law of one price, billion. Thus, the global market capitalization is $20 billion.
billion. Thus, the global market capitalization is $20 billion. The market portfolio consists of each
The law of one price is the economic theory that states the price of an identical security,
commodity or asset traded anywhere should have the same price regardless of location
when currency exchange rates are taken into consideration, if it is traded in a free market
with no trade restrictions. The law of one price exists because differences between asset prices in
different locations should eventually be eliminated due to the arbitrage opportunity.
arbitrage,
Arbitrage is the simultaneous purchase and sale of an asset to profit from an imbalance in the
price. It is a trade that profits by exploiting the price differences of identical or similar financial
instruments on different markets or in different forms. Arbitrage exists as a result of market
inefficiencies and would therefore not exist if all markets were perfectly efficient.
Arbitrage occurs when a security is purchased in one market and simultaneously sold in
another market at a higher price, thus considered to be risk-free profit for the trader.
Arbitrage provides a mechanism to ensure prices do not deviate substantially from fair value for
long periods of time. With advancements in technology, it has become extremely difficult to
profit from pricing errors in the market. Many traders have computerized trading systems set to
monitor fluctuations in similar financial instruments. Any inefficient pricing setups are usually
acted upon quickly, and the opportunity is often eliminated in a matter of seconds. Arbitrage is a
necessary force in the financial marketplace.
moral hazard,
Moral hazard is a situation in which one party gets involved in a risky event knowing that
it is protected against the risk and the other party will incur the cost. It arises when both the
parties have incomplete information about each other.
In a financial market, there is a risk that the borrower might engage in activities that are
undesirable from the lender's point of view because they make him less likely to pay back a loan.
It occurs when the borrower knows that someone else will pay for the mistake he makes. This in
turn gives him the incentive to act in a riskier way. This economic concept is known as moral
hazard.
market portfolio,
A market portfolio is a theoretical bundle of investments that includes every type of asset
available in the world financial market, with each asset weighted in proportion to its total
presence in the market. The expected return of a market portfolio is identical to the expected
return of the market as a whole.
A market portfolio, by nature of being completely diversified, is subject only to systematic risk, or
risk that affects the market as a whole, and not to unsystematic risk, which is the risk inherent to
a particular asset class.
As a simple example of a theoretical market portfolio, assume three companies exist: Company
A, Company B and Company C. The market capitalization of Company A is $2 billion, the market
capitalization of Company B is $5 billion, and the market capitalization of Company C is $13
of these companies, which are weighed in the portfolio as follows:
Company A portfolio weight = $2 billion / $20 billion = 10%
Company B portfolio weight = $5 billion / $20 billion = 25%
Company C portfolio weight = $13 billion / $20 billion = 65%
The market portfolio is an essential component of the capital asset pricing model (CAPM). The
CAPM shows what an asset's expected return should be based on its amount of systematic
risk. The relationship between these two items is expressed in an equation called the security
market line. The equation for the security market line is:
Expected return = R(f) + B x (R(m) - R(f))
Where, R(f) = the risk-free rate; R(m) = the expected return of the market portfolio; B = the beta
of the asset in question versus the market portfolio
For example, if the risk-free rate is 3%, the expected return of the market portfolio is 10%, and
the beta of the asset with respect to the market portfolio is 1.2, the expected return of the asset
is: Expected return = 3% + 1.2 x (10% - 3%) = 3% + 8.4% = 11.4%
annuity,
An annuity is a series of payments made at equal intervals. Examples of annuities are regular
deposits to a savings account, monthly home mortgage payments, monthly insurance payments
and pension payments. Annuities can be classified by the frequency of payment dates. The
payments (deposits) may be made weekly, monthly, quarterly, yearly, or at any other regular
interval of time. An annuity which provides for payments for the remainder of a person's lifetime
is a life annuity.
