Market capitalization/capitalisation (often market cap) is a measurement of size of a business enterprise (corporation) equal to the share price times

the number of shares outstanding(shares that have been authorized, issued, and purchased by investors) of a publicly traded company. As owning stock represents ownership of the company, including all its equity, capitalization could represent the public opinion of a company's net worth and is a determining factor in stock valuation. Likewise, the capitalization of stock markets or economic regions may be compared to other economic indicators. The total market capitalization of all publicly traded companies in the world was US$51.2 trillion in January 2007[1] and rose as high as US$57.5 trillion in May 2008[2] before dropping below US$50 trillion in August 2008 and slightly above US$40 trillion in September 2008.[2] Market capitalization represents the public consensus on the value of a company's equity. An entirely public corporation, including all of its assets, may be freely bought and sold through purchases and sales of stock, which will determine the price of the company's shares. Its market capitalization is the share price multiplied by the number of shares in issue, providing a total value for the company's shares and thus for the company as a whole. Many companies have a dominant shareholder, which may be a government entity, a family, or another corporation. Many stock market indices such as the S&P 500, Sensex, FTSE, DAX,Nikkei, Ibovespa, and MSCI adjust for these by calculating on a free float basis, i.e. the market capitalization they use is the value of the publicly tradable part of the company. Thus, market capitalization is one measure of "float" i.e., share value times an equity aggregate, with free and public being others. Note that market capitalization is a market estimate of a company's value, based on perceived future prospects, economic and monetary conditions. Stock prices can also be moved by speculation about changes in expectations about profits or about mergers and acquisitions. It is possible for stock markets to get caught up in an economic bubble, like the steep rise in valuation of technology stocks in the late 1990s followed by the dot-com crash in 2000. Speculation can affect any asset class, such as gold or real estate. In such events, valuations rise disproportionately to what many people would consider the fundamental value of the assets in question. In the case of stocks, this pushes up market capitalization in what might be called an "artificial" manner. Market capitalization is therefore only a rough measure of the true size of a market.

[edit]Categorization

of companies by capitalization

Traditionally, companies are divided into large-cap, mid-cap, and small-cap. Recently people have added 'micro-cap' and 'nano-cap'. People have rules of thumb to determine category from market capitalization. These need to be adjusted over time due to inflation, population change, and overall market valuation (for example, $1 billion was a large market cap in 1950 but it is not very large now), and they may be different for different countries. A rule of thumb may look like:[3]

Mega-cap: Over $200 billion Large-cap: $10 billion$200 billion Mid-cap: $1 billion$10 billion Small-cap: $300 million$1 billion Micro-cap: $50 million-$300 million[4] Nano-cap: Below $50 million

Different numbers are used by different indexes; there is no official definition of or general agreement about the exact cutoffs. They also may be done by percentiles rather than fixed cutoffs. [edit]Related

measures

Market cap reflects only the equity value of a company. A more comprehensive measure is enterprise value (EV), which includes debt and other factors. Insurance firms use a value called the embedded value (EV). The Sharpe ratio or Sharpe index or Sharpe measure or reward-tovariability ratio is a measure of the excess return (or Risk Premium) per unit of risk in an investment asset or a trading strategy, named after William Forsyth Sharpe. Since its revision by the original author in 1994, it is defined as:

where R is the asset return, Rf is the return on a benchmark asset, such as the risk free rate of return, E[R Rf] is the expected value of the excess of the asset return over the benchmark return, and is the standard deviation of the excess of the asset return over the benchmark return.[1] In practice, is often incorrectly calculated as the standard deviation of the asset return, as opposed to the standard

deviation of the numerator. However, this typically doesn't materially affect results or conclusions based on those results. Note, if Rf is a constant risk free return throughout the period,

