FIN 320F Notes PDF

Unit 5: Economic Value: The Basics Lesson 1: Calculating Economic Value Economic assets: - Provide economic benefits - Property rights traded in markets Economic value: - The maximum dollar price that one is willing to pay for an economic asset. There are f...

Unit 5: Economic Value: The Basics Lesson 1: Calculating Economic Value Economic assets: - Provide economic benefits - Property rights traded in markets Economic value: - The maximum dollar price that one is willing to pay for an economic asset. There are four elements of economic value. Opportunity cost: The best alternative that is foregone because a particular course of action is pursued. Opportunity cost is affected by alternatives. Opportunity costs are generally stated as rates of return that one would expect to earn on one investment. You invest in Target stock to earn a rate of return. You compare Target’s rate of return to the returns offered by similar companies - the opportunity cost. Opportunity cost may be called: - Required rate of return - Discount rate - Benchmark rate - Hurdle rate The opportunity cost, stated as a risk-adjusted rate of return, is an important element of economic decision-making. Cash: - Command over economic assets - Accepted by other market participants in settlement of obligations. - Pay debt - Purchase assets The first principle of Finance: A dollar today is worth more than a dollar tomorrow. Some market participants need capital. Some market participants want to earn a return on surplus capital. Market participants receive or pay a rate of return: the interest rate. r: Interest rates connect the functions of consumption and investing. Interest rates map the present into the future. Compounding: calculating a future value. Discounting: Finding the present value of a future cash flow. Managers can estimate the present values of future cash flows, and use these present values to make project decisions. Key Concepts: Economic Value: What is it Worth? Creating wealth:  - Economic assets: entities functioning as stores of value and over which ownership rights are enforced by institutional units, individually or collectively, and from which economic benefits may be derived by their owners by holding them, or using them, over a period of time. - Economic value: the maximum dollar price someone will pay for an economic asset. In practice, the economic value is the present value of the asset’s cash flows discounted by the opportunity cost. - Economic decision-making: involves calculating economic values and comparing the economic value of an asset to the cost of obtaining the asset. - Creating wealth: economic decisions create wealth when the price paid for an economic asset is less than its economic value. The elements of economic value: - Opportunity cost: the best alternative that is not chosen because another course of action is pursued. You want to earn the highest rate of return on an investment. - Cash flow: economic activity and the decisions concerning economic value and cost/benefit analysis are stated in cash flows. - Time value of money: a major element of economic decision-making. Time and cash are related because most economic decisions involve multi-period cash flows. The decision-maker must compare cash at one point in time with cash at other points in time. - Risk: in making economic decisions, you use estimates of what you think the cash flows will be, not necessarily what you actually end up with. Key Concepts: Quantifying Economic Value The elements of economic value in-depth: - Opportunity cost is thus expressed as an interest rate - a rate of return on an investment or a debt, which means that there is a time value of money. - Time value of money: Interest rates exist because humans need to: - Reward delayed consumption: You will delay consumption only if you’re offered more consumption in the future. The increase in future consumption is produced by your earning a positive rate of return on your delayed consumption - your savings. - Make investments: Capital is productive; it can be invested to produce more capital. - Given that interest rates exist, the First Principle of Finance is that a dollar received today is worth more than a dollar received in the future. - Cash flow: market participants deal in cash, the flow of purchasing power that can be used to value and facilitate the transfer of economic assets. - Risk: future cash flows and thus, rates of return are uncertain. This variability is a major issue with all financial decisions and we must factor this uncertainty into economic values via a risk premium. Future value, present value, and economic value: - The basic elements of time value calculations:  - Calculating economic value: Unit 5: Lesson 1 Summary The economic value of an asset is the maximum price that you are willing to pay. It has four elements. 1. The opportunity cost is the rate of return we should expect to earn on an investment given our alternatives. 2. There is an interest rate, and thus time value of money. As the First Principle of Finance states the closer to the present an amount is, the higher its value to us. 3. Economic value focuses on cash flows. Most of our decisions involve comparing cash flows at various times. 