systemic risk,
Systemic risk is the possibility that an event at the company level could trigger severe
instability or collapse an entire industry or economy. Companies considered to be a systemic
risk are called "too big to fail." These institutions are large relative to their respective industries
or make up a significant part of the overall economy. A company highly interconnected with
others is also a source of systemic risk. Systemic risk should not be confused with systematic risk;
systematic risk relates to the entire financial system. (Investopedia)
Systemic risk is the risk of collapse of an entire financial system or entire market, as opposed to
risk associated with any one individual entity, group or component of a system, that can be
contained therein without harming the entire system. It can be defined as "financial system
instability, potentially catastrophic, caused or exacerbated by idiosyncratic events or conditions
in financial intermediaries".[4] It refers to the risks imposed by interlinkages and
interdependencies in a system or market, where the failure of a single entity or cluster of entities
can cause a cascading failure, which could potentially bankrupt or bring down the entire system
or market. It is also sometimes erroneously referred to as "systematic risk". (Wikipedia)
Systematic Risk,
Systematic risk is the risk inherent to the entire market or market segment. Systematic risk,
also known as “undiversifiable risk,” “volatility” or “market risk,” affects the overall
market, not just a particular stock or industry. This type of risk is both unpredictable and
impossible to completely avoid. It cannot be mitigated through diversification, only through
hedging or by using the correct asset allocation strategy.
Systematic risk underlies other investment risks, such as industry risk. If an investor has placed
too much emphasis on cybersecurity stocks, for example, it is possible to diversify by investing in
a range of stocks in other sectors, such as healthcare and infrastructure. Systematic risk, however,
incorporates interest rate changes, inflation, recessions and wars, among other major changes.
Shifts in these domains can affect the entire market and cannot be mitigated by changing
around positions within a portfolio of public equities.
To help manage systematic risk, investors should ensure that their portfolios include a variety of
asset classes, such as fixed income, cash and real estate, each of which will react differently in the
event of a major systemic change. An increase in interest rates, for example, will make some
new-issue bonds more valuable, while causing some company stocks to decrease in price as
investors perceive executive teams to be cutting back on spending. In the event of an interest
rate rise, ensuring that a portfolio incorporates ample income-generating securities will mitigate
the loss of value in some equities.
fundamental value, “The price a rational investor is willing to pay for an investment, given its level of risk.”
In finance, intrinsic value refers to the value of a company, stock, currency or product
determined through fundamental analysis without reference to its market value. It is also
frequently called fundamental value. It is ordinarily calculated by summing the discounted future
income generated by the asset to obtain the present value. It is worthy to note that this term
may have different meanings for different assets.
In valuing equity, securities analysts may use fundamental analysis—as opposed to technical
analysis—to estimate the intrinsic value of a company. Here the "intrinsic" characteristic
considered is the expected cash flow production of the company in question. Intrinsic value is
therefore defined to be the present value of all expected future net cash flows to the company; it
is calculated via discounted cash flow valuation. (This is not a proven theorem or a validated
theory, but a general assumption.
An alternative, though related approach, is to view intrinsic value as the value of a business'
ongoing operations, as opposed to its accounting-based book value, or break-up value. Warren
Buffett is known for his ability to calculate the intrinsic value of a business, and then buy that
business when its price is at a discount to its intrinsic value.
There are two basic methodologies investors rely upon when the objective of the analysis is to
determine what stock to buy and at what price, :
Fundamental analysis maintains that markets may incorrectly price a security in the short run
but that the "correct" price will eventually be reached. Profits can be made by purchasing
thewrongly priced security and then waiting for the market to recognize its "mistake" and reprice
the security.
Technical analysis maintains that all information is reflected already in the price of a security.