The Sharpe ratio is used to characterize how well the return of an asset compensates the investor for the risk taken, the higher the Sharpe ratio number the better. When comparing two assets each with the expected return E[R] against the same benchmark with return Rf, the asset with the higher Sharpe ratio gives more return for the same risk. Investors are often advised to pick investments with high Sharpe ratios. However like any mathematical model it relies on the data being correct. Pyramid schemes with a long duration of operation would typically provide a high Sharpe ratio when derived from reported returns but the inputs are false. When examining the investment performance of assets with smoothing of returns (such as With profits funds) the Sharpe ratio should be derived from the performance of the underlying assets rather than the fund returns. Sharpe ratios, along with Treynor ratios and Jensen's alphas, are often used to rank the performance of portfolio or mutual fund managers. [edit]History In 1952, Arthur D. Roy of Cambridge suggested maximizing the ratio "(m-d)/", where m is expected gross return, d is some "disaster level" (a.k.a., minimum acceptable return) and is standard deviation of returns.[2] This ratio is just the Sharpe Ratio, only using minimum acceptable return instead of risk-free return in the numerator, and using standard deviation of returns instead of standard deviation of excess returns in the denominator. In 1966, William Forsyth Sharpe developed what is now known as the Sharpe ratio.[3] Sharpe originally called it the "reward-tovariability" ratio before it began being called the Sharpe Ratio by later academics and financial operators.

Sharpe's 1994 revision acknowledged that the risk free rate changes with time. Prior to this revision the definition was assuming a constant Rf . Recently, the (original) Sharpe ratio has often been challenged with regard to its appropriateness as a fund performance measure during evaluation periods of declining markets.[4] [edit]Examples Suppose the asset has an expected return of 15% in excess of the risk free rate. We typically do not know if the asset will have this return; suppose we assess the risk of the asset, defined as standard deviation of the asset's excess return, as 10%. The risk-free return is constant. Then the Sharpe ratio (using a new definition) will be 1.5 (R Rf = 0.15 and = 0.10). As a guide post, one could substitute in the longer term return of the S&P500 as 10%. Assume the risk-free return is 3.5%. And the average standard deviation of the S&P500 is about 16%. Doing the math, we get that the average, long-term Sharpe ratio of the US market is about 0.40625 ((10%-3.5%)/16%). But we should note that if one were to calculate the ratio over, for example, three-year rolling periods, then the Sharpe ratio could vary dramatically. [edit]Strengths

and weaknesses

The Sharpe ratio has as its principal advantage that it is directly computable from any observed series of returns without need for additional information surrounding the source of profitability. Other ratios such as the bias ratio have recently been introduced into the literature to handle cases where the observed volatility may be an especially poor proxy for the risk inherent in a time-series of observed returns. While the Treynor ratio works only with systematic risk of a portfolio, the Sharpe ratio observes both systematic and idiosyncratic risks. The returns measured can be of any frequency (i.e. daily, weekly, monthly or annually), as long as they are normally distributed, as the returns can always be annualized. Herein lies the underlying weakness of the ratio - not all asset returns

are normally distributed. Abnormalities like kurtosis, fatter tails and higher peaks, or skewness on the distribution can be a problematic for the ratio, as standard deviation doesn't have the same effectiveness when these problems exist. Sometimes it can be downright dangerous to use this formula when returns are not normally distributed. [5] Because it is a dimensionless ratio, laypeople find it difficult to interpret Sharpe Ratios of different investments. For example, how much better is an investment with a Sharpe Ratio of 0.5 than one with a Sharpe Ratio of -0.2? This weakness was well addressed by the development of the Modigliani Risk-Adjusted Performance measure, which is in units of percent return -universally understandable by virtually all investors. In finance, the capital asset pricing model (CAPM) is used to determine a theoretically appropriate required rate of return of an asset, if that asset is to be added to an already well-diversified portfolio, given that asset's nondiversifiable risk. The model takes into account the asset's sensitivity to nondiversifiable risk (also known as systematic risk or market risk), often represented by the quantity beta () in the financial industry, as well as the expected return of the market and the expected return of a theoretical riskfree asset. The model was introduced by Jack Treynor (1961, 1962),[1] William Sharpe (1964), John Lintner(1965a,b) and Jan Mossin (1966) independently, building on the earlier work of Harry Markowitz ondiversification and modern portfolio theory. Sharpe, Markowitz and Merton Miller jointly received theNobel Memorial Prize in Economics for this contribution to the field of financial economics.

