Principles of Finance

# Key Terms

arithmetic average return
the sum of an asset’s annual returns over a number of years divided by the number of years
beta
a measure of how a stock moves relative to the market
capital asset pricing model (CAPM)
the expected return of a security, equal to the risk-free rate plus a premium for the amount of risk taken
capital gain yield
the difference between the price a stock is sold for and the price that was originally paid for it divided by the price originally paid
diversification
holding a variety of assets in a portfolio
dividend yield
the total dividends received by the owner of a share of stock divided by the price originally paid for the stock
effective annual rate (EAR)
returns expressed on an annualized or yearly basis; allows for the comparison of various investments
firm-specific risk
the risk that an event may impact the expected revenue or costs of a firm, thereby impacting the returns to investors; also known as diversifiable risk
geometric average return
the compound annual return derived from the effective annual rate and time value of money formulas
holding period percentage return
the gain received from holding a stock, calculated by adding the amount received when the stock is sold to any dividends earned while holding the stock, subtracting the price originally paid for the stock, then dividing the difference by the price originally paid
Jensen’s alpha
a measure of portfolio performance, calculated as the raw portfolio return minus the expected portfolio return predicted by the CAPM
the reward for taking on the average amount of market risk
portfolio
a collection of owned stocks
realized return
the total return of an investment that occurs over a particular time period
the extra return earned by taking on risk
risk-free rate
the reward for lending money when there is no risk of not receiving the principal and interest as promised
Sharpe ratio
a reward-to-risk measure of portfolio performance, calculated by subtracting the risk-free rate from the average portfolio return and then dividing by the standard deviation of the portfolio
systematic risk
risk that impacts the entire market and cannot be diversified away; also known as market risk
Treynor ratio
a reward-to-risk measure of portfolio performance, calculated by subtracting the risk-free rate from the average portfolio return and then dividing by the beta of the portfolio
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