Technical analysts look at trends and believe that sentiment changes predate and predict trend
changes. Investors' emotional responses to price movements lead to recognizable price chart
patterns. Technical analysts also evaluate historical trends to predict future price movement.
technical analysis,
In finance, technical analysis is an analysis methodology for forecasting the direction of
prices through the study of past market data, primarily price and volume. Behavioral
economics and quantitative analysis use many of the same tools of technical analysis, which,
being an aspect of active management, stands in contradiction to much of modern portfolio
theory. The efficacy of both technical and fundamental analysis is disputed by the efficient-
market hypothesis which states that stock market prices are essentially unpredictable.
fundamental analysis,
Fundamental analysis, in accounting and finance, is the analysis of a business's financial
statements (usually to analyze the business's assets, liabilities, and earnings); health; and
competitors and markets. It also considers the overall state of the economy and factors
including interest rates, production, earnings, employment, GDP, housing, manufacturing and
management. There are two basic approaches that can be used: bottom up analysis and top
down analysis. These terms are used to distinguish such analysis from other types of investment
analysis, such as quantitative and technical.
Fundamental analysis is performed on historical and present data, but with the goal of making
financial forecasts. There are several possible objectives:
to conduct a company stock valuation and predict its probable price evolution;
to make a projection on its business performance;
to evaluate its management and make internal business decisions and/or to calculate its
credit risk.
to find out the intrinsic value of the share.
variance,
Variance is a measurement of the spread between numbers in a data set. It measures how
far each number in the set is from the mean and is calculated by taking the differences between
each number in the set and the mean, squaring the differences (to make them positive) and
dividing the sum of the squares by the number of values in the set.
Variance is one of the key parameters in asset allocation. Along with correlation, the variance of
asset returns helps investors to develop optimal portfolios by optimizing the return-volatility
trade-off in investment portfolios.
The square root of variance is the standard deviation (σ). Risk or volatility is often expressed as a
standard deviation rather than variance because the former is more easily interpreted.
coefficient of variation,
The coefficient of variation (CV) is a statistical measure of the dispersion of data points in
a data series around the mean. The coefficient of variation represents the ratio of the standard
deviation to the mean, and it is a useful statistic for comparing the degree of variation from one
data series to another, even if the means are drastically different from one another.
The coefficient of variation shows the extent of variability of data in sample in relation to the
mean of the population. In finance, the coefficient of variation allows investors to determine
how much volatility, or risk, is assumed in comparison to the amount of return expected
from investments. The lower the ratio of standard deviation to mean return, the better risk-
return trade-off. Note that if the expected return in the denominator is negative or zero, the
coefficient of variation could be misleading.
The coefficient of variation is helpful when using the risk/reward ratio to select investments. For
example, an investor who is risk-averse may want to consider assets with a historically low
degree of volatility and a high degree of return, in relation to the overall market or its industry.
Conversely, risk-seeking investors may look to invest in assets with a historically high degree of
volatility.
While most often used to analyze dispersion around the mean, quartile, quintile, or decile CVs
can also be used to understand variation around the median or 10th percentile, for example.
incremental cash flow,
Incremental cash flow is the additional operating cash flow that an organization receives
from taking on a new project. A positive incremental cash flow means that the company's cash
flow will increase with the acceptance of the project. A positive incremental cash flow is a good
indication that an organization should invest in a project.
There are several components that must be identified when looking at incremental cash flows:
the initial outlay, cash flows from taking on the project, terminal cost or value, and the scale and
timing of the project. Incremental cash flow is the net cash flow from all cash inflows and
outflows over a specific time and between two or more business choices.
For example, a business may project the net effects on the cash flow statement of investing in a
new business line or expanding an existing business line. The project with the highest
incremental cash flow may be chosen as the better investment option. Incremental cash flow
projections are required for calculating a project's net present value (NPV), internal rate of return
(IRR), and payback period. Projecting incremental cash flows may also be helpful in the decision
of whether to invest in certain assets that will appear on the balance sheet.
NPV,
Net present value (NPV) is the difference between the present value of cash inflows and the
present value of cash outflows over a period of time. NPV is used in capital budgeting and
investment planning to analyze the profitability of a projected investment or project.
here is an easier way to remember the concept of NPV:
NPV=TVECF−TVIC, where:
TVECF=Today’s value of the expected cash flows
TVIC=Today’s value of invested cash
A positive net present value indicates that the projected earnings generated by a project or
investment - in present dollars - exceeds the anticipated costs, also in present dollars. It is
assumed that an investment with a positive NPV will be profitable, and an investment with a
negative NPV will result in a net loss. This concept is the basis for the Net Present Value Rule,
which dictates that only investments with positive NPV values should be considered.