4. Given that we're focused on the future, there is risk, in that we can only predict, not determine, future cash flows. Lesson 2: Making Wealth-Increasing Decisions Wealth is the control of economic assets. A wealth increase occurs if you can get a bargain: obtain an asset by paying less than its opportunity cost. Fortunately, there are two decision rules that help us turn this intuitive concept into a clear decision. - Internal rate of return: percent measure of benefit - Net Present Value: dollar measure of benefit Internal rate of return: The rate of return earned on an investment given its cash flows. The IRR rule compares two rates of return: - The IRR: rate of return earned on an investment given its cash flows. - The opportunity cost: What you should expect to earn. Fairly priced: We are being fairly compensated for the risk of the project. Underpriced: The investment increases wealth. IRR is greater than the Opportunity cost. Overpriced: The investment reduces wealth. IRR is less than the Opportunity cost. IRR Decision Rule: An investment will make you better off if it offers a rate of return - its Internal Rate of Return - that exceeds what you’d earn on equivalent investments - your opportunity cost. Net Present Value measured the dollar change in wealth, stated today, from an investment. NPV provides a decision rule that measures economic profit: the difference between inflows and outflows considering cash flows, time value, and opportunity cost. - Accept if NPV is positive or zero. - Reject if NPV is negative. Fairly priced: The economic value equals the cost of the asset. Acceptable Underpriced: The economic value exceeds the cost of the asset. Increases wealth Overpriced: The economic value is less than the cost of the asset. Reduces wealth Key Concepts: Internal Rate of Return Measuring wealth creation with IRR: - Wealth is the control of economic assets. - How do I get wealthier? You make good economic decisions, which involves identifying the cash flows involved in the project and selecting a decision rule: a quantitative rule that evaluates whether a course of action should be undertaken. - The Internal Rate of Return (IRR) is the rate of return on an investment adjusted for time value. - Internal Rate of Return rule: accept an investment if its IRR (the rate of return that you’re earning on the project) exceeds its opportunity cost (the rate of return that you would earn on equivalent investments). Valuing investments with IRR: - A fairly valued CD: The price she pays for future cash flows gives an IRR that matches that of other equivalent investments. This is an acceptable outcome--in the real world getting a fair deal is OK. - An overvalued CD: The price she pays for future cash flows gives an IRR that is less than other equivalent investments. This is not attractive, as Dianne would be paying more than the investment is worth. - An undervalued CD: The price she pays for future cash flows gives an IRR that is greater than other equivalent investments. This is the bargain: Dianne is able to pay less for an asset than it's economic value. Key Concepts: Net Present Value Using NPV to increase wealth: - Economic wealth is the possession of economic assets. - Net Present Value is a decision-making process using time value, and opportunity cost to compare the benefits of a decision with its costs. - NPV = Net Present Value - NPV = PV(Inflows) − PV(Outflows) - If the NPV is positive, then you should accept the project, as it increases wealth measured in dollars stated as of today. - If NPV is zero, it is earning it's opportunity costs and is an acceptable project that provides a fair rate of return. - If the NPV is negative, then you should reject the project as it would actually reduce wealth. Unit 5 Lesson 2 Summary Focusing on a rate of return: The Internal Rate of Return (IRR) is the rate of return earned on an investment. The IRR must be compared to the opportunity cost to determine the desirability of the investment. If you're earning a higher rate of return than what you should expect to earn, the investment is desirable.  Focusing on an increase in wealth: Net Present Value (NPV) is a cost/benefit analysis that compares the present value of the cost of the investment to its economic value (present value of inflows) using the opportunity cost. A positive NPV means an increase in wealth (cash flow) stated in today's dollars would occur, and the project is desirable. Lesson 3: Adjusting Economic Decisions for Risk Expected return: What you think you will earn given what you know when you make the investment. The realized return is determined by the economic, political, social, environmental, and other events that occur after you make your investment. Uncertainty: The expected and realized returns may differ! The more uncertain the future cash flows, the more the realized return may vary from the expected return. Risk: Risk is quantified uncertainty. Opportunity cost = Rf + Risk premium Rf: The nominal certain rate of return Risk premium: The extra return required to compensate for risk. Investors adjust the price they will pay to give them their expected risk-adjusted opportunity cost. Key Concepts: Risk and Economic Value Risk, return, and opportunity cost: - In Finance risk is defined as getting a lower return than you had expected to get. This statement can be understood by considering the two returns investors face. 1. The expected return is the future return, generally uncertain, that one expects to get from an investment. This is the return that is used in making most business decisions. 