The formula

The Security Market Line, seen here in a graph, describes a relation between the beta and the asset's expected rate of return.

The CAPM is a model for pricing an individual security or a portfolio. For individual securities, we make use of the security market line (SML) and its relation to expected return and systematic risk (beta) to show how the market must price individual securities in relation to their security risk class. The SML enables us to calculate the reward-to-risk ratio for any security in relation to that of the overall market. Therefore, when the expected rate of return for any security is deflated by its beta coefficient, the reward-to-risk ratio for any individual security in the market is equal to the market reward-to-risk ratio, thus:

The market reward-to-risk ratio is effectively the market risk premium and by rearranging the above equation and solving for E(Ri), we obtain the Capital Asset Pricing Model (CAPM).

where:

is the expected return on the capital asset

is the risk-free rate of interest such as interest arising from government bonds (the beta) is the sensitivity of the expected excess asset returns to the expected excess market returns, or

also

, is the expected return of the market

is sometimes known as the market premium or risk premium (the difference between the expected market rate of return and the risk-free rate of return).

Restated, in terms of risk premium, we find that:

which states that the individual risk premium equals the market premium times . Note 1: the expected market rate of return is usually estimated by measuring the Geometric Average of the historical returns on a market portfolio (e.g. S&P 500). Note 2: the risk free rate of return used for determining the risk premium is usually the arithmetic average of historical risk free rates of return and not the current risk free rate of return. For the full derivation see Modern portfolio theory. [edit]Security

market line

The SML essentially graphs the results from the capital asset pricing model (CAPM) formula. The x-axis represents the risk (beta), and the y-axis represents the expected return. The market risk premium is determined from the slope of the SML. The relationship between and required return is plotted on the securities market line (SML) which shows expected return as a function of . The intercept is the nominal risk-free rate available for the market, while the slope is the market premium, E(Rm) Rf. The securities market line can be regarded as representing a single-factor model of the asset price, where Beta is exposure to changes in value of the Market. The equation of the SML is thus:

It is a useful tool in determining if an asset being considered for a portfolio offers a reasonable expected return for risk. Individual securities are plotted on the SML graph. If the security's expected return versus risk is plotted above the SML, it is undervalued since the investor can expect a greater return for the inherent risk. And a security plotted

below the SML is overvalued since the investor would be accepting less return for the amount of risk assumed. [edit]Asset

pricing

Once the expected/required rate of return, E(Ri), is calculated using CAPM, we can compare this required rate of return to the asset's estimated rate of return over a specific investment horizon to determine whether it would be an appropriate investment. To make this comparison, you need an independent estimate of the return outlook for the security based on either fundamental or technical analysis techniques, including P/E, M/B etc. In theory, therefore, an asset is correctly priced when its estimated price is the same as the required rates of return calculated using the CAPM. If the estimate price is higher than the CAPM valuation, then the asset is undervalued (and overvalued when the estimated price is below the CAPM valuation). [edit]Asset-specific

required return

The CAPM returns the asset-appropriate required return or discount ratei.e. the rate at which future cash flows produced by the asset should be discounted given that asset's relative riskiness. Betas exceeding one signify more than average "riskiness"; betas below one indicate lower than average. Thus, a more risky stock will have a higher beta and will be discounted at a higher rate; less sensitive stocks will have lower betas and be discounted at a lower rate. Given the accepted concave utility function, the CAPM is consistent with intuitioninvestors (should) require a higher return for holding a more risky asset. Since beta reflects asset-specific sensitivity to nondiversifiable, i.e. market risk, the market as a whole, by definition, has a beta of one. Stock market indices are frequently used as local proxies for the marketand in that case (by definition) have a beta of one. An investor in a large, diversified portfolio (such as a mutual fund), therefore, expects performance in line with the market.

