03 - Risk and Rate of Return

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  1. Risk
    The potential variability in future cash flows.

    Measured by the standard deviation of the expected return.
  2. Default Risk
    The possibility that the borrower will not repay a debt in the future.
  3. Risk Premium
    Additional return expected for taking on additional risk.
  4. Nominal Interest Rate
    The interest rate paid on debt securities without an adjustment for loss in purchasing power.
  5. Real Interest Rate
    The nominal rate of interest less any loss in purchasing power during the time of the investment.
  6. Term Structure of Interest Rates
    Relationship between interest rates and the term to maturity, where the risk of default is held constant.
  7. Yield Curve
    A graphical representation of the term structure of interest rates.
  8. Yield to Maturity
    Annual rate of return the investor will earn if a bond is held to maturity.
  9. Historical Return
    The observed return earned on an investment in the past.
  10. Expected Rate of Return
    The arithmetic mean (average) of all possible outcomes where each outcome is weighted by its probability.
  11. Company Unique Risk
    The risk component that can be eliminated by diversification.

    • Also known as
    • - Firm specific
    • - Diversifiable
    • - Unsystematic
  12. Market Risk
    The risk component that cannot be diversified away by holding more than one security in the portfolio, and is measured by betas.

    • Also known as
    • - Systematic
    • - Non-diversifiable
  13. All Ordinaries Index
    Index number representing the average value of shares on the ASX.

    The change in the index number between two dates represents the average rate of return during that time interval (excluding dividends).
  14. Holding Period Return
    The return an investor would receive from holding a security for a designated period of time.
  15. Beta
    Relationship between an investment's returns and the markets returns.

    A relative measure of the investment's market risk.
  16. Characteristic Line
    Line of 'best fit' through a series of returns for a firm's shares relative to the market returns.

    Slope of line (beta) represents the average movement of the firm's share returns in response to a movement in the market's returns.
  17. Correlation Coefficient
    Standardised measure of covariance.

    Values between -1 and 1.
  18. Covariance
    Statistical measure of the degree of co-movement between two asset returns.

    Measures the tendency of two stocks to 'co-vary'.

    • Positive - both stocks go up/down.
    • Negative - one stock goes up, the other goes down.
  19. Required Rate of Return (RRR)
    Minimum rate of return necessary to attract an investor to purchase or hold a security.
  20. Capital Asset Pricing Model (CAPM)
    "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 premium in the market."
  21. Security Market Line
    Graph of the CAPM.

    The return line that reflects the attitudes of investors regarding the minimal acceptable return for a given level of systematic risk (beta).
  22. Efficient Portfolios
    Higher level of returner the same level of risk or a lower level of risk for the same return.
  23. 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.
  24. Efficient Markets Hypothesis (EMH)
    States that securities prices accurately reflect future expected cash flows and are based on all information available to investors.
  25. Efficient Market
    The values of all assets and securities at any instant in time fully reflect all available information.
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03 - Risk and Rate of Return
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211 - Risk and Rate of Return
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