2. The realized return is the return that is actually received at the end of the investment period. - This means that the opportunity cost for most investments consists of two parts. The current risk-less rate of return and a risk premium appropriate to the risk perceived to be in the project. - Risk-free rate of return: A rate of return on an asset whose future cash flows are certain. Given the known payment made today for the promise of future cash flows that will be received with certainty, the rate of return is also certain. - Risk premium: The extra return above the risk-free rate that is required given the uncertainty of the future cash flows. Risk, opportunity cost, and economic value of risky assets: Unit 5 Lesson 3 Summary Risk, the variability of future cash flows, affects the opportunity cost used in economic decisions. The expected return you think you'll earn may differ from the realized return that you actually end up receiving.  The opportunity cost has two components: the risk-free rate of return and a risk premium that reflects the risk of the investment. As risk affects the opportunity cost, it must impact economic value: the higher the risk, the higher the discount rate and thus, the lower the present value of a given future cash flow. Unit 5 Working Words: Lesson 1: Calculating economic value: Economic assets: Economic assets are entities functioning as stores of value and over which ownership rights are enforced by institutional units, individually or collectively, and from which economic benefits may be derived by their owners by holding them, or using them, over a period of time. Economic value: Economic value is the maximum dollar price someone will pay for an economic asset. Economic decision-making: Economic decision-making involves calculating economic values and comparing the economic value of an asset to the cost of obtaining the asset. Creating wealth: Economic decisions create wealth when the price paid for an economic asset is less than its economic value. This is at the heart of financial decisions and is the basis for every action in markets. Positional goods: Goods and services that people value because of their limited supply, and because they convey a high relative standing within society. They derive most of their value if they succeed in distinguishing their owners as members of a favored group. In general, the definition of positional goods extends to luxury services, memberships and vacations, even though these are not goods. Investopedia.com Opportunity cost: The best alternative that is not chosen because another course of action is pursued. Economic decisions generally involve comparing rates of return. Opportunity cost is often called the discount rate, the hurdle rate, the benchmark rate, or the required rate of return. The time value of money: The concept that money available at the present time is worth more than the identical sum in the future due to its potential earning capacity. This core principle of finance holds that, provided money can earn interest, any amount of money is worth more the sooner it is received. Investopedia.com. Interest rate: a rate of return on an investment or paid on a debt. The First Principle of Finance: A dollar received today is worth more than a dollar received in the future. Cash flow: The flow of purchasing power that can be used to value and facilitate the transfer of economic assets. Risk: The uncertain nature of future cash flows and rates of return will cause current economic values to vary. This variability is the major issue with all financial decisions. Present value: The value of a future cash flow stated as of today.. Future value: The future value of an amount given today. Compounding: The process of using a rate of return to determine a future value. Discounting: The process of using a rate of return to determine a present value. Lesson 2: Making wealth-increasing decisions  Decision rule: A quantitative rule that evaluates whether a course of action should be undertaken. Internal Rate of Return (IRR): The rate of return earned on an investment adjusted for time value. Net Present Value (NPV): A decision-making process using time value and opportunity cost to compare the benefits of a decision with its costs. If the benefits exceed the costs then the decision creates wealth. Fairly valued asset: The asset offers an acceptable rate of return equal to the rate of return offered on assets of equivalent risk. The IRR is equal to the opportunity cost, and the NPV = $0. This is an acceptable investment. Overvalued asset: The asset's rate of return is less than the rate of return offered on assets of equivalent risk.The IRR is less than the opportunity cost, and the NPV is negative. This is not an acceptable investment. Undervalued asset: The asset's rate of return is greater than the rate of return offered on assets of equivalent risk. The IRR exceeds the opportunity cost, and the NPV is positive. This is a desirable investment. Lesson 3: Adjusting economic decisions for risk Expected return: The future return, generally uncertain, that one expects to get from an