IRR,
The internal rate of return (IRR) is a metric used in capital budgeting to estimate the profitability
of potential investments. The internal rate of return is a discount rate that makes the net
present value (NPV) of all cash flows from a particular project equal to zero. IRR
calculations rely on the same formula as NPV does.
To calculate IRR using the formula, one would set NPV equal to zero and solve for the discount
rate (r), which is the IRR. Because of the nature of the formula, however, IRR cannot be calculated
analytically and must instead be calculated either through trial-and-error or using software
programmed to calculate IRR.
Generally speaking, the higher a project's internal rate of return, the more desirable it is to
undertake. IRR is uniform for investments of varying types and, as such, IRR can be used to rank
multiple prospective projects on a relatively even basis. Assuming the costs of investment are
equal among the various projects, the project with the highest IRR would probably be
considered the best and be undertaken first.
uncertainty,
Uncertainty refers to epistemic situations involving imperfect or unknown information. It
applies to predictions of future events, to physical measurements that are already made, or to
the unknown. Uncertainty arises in partially observable and/or stochastic environments, as well
as due to ignorance, indolence, or both.
Concerns about uncertainty often involve financial statements and the integrity of the
information provided. Generally accepted accounting principles, such as those prepared by the
Financial Accounting Standards Board, provide standard processes for recognizing, recording
and disclosing uncertainty. Consistent use of standard accounting practices for uncertainty
increases comparability of financial statements from different reporting periods and from
different companies.
3 pillars,
Time value of money
Asset valuation
Risk Management
random walk, “Efficient markets are random”
Random walk theory suggests that changes in stock prices have the same distribution and
are independent of each other. Therefore, it assumes the past movement or trend of a stock
price or market cannot be used to predict its future movement. In short, random walk theory
proclaims that stocks take a random and unpredictable path that makes all methods of
predicting stock prices futile in the long run.
Random walk theory believes it's impossible to outperform the market without assuming
additional risk. It considers technical analysis undependable because chartists only buy or
sell a security after an established trend has developed. Likewise, the theory finds
fundamental analysis undependable due to the often-poor quality of information collected
and its ability to be misinterpreted. Critics of the theory contend that stocks do maintain price
trends over time – in other words, that it is possible to outperform the market by carefully
selecting entry and exit points for equity investments.
beta,
A beta coefficient is a measure of the volatility, or systematic risk, of an individual stock in
comparison to the unsystematic risk of the entire market. In statistical terms, beta represents
the slope of the line through a regression of data points from an individual stock's returns
against those of the market. Beta describes the activity of a security's returns responding to
swings in the market
Beta coefficient(β) = Covariance( Re, Rm)/Variance, where:
Re = the return on an individual stock
Rm = the return on the overall market
Covariance = how changes in a stock’s returns are related to changes in the market’s returns
Variance=how far the market’s data points spread out from their average value
emh types,
Though the efficient market hypothesis as a whole theorizes that the market is generally
efficient, the theory is offered in three different versions: weak, semi-strong and strong.
The basic efficient market hypothesis posits that the market cannot be beaten because it
incorporates all important determinative information into current share prices. Therefore, stocks
trade at the fairest value, meaning that they can't be purchased undervalued or sold overvalued.
The theory determines that the only opportunity investors have to gain higher returns on their
investments is through purely speculative investments that pose substantial risk.
Weak Form
The three versions of the efficient market hypothesis are varying degrees of the same
basic theory. The weak form suggests that today’s stock prices reflect all the data
of past prices and that no form of technical analysis can be effectively utilized to
aid investors in making trading decisions. Advocates for the weak form efficiency
theory believe that if fundamental analysis is used, undervalued and overvalued stocks
can be determined, and investors can research companies' financial statements to
increase their chances of making higher-than-market-average profits.
