dollar return
the amount of profit or loss from an investment denoted in dollars
percentage return
the dollar return characterized as a percentage of money invested
average returns
a measure summarizing the past performance of an investment
geometric mean return
the mean return computed by finding the equivalent return that is compounded for N periods
standard deviation
a measure of past return volatility, or risk, of an investment
total risk
the volatility of an investment, which includes current portions of firm-specific risk, and market-risk
coefficient of variation
a measure of risk to reward (standard deviation divided by average return) earned by an investment over a specific period of time
portfolio
a combination of investment assets held by an investor
diversification
the process of putting money in different types of investments for the purpose of reducing the overall risk of the portfolio
firm-specific risk
the portion of total risk that is attributable to firm or industry factors. firm-specific risk can be reduced through diversification
market risk
the portion of total risk that is attributable to overall economic factors
diversifiable risk
another term for firm specific risk
nondiversifiable risk
another term for market risk
modern portfolio theory
a concept and procedure for combining securities into a portfolio to minimize risk
optimal portfolio
the best portfolio of securities for the investor's level of risk aversion
efficient portfolios
the set of portfolios that have the maximum expected return for each level of risk
efficient frontier
the combination of all efficient portfolios
correlation
a measurement of the co movement between two variables that ranges between -1 and +1
probability
the likelihood of occurrence
expected return
the average of the possible returns weighted by the likelihood of those returns occurring
probability distribution
the set of probabilities for all possible occurrences
required return
the level of total return needed to be compensated for the risk taken. it is made up of a risk free rate and risk premium
risk premium
the portion of the required return that represents the reward for taking risk
market risk premium
the return on the market portfolio minus the risk free rate. risk premiums for specific firms are based on the market risk premium
asset pricing
the process of directly specifying the relationship between required return and risk
capital asset pricing model (CAPM)
an asset pricing theory based on beta, a measure of market risk
capital market line (CML)
the line on a graph of return and risk (standard deviation) firm from the risk free rate through the market portfolio
market portfolio
in theory, the market portfolio is the combination of securities that places the portfolio on the efficient frontier and on a line tangent from the risk free rate. in practice, the S&P 500 index is used to proxy for the market portfolio
financial leverage
the use of debt to increase an investment position
beta (B)
a measure of the sensitivity of a stock or portfolio to market risk
security market line
similar to the capital market line except risk is characterized by beta instead of standard deviation
portfolio beta
the combination of the individual company beta's in an investor's portfolio
efficient market
a securities market in which prices fully reflect available information on each security
penny stocks
the stocks of small companies that are prices below $1 per share
efficient market hypothesis (EMH)
a theory that describes what types of information are reflected in current stock prices
public information
the set of information that has been publicly released, includes sate on past stock prices and volume, corporate news, analyst opinion, etc.
privately held information
the set of information that has not been released to the public but is known by a few individuals, likely company insiders
stock market bubble
investor enthusiasm causes an inflated bull market that drives prices too high, ending in a dramatic collapse in prices
behavioral finance
the study of the cognitive processes and biases associated with making financial and economic decisions
overconfidence
used to describe the three psychological observations: 1) people are miscalibrated on understanding the precision of their knowledge 2) people have a tendency to underestimate risks 3) people tend to believe that they are better than average at tasks they
restricted stock
shares of stock issued to executives that have limitations on when they can be sold
executive stock options
special rights given to corporate executives to buy a specific number of shares of the company stock at a fixed price during a specific period of time
component costs
the individual costs of each type of capital - bonds, preferred stock, and common stock
weighted average cost of capital (WACC)
the weighted average after tax cost of the capital used by a firm, with weights set equal to the relative percentage of each type of capital used
business risk
the risk of a project arising from the line of business it is in; the variability of a firm's or division's cash flow
proxy beta
the beta (a measure of the riskiness) of a firm in a similar line of business as a proposed new project
financial risk
the risk of a project to equity holders stemming from the use of debt in the financial structure of the firm; refers to the issue of how a firm decides to distribute the business risk between debt an equity holders
flotation costs
fees paid by firms to investment banks for issuing new securities
separation principle
theory maintaining that the sources and uses of capital should be decided upon independently