[edit]Risk

and diversification

The risk of a portfolio comprises systematic risk, also known as undiversifiable risk, and unsystematic risk which is also known as idiosyncratic risk or diversifiable risk. Systematic risk refers to the risk common to all securitiesi.e. market risk. Unsystematic risk is the risk associated with individual assets. Unsystematic risk can be diversified away to smaller levels by including a greater number of assets in the portfolio (specific risks "average out"). The same is not possible for systematic risk within one market. Depending on the market, a portfolio of approximately 30-40 securities in developed markets such as UK or US will render the portfolio sufficiently diversified such that risk exposure is limited to systematic risk only. In developing markets a larger number is required, due to the higher asset volatilities. A rational investor should not take on any diversifiable risk, as only non-diversifiable risks are rewarded within the scope of this model. Therefore, the required return on an asset, that is, the return that compensates for risk taken, must be linked to its riskiness in a portfolio context - i.e. its contribution to overall portfolio riskiness - as opposed to its "stand alone riskiness." In the CAPM context, portfolio risk is represented by higher variance i.e. less predictability. In other words the beta of the portfolio is the defining factor in rewarding the systematic exposure taken by an investor. [edit]The

efficient frontier

Main article: Efficient frontier

The (Markowitz) efficient frontier. CAL stands for the capital allocation line.

The CAPM assumes that the risk-return profile of a portfolio can be optimizedan optimal portfolio displays the lowest possible level of risk for its level of return. Additionally, since each additional asset introduced into a portfolio further diversifies the portfolio, the optimal portfolio must comprise every asset, (assuming no trading costs) with each asset value-weighted to achieve the above (assuming that any asset is infinitely divisible). All such optimal portfolios, i.e., one for each level of return, comprise the efficient frontier. Because the unsystematic risk is diversifiable, the total risk of a portfolio can be viewed as beta. [edit]The

market portfolio

An investor might choose to invest a proportion of his or her wealth in a portfolio of risky assets with the remainder in cashearning interest at the risk free rate (or indeed may borrow money to fund his or her purchase of risky assets in which case there is a negative cash weighting). Here, the ratio of risky assets to risk free asset does not determine overall returnthis relationship is clearly linear. It is thus possible to achieve a particular return in one of two ways: 1. By investing all of one's wealth in a risky portfolio,

2. or by investing a proportion in a risky portfolio and the remainder in cash (either borrowed or invested). For a given level of return, however, only one of these portfolios will be optimal (in the sense of lowest risk). Since the risk free asset is, by definition, uncorrelated with any other asset, option 2 will generally have the lower variance and hence be the more efficient of the two. This relationship also holds for portfolios along the efficient frontier: a higher return portfolio plus cash is more efficient than a lower return portfolio alone for that lower level of return. For a given risk free rate, there is only one optimal portfolio which can be combined with cash to achieve the lowest level of risk for any possible return. This is the market portfolio. ASSUPTIONS of CAPM All investors: 1. 2. 3. 4. Aim to maximize economic utilities. Are rational and risk-averse. Are broadly diversified across a range of investments. Are price takers, i.e., they cannot influence prices.

5. Can lend and borrow unlimited amounts under the risk free rate of interest. 6. 7. Trade without transaction or taxation costs. Deal with securities that are all highly divisible into small parcels.

