Chapter_2_-_Terms_and_Questions_Answers

Chapter_2_-_Terms_and_Questions_Answers - Chapter 2 - Ten...

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Chapter 2 - Ten Principles of Finance List of Terms 1. Return and Risk - There is a positive relationship between risk and return. The more risk an investor is willing to accept, the higher the expected return must be. 2. Mean reversion - Reversion to the mean is the tendency for measures of performance such as percentage rates of return to revert to their historical averages 3. Efficient capital markets - The stock market is brutally efficient, current prices reflect all publicly available information and prices react completely, correctly and almost instantaneously to incorporate the receipt of new information. 4. Capital Asset Pricing Model - A model that describes the relationship between risk and expected return and that is used in the pricing of risky securities. The general idea behind CAPM is that investors need to be compensated in two ways: time value of money and risk. The time value of money is represented by the risk-free (rf) rate in the formula and compensates the investors for placing money in any investment over a period of time. The other half of the formula represents risk and calculates the amount of compensation the investor needs for taking on additional risk. This is calculated by taking a risk measure (beta) which compares the returns of the asset to the market over a period of time and compares it to the market premium (Rm-rf). 5. Beta - A measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole. Also known as "beta coefficient". 6. Market risk premium - The difference between the expected return on a market portfolio and the risk-free rate 7. Risk Aversion - Describes an investor who, when faced with two investments with a similar expected return (but different risks), will prefer the one with the lower risk. Investors are risk averse in that they want to take on less risk.
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This note was uploaded on 09/22/2008 for the course B A 301 taught by Professor Gray,garyjosephwoolridge,joseph during the Spring '07 term at Pennsylvania State University, University Park.

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Chapter_2_-_Terms_and_Questions_Answers - Chapter 2 - Ten...

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