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What is represented by E (Ri)

Expected Return on a Risky Asset - The rate of return an investor expects to earn on an asset over time based on the asset's risk level (this is based on systematic risk)

What is represented by E (Rm)

Expected Return on the Market - The average return of the stock market or the return on a stock market index

S&P 500 Index or Wilshire 5000 Index

What is usually used as a measure of market performance?

What is represented by Rf

Return on the risk-free asset - The return that an investor receives on a safe asset that is free from credit risk

What do investors usually use as the risk-free rate?

The rate of return on U.S. Treasury bills - because there is an underlying assumption that the U.S. government will always meet is financial obligations

What is beta?

Beta is a measure of an asset's systematic risk

1

What does the overall market have a beta of?

That the asset is riskier than the market

What does it mean if an asset has a beta greater than 1?

Technology

What is an example of an asset that has a beta great than 1?

That the asset is less risky than the market

What does it mean if an asset has a beta less than 1?

Utilities (stable business)

What are examples of an asset that has beta less than 1?

How do you calculate the market risk premium?

It is the expected return of the stock market minus the risk-free rate

[ E (Rm) - Rf]

What is the formula for the market risk premium?

Measures the risk of an asset

What does standard deviation of a return measure?

Higher means greater risk

What does a lower standard deviation mean?

Theory used to price risk asset

What is the Capital Asset Pricing Model? (CAPM)

What is the formula used for CAPM?

E (Ri) = (Rf) + (Bi) [ E(Rm) - (Ef) ]

What is CAPM a tool for?

CAPM is a very simple yet powerful way to estimate the cost of equity, which is usually the most significant component of a company's weighted cost of capital

What is a risk premium?

The amount by which an investment is expected to outperform T-bills or the average amount by which an investment has outperformed T-bills in the past.

How do we calculate a risk premium?

(Market Average) - (Risk free rate) = Risk premium

What is a portfolio?

The specific securities (stocks, bonds, mutual funds) owned by an investor

How do you calculate the return on a portfolio?

The return on a portfolio is calculated by multiplying the return on a specific security by the percent of the portfolio the security represents and then adding the result for each security together.

What does a portfolio's beta measure?

Measures the systematic risk of the portfolio

What is Alpha?

Alpha relates to returned, observed performance after the fact.

How do you determine alpha?

Observed Return - Expected Return

What does a positive alpha mean?

The security outperformed the returns expected under the CAPM benchmark

What does a negative alpha mean?

The security underperformed the returns expected under the CAPM benchmark

CAPM formula to use is?

E (Ri) = Rf + Bi * (Rm - Rf)

Market Premium formula?

(Rm - Rf)

How do you find out alpha?

Observed return of asset - Expected return of asset

Unsystematic Risk

The risk that effects at most a small number of assets; it is also called unique or asset-specific risk. For example, oil strike by a single company.

Systematic Risk

Cannot be diversified and is relevant. Measured by beta. Beta determines the level of expected return on a security or portfolio (SML)

homogeneous equation

the assumption that all investors use the same expected returns and covariance matrix of security returns as inputs in security analysis

Market Portfolio

The portfolio of all risky investments, held in proportion to their value.

Mutual Fund Theorem

The passive strategy of investing in a market index portfolio is efficient. A passive investor may view the market index as a reasonable first approximation of an efficient risky portfolio

Market Price of Risk

Quantifes the extra return that investors demand to bear portfolio risk

beta

responsiveness of a stocks expected return to changes in teh value of the complete marekt portfolio of that stock

expected return-beta relationship

implication of the CAPM that security risk premims ( expected excess returns) will be proportional to beta.

Security Market Line

The positively sloped straight line displaying the relations between expected return and beta.

Alpha

The difference between the fair and actually expected rates of return on a stock

Market model

a regression equation that specifies a linear relationship between the return on a security (or portfolio) and the return on a broad market index

zero-beta portfolio

the minimum variance portfolio uncorrelated with a chosen efficient portfolio.

liquidity

the ability to be used as, or directly converted to, cash

illiquidity

difficultty, cost, and /or delay in selling an asset on short notice without offering substantial price concessions.