8. Assume all information is available at the same time to all investors.

Diversifiable and non-diversifable risk

The Capital Asset Pricing Model introduced the concepts of diversifiable and non-diversifiable risk. Synonyms for diversifiable risk are idiosyncratic risk and security-specific risk. Synonyms for non-diversifiable risk are systematic risk, beta risk and market risk. If you buy all the stocks in the S&P 500 you are obviously exposed only to movements in that index. If you buy a single stock in the S&P 500, you are exposed both to index movements and movements in the stock relative to the

index. The first risk is called non-diversifiable, because you have it however many S&P 500 stocks you buy. The second risk is called diversifiable, because you can reduce it by diversifying among stocks, and eliminate it completely by buying all the stocks in the index. Of course, there's nothing special about the S&P 500; the same argument can apply to any index, up to and including the market portfolio of all assets. The Capital Asset Pricing Model argues that investors should only be compensated for non-diversifiable risk. Other financial models allow for multiple sources of non-diversifiable risk, but also insist that diversifiable risk should not carry any extra expected return. Still other models do not accept this contention[11]

Maximum diversification
Given the advantages of diversification, many experts recommend maximum diversification, also known as buying the market portfolio. Unfortunately, identifying that portfolio is not straightforward. The earliest definition comes from the Capital Asset Pricing Model which argues the maximum diversification comes from buying a pro rata share of all available assets. This is the idea underlying index funds. One objection to that is it means avoiding investments like futures that exist in zero net supply. Another is that your portfolio is determined by what securities come to market, rather than underlying economic value. Finally, buying pro rata shares means that you overweight any assets that are overvalued, and underweight any assets that are undervalued. This line of argument leads to portfolios that are weighted according to some definition of economic footprint, such as total underlying assets or annual cash flow.[6] Risk Parity is an alternative idea. This weights assets in inverse proportion to risk, so you have equal risk in all asset classes. This is justified both on theoretical grounds, and with the pragmatic argument that future risk is much easier to forecast than either future market value or future economic footprint.
[7]

Indices like the MaxDiv (r) indices published by TOBAM (ex-Lehman Brothers quant team), or the Anti-Benchmark fund they manage are designed to maximize the degree of diversification when selecting the weighting of assets in the portfolio allocation process. TOBAM's proprietary measure of diversification is the Diversification Ratio. The Diversification Ratio is maximized to produce a portfolio designed to access risk premium evenly

from all the independent risk factors available in the market at any given time. Their investment process has been published in 2006 (USPTO) and later in "Towards Maximum Diversification" (Journal of Portfolio Management Fall 2008) In finance, volatility most frequently refers to the standard deviation of the continuously compounded returns of a financial instrument within a specific time horizon. It is used to quantify the risk of the financial instrument over the specified time period. Volatility is normally expressed in annualized terms, and it may either be an absolute number ($5) or a fraction of the mean (5%).

Volatility terminology
Volatility as described here refers to the actual current volatility of a financial instrument for a specified period (for example 30 days or 90 days). It is the volatility of a financial instrument based on historical prices over the specified period with the last observation the most recent price. This phrase is used particularly when it is wished to distinguish between the actual current volatility of an instrument and actual historical volatility which refers to the volatility of a financial instrument over a specified period but with the last observation on a date in the past

actual future volatility which refers to the volatility of a financial instrument over a specified period starting at the current time and ending at a future date (normally the expiry date of a option)

historical implied volatility which refers to the implied volatility observed from historical prices of the financial instrument (normally options)

current implied volatility which refers to the implied volatility observed from current prices of the financial instrument

future implied volatility which refers to the implied volatility observed from future prices of the financial instrument

For a financial instrument whose price follows a Gaussian random walk, or Wiener process, the width of the distribution increases as time increases. This is because there is an increasing probability that the instrument's price will be farther away from the initial price as time increases. However, rather than increase linearly, the volatility increases with the square-root of time as time increases, because some fluctuations are expected to cancel each other

out, so the most likely deviation after twice the time will not be twice the distance from zero. Since observed price changes do not follow Gaussian distributions, others such as the Lvy distribution are often used.[1] These can capture attributes such as "fat tails".

Volatility for market players

When investing directly in a security, volatility is often viewed as a negative in that it represents uncertainty and risk. However, with other investing strategies, volatility is often desirable. For example, if an investor is short on the peaks, and long on the lows of a security, the profit will be greatest when volatility is highest.