Semi-Strong Form
The semi-strong form efficiency theory follows the belief that because all
information that is public is used in the calculation of a stock's current price,
investors cannot utilize either technical or fundamental analysis to gain higher
returns in the market. Those who subscribe to this version of the theory believe that
only information that is not readily available to the public can help investors boost their
returns to a performance level above that of the general market.
Strong Form
The strong form version of the efficient market hypothesis states that all
information – both the information available to the public and any information
not publicly known – is completely accounted for in current stock prices, and
there is no type of information that can give an investor an advantage on the
market. Advocates for this degree of the theory suggest that investors cannot make
returns on investments that exceed normal market returns, regardless of information
retrieved or research conducted.
There are anomalies that the efficient market theory cannot explain and that may even flatly
contradict the theory. For example, the price/earnings (P/E) ratio shows that firms trading at
lower P/E multiples are often responsible for generating higher returns. The neglected firm effect
suggests that companies that are not covered extensively by market analysts are sometimes
priced incorrectly in relation to their true value and offer investors the opportunity to pick stocks
with hidden potential. The January effect shows historical evidence that stock prices – especially
smaller cap stocks – tend to experience an upsurge in January.
Though the efficient market hypothesis is an important pillar of modern financial theories and
has a large backing, primarily in the academic community, it also has a large number of critics.
The theory remains controversial, and investors continue attempting to outperform market
averages with their stock selections.
The general name for these studies is the efficient markets hypothesis, or EMH. It was, and still is, a
hypothesis that needs to be proved or disproved empirically. In the literature, researchers identified three
levels of efficiency:
weak form, which contends that information on past stock price movements cannot be used to
predict future stock prices;
semi-strong form, which contends that all publicly available information is immediately
incorporated into stock prices (i.e., that one cannot analyze published reports and then beat
the market);
strong form, which contends that even company insiders, with inside information, cannot earn
abnormally high returns. Few people believe the strong form today, as a number of insiders
have made large profits, been caught (it’s illegal to trade on inside information), and gone to
jail.
yield curve,
A yield curve is a line that plots the interest rates, at a set point in time, of bonds having
equal credit quality but differing maturity dates. The most frequently reported yield curve
compares the three-month, two-year, five-year, 10-year and 30-year U.S. Treasury debt. This
yield curve is used as a benchmark for other debt in the market, such as mortgage rates or bank
lending rates, and it is used to predict changes in economic output and growth.
The shape of the yield curve gives an idea of future interest rate changes and economic activity.
There are three main types of yield curve shapes: normal, inverted and flat (or humped). A
normal yield curve is one in which longer maturity bonds have a higher yield compared with
shorter-term bonds due to the risks associated with time. An inverted yield curve is one in which
the shorter-term yields are higher than the longer-term yields, which can be a sign of upcoming
recession. In a flat or humped yield curve, the shorter- and longer-term yields are very close to
each other, which is also a predictor of an economic transition.
repackages them as zero-coupon bonds. Because they offer the entire payment at maturity,
zero-coupon bonds tend to fluctuate in price, much more so than coupon bonds.
A zero-coupon bond is also known as an accrual bond.
real interest,
A real interest rate is an interest rate that has been adjusted to remove the effects of inflation to
reflect the real cost of funds to the borrower and the real yield to the lender or to an investor.
The real interest rate reflects the rate of time-preference for current goods over future goods.
The real interest rate of an investment is calculated as the difference between the nominal
interest rate and the inflation rate:
Real Interest Rate = Nominal Interest Rate - Inflation (Expected or Actual)
mutually exclusive,

premium bond, Mutually exclusive is a statistical term describing two or more events that cannot coincide.
