Risk
the chance that an outcome other than the expected one will occur
probability distribution
a listing of all possible outcomes or events, with a probability (chance of occurrence) assigned to each outcome
Expected rate or return
the rate of return expected to be realized from an investment, which is the mean value of the probability distribution of possible outcomes
*measured by computing the weighted average of the outcomes using the probabilities as the weights
Standard Deviation
a measure of the tightness, or variability of a set of outcomes
*the smaller the value of the standard deviation, the tighter the probability distribution, and accordingly, the lower the total risk associated with the investment
Coefficient of variation (CV)
a standardized measure of the risk per unit of return. it is calculated by dividing the standard deviation by the expected return
Risk/Return
Risk Aversion
Risk-averse investors require higher rates of return to invest in higher-risk securities.
Risk Premium (RP)
The portion of the expected return that can be attributed to the additional risk of an investment. It is the difference between the expected rate of return on a given risky asset and the expected rate of return on a less risky asset.
stand-alone risk
the risk associated with an investment that is held by itself (in isolation); it is the total risk associated with the investment
expected return on a portfolio
the weighted average of the expected returns on the assets held in the portfolio
realized rate of return
The return that is actually earned. The actual return usually differs from the expected return.
Diversification
reduction of the stand-alone risk of an individual investment by combining it with other investments in a portfolio
correlation coefficient
the measure of the degree of correlation between variables
firm-specific, or diversifiable risk
that part of a security's risk associated with random outcomes generated by events or behaviors specific to the firm, it can be eliminated through proper diversification
market or non-diversifiable risk
the part of a security's risk associated with economic, or market, factors that systematically affect all firms to some extent, it cannot be eliminated through diversification
Example: War, inflation, recessions, high interest rates
*the risker a security
relevant risk
The portion of a security's risk that cannot be diversified away; the security's market risk. It reflects the security's contribution to the risk of a portfolio.
beta coefficient
A measure of the extent to which the returns on a given stock move with the stock market.
Capital Asset Pricing Model (CAPM)
A model used to determine the required return on an asset, which is based on the proposition that an asset's return should be equal to the risk-free return plus a risk premium that reflects the asset's nondiversifiable (relevant) risk
Security market line
The line that shows the relationship between risk as measured by beta and the required rate of return for individual securities.
market risk premium
The additional return over the risk-free rate needed to compensate investors for assuming an average amount of risk.
Equilibrium
the condition under which the expected return on a security is just equal to its required return and the price is stable