Risk and rates of Return
Firm-specific risk
(Also called: Company unique risk, diversifiable risk, or unsystematic risk) The portion of the variation in investment returns that can be eliminated through investor diversification. This diversifiable risk is the result of factors that are unique to the particular firm.
Market-related risk
(Also called: Nondiversifiable risk or systematic risk) The portion of variations in investment returns that cannot be eliminated through investor diversification. This variation results from factors that effect all stocks.
Term structure of interest rates (yield to maturity)
Relationship between a debt security's rate of return and the length of time until the debt matures.
Rate of return formula
Stock price at end of this month/Stock price at the end of last month
Risk premium
The additional rate of return we expect to earn above the risk-free rate for assuming risk.
Characteristic line
The line of "best fit" through a series of returns for a firm's stock relative to the market returns. The slope of the line, frequently called the beta, represents the average movement of the firm's stock returns in response to a movement in the market's returns.
Investor's required rate of return
The minimum rate of return necessary to attract an investor to purchase or hold a security. It is also the discount rate that equates the present value f the cash flows with the value of the security.
Opportunity cost of funds
The next best rate of return available to the investor for a given level of risk
Real rate of interest
The nominal rate of interest less the expected rate of inflation over the maturity of the fixed-income security. This represents the expected increase in actual purchasing power to the investor.
Risk
The prospect of an unfavorable outcome. This concept has been measured operationally as the standard deviation or beta.
Risk-free or riskless rate of return
The rate of return on risk-free investments. The interest rate of short term U.S. government securities is commonly used to measure this rate.
Portfolio beta
The relationship between a portfolio's returns and the market's different returns. It is a measure of the portfolio's non diversifiable risk.
Expected rate of return
The weighted average of all possible returns where the returns are weighted by the probability that each will occur.
Market cap formula
market cap = outstanding shares * market price
Fisher effect (nominal) formula
nominal rate = real rate + inflation + (real rate * inflation)
Nominal return formula
nominal return = inflation + real return
Portfolio beta formula
portfolio beta = (% invested) * (beta of stock)
Required rate of return formula (CAPM)
required rate of return = risk free rate + beta(market rate- risk free rate)
Risk premium formula
risk premium = market rate - risk free rate
Standard deviation formula
standard deviation = return minus expected return squared times the probability, then take the square root
Beta
stock return/market return
Capital asset pricing model (CAPM)
An equation that the expected rate of return on an investment is a function of (1) the risk free rate, (2) the investment's systematic risk, and (3) the expected risk premiu for the market portfolio of all risky securities.
Beta
A measure of the relationship between an investment's returns and the market's returns. This is a measure of the investment's nondiversifiable risk.
Standard deviation
A measure of the spread or dispersion about the mean of a probability distribution. It is calculated by squaring the difference between each outcome and its expected value, weighted each squared difference by its associated probability, summing over all possible outcomes and taking the square root of this sum.
Asset allocation
Identifying and selecting the asset classes appropriate for a specific investment portfolio and determining the proportions of these assets within the given portfolio.