It is commonly used to describe a situation where the occurrence of one outcome
A premium bond is a bond trading above its face value or in other words; it costs more
supersedes the other. Mutually exclusive events may also be considered independent events.
than the face amount on the bond. A bond might trade at a premium because its interest rate
Independent events have no impact on the viability of other options. For a basic example,
is higher than current rates in the market. As interest rates fall, bond prices rise while conversely,
consider the rolling of dice. You cannot roll both a five and a three simultaneously on a single
rising interest rates lead to falling bond prices.
die. Furthermore, getting a three on an initial roll has no impact on whether or not a subsequent
Most bonds are fixed-rate instruments meaning that the interest paid will never change over the roll yields a five. All rolls of a die are independent events.
life of the bond. No matter where interest rates move or by how much they move, bondholders
When faced with a choice between mutually exclusive options, a company must consider the
receive the interest rate—coupon rate—of the bond. As a result, bonds offer the security of
opportunity cost, which is what the company would be giving up to pursue each option. The
stable interest payments. Fixed-rate bonds are attractive when the market interest rate is falling
concepts of opportunity cost and mutual exclusivity are inherently linked because each mutually
because this existing bond is paying a higher rate than investors can get for a newly issued,
exclusive option requires the sacrifice of whatever profits could have been generated by
lower rate bond.
choosing the alternate option. Mutually exclusive events are completely independent of all other
A premium bond will usually have a coupon rate higher than the prevailing market interest rate. events and have no impact on the outcome of the other event.
However, with the added premium cost above the bond's face value, the effective yield on a
The time value of money (TVM) and other factors make mutually exclusive analysis a bit more
premium bond might not be advantageous for the investor. The effective yield assumes the
complicated. For a more comprehensive comparison, companies use the net present value
funds received from coupon payment are reinvested at the same rate paid by the bond. In a
(NPV) and internal rate of return (IRR) formulas to mathematically determine which
world of falling interest rates, this may not be possible.
project is most beneficial when choosing between two or more mutually exclusive options.
The bond market is efficient and matches the current price of the bond to reflect whether current
The concept of mutual exclusivity is often applied in capital budgeting. Companies may have to
interest rates are higher or lower than the bond's coupon rate. It's important for investors to
choose between multiple projects that will add value to the company upon completion. Some of
know why a bond is trading for a premium—whether it's because of market interest rates or the
these projects are mutually exclusive.
underlying company's credit rating. In other words, if the premium is so high, it might be worth
the added yield as compared to the overall market. However, if investors buy a premium bond sunk cost,
and market rates rise significantly, they'd be at risk of overpaying for the added premium.
A sunk cost is a cost that has already been incurred and cannot be recovered. A sunk cost differs
zero coupon bond, from future costs that a business may face, such as decisions about inventory purchase costs or
product pricing. Sunk costs (past costs) are excluded from future business decisions because the
A zero-coupon bond is a debt security that does not pay interest but instead trades at a deep
cost will be the same regardless of the outcome of a decision.
discount, rendering a profit at maturity, when the bond is redeemed for its full face value.

Some bonds are issued as zero-coupon instruments from the start, while others bonds transform
into zero-coupon instruments after a financial institution strips them of their coupons, and
capm,
The Capital Asset Pricing Model (CAPM) describes the relationship between systematic risk
and expected return for assets, particularly stocks. CAPM is widely used throughout finance
for pricing risky securities and generating expected returns for assets given the risk of those
assets and cost of capital.
Investors expect to be compensated for risk and the time value of money. The risk-free rate in
the CAPM formula accounts for the time value of money. The other components of the CAPM
formula account for the investor taking on additional risk.
The beta of a potential investment is a measure of how much risk the investment will add to a
portfolio that looks like the market. If a stock is riskier than the market, it will have a beta greater
than one. If a stock has a beta of less than one, the formula assumes it will reduce the risk of a
portfolio.
A stock’s beta is then multiplied by the market risk premium, which is the return expected from
the market above the risk-free rate. The risk-free rate is then added to the product of the stock’s
beta and the market risk premium. The result should give an investor the required return or
discount rate they can use to find the value of an asset.
