03 - Risk and Rate of Return

The potential variability in future cash flows.

Measured by the standard deviation of the expected return.

The possibility that the borrower will not repay a debt in the future.

Additional return expected for taking on additional risk.

The interest rate paid on debt securities without an adjustment for loss in purchasing power.

The nominal rate of interest less any loss in purchasing power during the time of the investment.

Relationship between interest rates and the term to maturity, where the risk of default is held constant.

A graphical representation of the term structure of interest rates.

Annual rate of return the investor will earn if a bond is held to maturity.

The observed return earned on an investment in the past.

The arithmetic mean (average) of all possible outcomes where each outcome is weighted by its probability.

The risk component that can be eliminated by diversification.

• Also known as
• - Firm specific
• - Diversifiable
• - Unsystematic

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

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).

The return an investor would receive from holding a security for a designated period of time.

Relationship between an investment's returns and the markets returns.

A relative measure of the investment's market risk.

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.

Standardised measure of covariance.

Values between -1 and 1.

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.

Minimum rate of return necessary to attract an investor to purchase or hold a security.

"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."

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).

Higher level of returner the same level of risk or a lower level of risk for the same return.

Identifying and selecting the asset classes appropriate for a specific investment portfolio and determining the proportions of these assets within the given portfolio.

States that securities prices accurately reflect future expected cash flows and are based on all information available to investors.

The values of all assets and securities at any instant in time fully reflect all available information.