traded securities.
return
the total gain or loss experienced on an investment over a given period of time; calculated by dividing the asset's cash distributions during the period, plus chang in value, by its beginning of period investment value.