The goal of the CAPM formula is to evaluate whether a stock is fairly valued when its risk and the
time value of money are compared to its expected return. (Investopedia)
In finance, the capital asset pricing model (CAPM) is a model used to determine a
theoretically appropriate required rate of return of an asset, to make decisions about
adding assets to a well-diversified portfolio. (Wikipedia)
Required Return = Risk Free Rate of Return + Beta (Market Return - Risk Free Rate of
Return)
efficient portfolio,
An efficient portfolio is either a portfolio that offers the highest expected return for a given
level of risk, or one with the lowest level of risk for a given expected return. The line that
connects all these efficient portfolios is the efficient frontier. The efficient frontier represents that
set of portfolios that has the maximum rate of return for every given level of risk. The last thing
investors want is a portfolio with a low expected return and high level of risk.
No point on the efficient frontier is any better than any other point. Investors must examine their
own risk/return preferences to determine where they should invest on the efficient frontier. But,
theoretically at least, the efficient frontier allows you to reduce your risk at no cost in return. Or
you can increase return at any particular level of risk.
market risk premium,
The market risk premium is the difference between the expected return on a market
portfolio and the risk-free rate. The market risk premium is equal to the slope of the security
market line (SML), a graphical representation of the capital asset pricing model (CAPM). CAPM
measures required rate of return on equity investments, and it is an important element of
modern portfolio theory and discounted cash flow valuation.
Market risk premium describes the relationship between returns from an equity market portfolio
and treasury bond yields. The risk premium reflects required returns, historical returns and
expected returns. The historical market risk premium will be the same for all investors since the
value is based on what actually happened. The required and expected market premiums,
however, will differ from investor to investor based on risk tolerance and investing styles.
(Market Return - Risk Free Rate of Return) = Market risk premium
security market line,
The security market line (SML) is a line drawn on a chart that serves as a graphical
representation of the capital asset pricing model (CAPM), which shows different levels of
systematic, or market, risk of various marketable securities plotted against the expected
return of the entire market at a given point in time. Also known as the "characteristic line,"
the SML is a visual of the capital asset pricing model (CAPM), where the x-axis of the chart
represents risk in terms of beta, and the y-axis of the chart represents expected return. The
market risk premium of a given security is determined by where it is plotted on the chart in
relation to the SML.
The security market line is an investment evaluation tool derived from the CAPM, a model that
describes risk-return relationships for securities, and is based on the assumptions that investors
have to be compensated for both the time value of money and the corresponding level of risk
associated with any investment, referred to as the risk premium.
The concept of beta is central to the capital asset pricing model and the security market line. The
beta of a security is a measure of its systematic risk that cannot be eliminated by diversification.
A beta value of one is considered as the overall market average. A beta value higher than one
represents a risk level greater than the market average, while a beta value lower than one
represents a level of risk below the market average.
The formula for plotting the security market line is as follows:
Required Return = Risk Free Rate of Return + Beta (Market Return - Risk Free Rate of
Return)
passive portfolio management,
Passive management is a style of management associated with mutual and exchange-traded
funds (ETF) where a fund's portfolio mirrors a market index. Passive management is the
opposite of active management in which a fund's manager(s) attempt to beat the market
with various investing strategies and buying/selling decisions of a portfolio's securities.
Passive management is also referred to as "passive strategy," "passive investing" or " index
investing."
Followers of passive management believe in the efficient market hypothesis. It states that at all
times markets incorporate and reflect all information, rendering individual stock picking futile. As
a result, the best investing strategy is to invest in index funds, which have historically
outperformed the majority of actively managed funds. (Investopedia)

Passive management (also called passive investing) is an investing strategy that tracks a market-
weighted index or portfolio. The most popular method is to mimic the performance of an
externally specified index by buying an index fund. By tracking an index, an investment portfolio
typically gets good diversification, low turnover (good for keeping down internal transaction
costs), and low management fees. With low fees, an investor in such a fund would have higher
returns than a similar fund with similar investments but higher management fees and/or
turnover/transaction costs. (Wikipedia)

capital market line

The capital market line (CML) represents portfolios that optimally combine risk and return.
