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FIN 427 Diversifiable Risk

Chapter 8 that part of a securitys risk associated with random


events; it can be eliminated by proper diversification.
Risk This risk is also known as company-specific, or
the chance that some unfavorable event will occur unsystematic, risk.

Stand-Alone Risk Market Risk


the risk an investor would face if he or she held only the risk that remains in a portfolio after diversification
one asset has eliminated all company-specific risk. This risk is
also known as non-diversifiable or systematic or beta
Probability Distribution risk.
a listing of possible outcomes or events with a
probability (chance of occurrence) assigned to each Market Portfolio
outcome a portfolio consisting of all stocks

Relevant Risk
Expected Rate of Return the risk that remains once a stock is in a diversified
the rate of return expected to be realized from an portfolio is its contribution to the portfolios market
investment; the weighted average of the probability risk. It is measured by the extent to which the stock
distribution of possible results moves up or down with the market

Standard Deviation, sigma Beta Coefficient, b


a statistical measure of the variability of a set of a metric that shows the extent to which a given
observations stocks returns move up and down with the stock
market. Beta measures market risk
Coefficient of Variation (CV)
the standardized measure of the risk per unit of return Average Stocks Beta, bA
calculated as the standard deviation divided by the by definition, bA = 1 because an average-risk stock is
expected return one that tends to move up and down in step with the
general market
Risk Aversion
risk-averse investors dislike risk and require higher Market Risk Premium, RPM
rates of return as an inducement to buy riskier the additional return over the risk-free rate needed to
securities compensate investor for assuming an average
amount of risk
Risk Premium (RP)
the difference between the expected rate of return on Security Market Line (SML) Equation
a given risky asset and that on a less risky asset an equation that shows the relationship between risk
as measured by beta and the required rates of return
Capital Asset Pricing Model (CAPM) on individual securities
a model based on the proposition that any stocks
required rate of return is equal to the risk-free rate of
return plus a risk premium that reflects only the risk
remaining after diversification

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 was actually earned during some past
period. The actual return usually turns out to be
different from the expected return except for riskless
assets.

Correlation
the tendency of two variables to move together

Correlation Coefficient, p
a measure of the degree of relationship between two
variables

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