Capital asset pricing model (CAPM), depicts the trade-off between risk and return for efficient
portfolios. It is a theoretical concept that represents all the portfolios that optimally combine the
risk-free rate of return and the market portfolio of risky assets. Under CAPM, all investors will
choose a position on the capital market line, in equilibrium, by borrowing or lending at the risk-
free rate, since this maximizes return for a given level of risk.
YTM,
Yield to maturity (YTM) is the total return anticipated on a bond if the bond is held until it
matures. Yield to maturity is considered a long-term bond yield but it is expressed as an annual
rate. In other words, it is the internal rate of return (IRR) of an investment in a bond if the
investor holds the bond until maturity, with all payments made as scheduled and reinvested at
the same rate. Yield to maturity is also referred to as "book yield" or "redemption yield."

Portfolios that fall on the capital market line (CML), in theory, optimize the risk/return
relationship, thereby maximizing performance. The capital allocation line (CAL) makes up the
allotment of risk-free assets and risky portfolio for an investor. CML is a special case of the CAL
where the risk portfolio is the market portfolio. Thus, the slope of the CML is the sharpe ratio of
the market portfolio. As a generalization, buy assets if the sharpe ratio is above the CML and sell
if the sharpe ratio is below the CML.
Yield to maturity is similar to current yield, which divides annual cash inflows from a bond by the
market price of that bond to determine how much money one would make by buying a bond
and holding it for one year. Yet, unlike current yield, YTM accounts for the present value of a
bond's future coupon payments. In other words, it factors in the time value of money, whereas a
simple current yield calculation does not. As such, it is often considered a more thorough means
of calculating the return from a bond.

CML differs from the more popular efficient frontier in that it includes risk-free investments. The YTC,
intercept point of CML and efficient frontier would result in the most efficient portfolio, called
Yield to call (YTC) is a financial term that refers to the return a bondholder receives if the
the tangency portfolio.
security is held until the call date, before the debt instrument reaches maturity. This
The CAPM, is the line that connects the risk-free rate of return with the tangency point on the number can be mathematically calculated as the compound interest rate at which the present
efficient frontier of optimal portfolios that offer the highest expected return for a defined level of value of a bond's future coupon payments and call price is equal to the current market price of
risk, or the lowest risk for a given level of expected return. The portfolios with the best trade-off the bond.
between expected returns and variance (risk) lie on this line. The tangency point is the optimal
Yield to call applies to callable bonds, which are those instruments that let bond investors
portfolio of risky assets, known as the market portfolio. Under the assumptions of mean-variance
redeem the bonds on what is known as the call date, at a price known as the call price. By
analysis – that investors seek to maximize their expected return for a given amount of variance
definition, the call date of a bond chronologically occurs before the maturity date. Generally
risk, and that there is a risk-free rate of return – all investors will select portfolios which lie on the
speaking, bonds are callable over several years and are normally called at a slight premium.
CML.
Many bonds are callable, especially those issued by corporations. Calculating the yield to call on
According to Tobin's separation theorem, finding the market portfolio and the best combination of that
such bonds is important because it reveals rate of return the investor will receive, assuming the
market portfolio and the risk-free asset are separate problems. Individual investors will either hold just the risk-
free asset or some combination of the risk-free asset and the market portfolio, depending on their risk- following points are true:
aversion. As an investor moves up the CML, the overall portfolio risk and return increases. Risk averse investors
will select portfolios close to the risk-free asset, preferring low variance to higher returns. Less risk averse The bond is called on the earliest possible date
investors will prefer portfolios higher up on the CML, with a higher expected return, but more variance. By The bond is purchased at the current market price
borrowing funds at the risk-free rate, they can also invest more than 100% of their investable funds in the risky The bond is held until the call date
market portfolio, increasing both the expected return and the risk beyond that offered by the market portfolio.