investment. This is the return that is used in making most business decisions. Realized return: The return that is actually received at the end of the investment period. Risk-free rate of return: A rate of return on an asset whose future cash flows are certain. Given the known payment made today for the promise of future cash flows that will be received with certainty, the rate of return is also certain. Risk premium: The extra return above the risk-free rate that is required given the uncertainty of the future cash flows. Market price: The current price at which an asset can be exchanged between a willing buyer and a willing seller. Value in use: The value that a user expects to get from the use of an asset. Unit 6: Economic Value: Applying Time Value Techniques Lesson 1: Single cash flows in multiple periods Direct relationship between future value and interest rate. The higher the interest rate the higher the future value. The lower the interest rate the lower the future value. Monetary policy: Refers to actions central banks take to pursue objectives such as price stability and maximum employment. There is an inverse relationship between present value and interest rate. Key Concepts: Future Values Calculating future values: - There are two ways of applying interest rates to cash flow.  1. Simple Interest is Interest earned on the original principal. Each period the interest rate is applied, but the principal remains the same. 2. Compound Interest occurs when the Interest earned is applied to the principal each period. With compound interest, the principal grows over time and, if the principal grows so does the amount of interest paid each period. The house purchase: - As you follow Dianne's developing plan, please note that there are four variables involved. - The first two are fairly obvious: 1. The present amount that she will deposit. 2. The future amount that she expects to get. 3. The Interest rate, which gives the rate of change in the value of her deposit. 4. The maturity, or time period, which determines the number of periods that interest rates are applied. Impact of changing variables on future values: Key Concepts: Present Values The legal settlement: calculating present value Impact of changing variables on present values The accounts payable decision Unit 6: Lesson 1 Summary Compounding allows a decision-maker to restate a cash flow to the future. Discounting allows a decision-maker to restate a cash flow to the present. The longer the time period, the larger the future value because the longer you save the more periods you'll earn compound interest. The shorter the time period the smaller the future value, as you will accumulate fewer compounded interest payments. The higher the interest rate, the larger the future value because the rate you earn in each period will compound into larger future wealth. The lower the interest rate, the smaller the annual (compounded) future value. Present values are influenced in exactly the opposite way by changes in time periods and interest rates as future values Lesson 2: Calculating multiple cash flow streams Ordinary annuity: A finite stream of equal cash flows: - For regular periods - With payments at the end of each period Annuity due: A finite stream of equal cash flows: - For regular periods - With payments at beginning of each period. In an annuity due, each cash flow is closer to today, and thus has a higher present value.  Growing annuity: Cash flows grow at a steady rate, g. - Each payment is not the same! - Each payment is g% larger than the previous payment! Level Perpetuity: An infinite stream of equal cash flows. - First cash flow occurs at end of first period. Growing Perpetuity: An infinite stream of cash flows that grow at a steady rate, g. Interest rates are generally quoted on an annual basis. Cash payments often involve periods of less than one year. Intra-period compounding impacts: - Future cash flows. - Effective annual rate of return Stated Annual Interest Rate: r The interest rate stated on an annual basis. Periodic rate: The interest rate for each compounding period. Effective Annual Interest Rate (EAR): Annual interest rate that reflects the effect of compounding within an annual period. Key Concepts: Multiple Cash Flows Key Concepts: Annuities Valuing Annuities: - An annuity is a series of regular payments at regular intervals for a defined period of time. - A level annuity has the same cash flow for each period of time. - The payments in an ordinary annuity occur at the end of each period, such as the salary a worker gets paid at the end of each month. - The payments for an annuity due occur at the beginning of each period. Your landlord expects the rent at the beginning of each month. - A growing annuity has payments that grow at a steady rate. The award: an ordinary annuity: The award: an annuity due: A growing annuity: - A growing annuity is different from a level annuity in that its cash flows grow each period by a set rate. Key Concepts: Compounding Periods Managing different compounding periods: - Compounding period: The length of time that passes before interest is recognized and added to the principle. Christina’s consumer loan The effective annual interest rate - The stated annual interest rate is the interest rate stated on an annual basis. - The periodic interest rate is the interest per period, such as the semiannual rate for bond interest payments and the quarterly rate paid via dividends.  - The effective annual interest rate (EAR) is the annual interest rate that reflects the impact of intra-year compounding. - A rate that you see a lot in consumer contracts is the annual percentage rate (APR), which is the interest rate charged per period multiplied by the number of periods, and also includes any fees or additional costs to the borrower. Christina’s effective annual interest rate Unit 6 Lesson 2 Summary Perpetuities are regular cash flows that have an indefinite life (go on forever). Annuities have regular cash flows but with a specified life. Stated annual interest rate: The interest rate stated on an annual basis. This is the rate normally used in contacts, including loans such as credit cards, auto loans and mortgages. Periodic interest rate: The interest per period, such as the semiannual rate for bond interest payments and the quarterly rate paid via dividends. Effective annual interest rate: The annual interest rate that reflects the impact of intra-year compounding. Unit 6 Working Words: Lesson 1: Calculating Single Cash Flows in Multiple Time Periods Simple Interest is Interest earned on the original principal. Each period the interest rate is applied, but the principal remains the same. Compound Interest occurs when the Interest earned is applied to the principal each period. With compound interest, the principle grows over time and, if the principle grows so does the amount of interest paid each period. Lesson 2: Making Wealth Increasing Decisions Annuity: A series of regular payments at regular intervals for a defined period of time.. Level annuity: An annuity with the same cash flow for each period of time. Level annuities are further classified as to when the payments are made in each period. Ordinary annuity: Payments occur at the end of each period. Annuity due: Payments occur at the beginning of each period. Growing annuity: An annuity where payments grow at a steady rate. Perpetuity: A series of regular payments for regular periods that go on indefinitely. Level perpetuity: Perpetual payments of the same amount at regular intervals Growing perpetuity: Perpetual payments where the amounts grow at a constant rate. Compounding period: The length of time that passes before interest is recognized and added to the principle. Stated annual interest rate: The interest rate stated on an annual basis. This is the rate normally used in contacts, including loans such as credit cards, auto loans and mortgages. Annual percentage rate (APR): The interest rate charged per period multiplied by the number of periods per year.  Periodic interest rate: The interest per period, such as the semiannual rate for bond interest payments and the quarterly rate paid via dividends. Effective annual interest rate: The annual interest rate that reflects the impact of intra-year compounding. Unit 7: Risk and the Opportunity Cost Lesson 1: Understanding Diversification Frequency distribution: Historic variability of the return. Opportunity cost = risk-free rate + risk premium Excess returns: The difference between the average return for an investment and the average return for T-Bills. Risk premium = Asset return - Treasury return Probability distribution: A formula or table of information; potential outcomes, likelihood. Expected return: The probability-weighted sum of all possible returns. Risk: the potential for variability in realized returns. Variance measures this risk. Standard deviation: The square root of the variance. Portfolio: A collection of assets. Diversification: The process of reducing risk by forming portfolios of securities with imperfectly correlated returns. Portfolio expected return: A wealth-weighted combination of the returns of the assets comprising the portfolio. Covariance: A statistical measure of how random variables (the rate of returns of the assets in the portfolio) move together. Key Concepts: Asset Risk and Return Introduction to Uncertainty: A Tale of Two Distributions: - In fact, most economic decisions have uncertain results: the rate of return you think you'll receive is often not what you'll actually end up getting. - However, observing investments over time suggests that the return on an investment seems to be positively related to the risk of the investment: the greater the risk of an investment, the greater the expected return on that investment. Return and risk: frequency distributions: - The historic relationship between return and risk is summarized in a frequency distribution which shows the frequency with which each rate of return was earned over a given period. Return and risk: probability distributions: - A probability distribution is a formula or table of information that gives the potential future outcomes and the likelihood--probability--of those outcomes. - The expected return is the average of the possible realized returns weighted by their probability of occurring.  - The realized return is the return actually received on the investment. - The variance is a measure of how the possible realized returns might vary from the expected return calculated above. The larger the variance the larger the returns in a given year will vary from the expected value. - The standard deviation is the square root of the variance. The variance is a squared percent, which cannot be directly compared to the expected return, which is measured as a percent. As the standard deviation is measured as a percent, it can be combined with the expected return to evaluate risk. Key Concepts: Portfolio Risk and Return Creating portfolios: - A portfolio is nothing more than a collection of assets such as stocks and bonds, a holding of real estate properties, and even an investment in collectibles such as baseball cards. - Covariance is a statistical measure of the degree to which two rates of return move relative to each other. - A positive covariance means that the returns tend to move together. - A negative covariance means that the returns tend to move in opposite directions. - Diversification is the process of reducing the risk of a portfolio by holding assets whose returns are not perfectly correlated. Market Risk Example: - Unique risk is the risk that is unique to an individual company. - Market risk is the risk that affects all companies in the economy. Insights: Hedge Funds vs. Mutual Funds "A mutual fund is a type of financial vehicle made up of a pool of money collected from many investors to invest in securities such as stocks, bonds, money market instruments, and other assets. Mutual funds are operated by professional money managers, who allocate the fund's assets and attempt to produce capital gains or income for the fund's investors. A mutual fund's portfolio is structured and maintained to match the investment objectives stated in its prospectus." "A hedge fund is basically a fancy name for an investment partnership. It's the marriage of professional fund managers, who can often be known as the general partners, and the investors, sometimes known as the limited partners, who pool their money together into the fund... Hedge funds are generally considered to be more aggressive, risky and exclusive than mutual funds." Unit 7 Lesson 1 Summary Historic frequency distributions show us that on average higher returns come with higher volatility: the spread between average return and realized returns. Even more important than the past, we must develop a view of the future involving probability distributions that identify the possible levels of economic activity and the rate of returns earned on an asset in these different states.  From these probability distributions, we can develop the summary measures of expected return and variance. To reduce our risk, we spread out our investments by holding portfolios. This reducing risk by spreading our investments is called diversification. The variance (total risk) of an asset comes from two sources. 1. Unique risk is the volatility connected with events unique to the individual company. 2. Market risk is the volatility caused by factors affecting all assets. Lesson 2: Determine the opportunity cost Uncertainty: The expected and realized returns may differ! Risk: The more uncertain the future cash flows, the more the realized return may vary from the expected return. Realized return: The return received from a project. General to the economy: correlated. Unique to a company: uncorrelated Total risk: The variance/SD of the asset. Market risk: Market risk reflects the correlation of an asset with the economy and is not diversifiable!! Unique risk: That portion of an asset’s risk that is individual to the company and is reduced by diversification. Total risk = Undiversifiable risk + Diversifiable risk Relevant Risk = Market Risk Total risk = Market Risk + Unique Risk Market portfolio: A theoretical portfolio that includes all assets in the economy - physical, intangible, financial, human - valued at their market values. The market portfolio is approximated by a large stock market index. Market/Systematic/Nondiversifiable risk: Risk of an asset that is not reduced by diversification. Beta coefficient: Measures market risk: the sensitivity of an asset’s return to changes in the market’s return. Market beta: As the market is perfectly correlated with itself, the beta of the market is 1. Risky assets: Assets riskier than the average asset in the market have a beta greater than one. Lower risk assets: Assets less risky than the average asset in the market have a beta less than one. Security Market Line: Shows the positive relation between market risk and the expected rate of return. An investment decision involves the comparison of two expected rates of return. 1. Required rate of return (RRR)/Opportunity cost: The return we should receive from the investment given its risk. 2. Internal Rate of Return (IRR): This is the return we expect to receive from the investment given its expected cash flows. This comparison should tell whether the investment is:  1. Fairly priced: Adequate compensation for the risk of the project. - RRR = IRR 2. Overpriced: The investment does not provide an acceptable return given its risk. - RRR > IRR 3. Underpriced: The investment is a good deal. It provides a return in excess of its opportunity cost. - RRR < IRR Key Concepts: Opportunity Cost Measuring market risk: - Unique risk is risk unique to an individual company. Unique risks that vary across investments tend to cancel out. Investors thus can eliminate unique risk by holding a diversified portfolio of many investments. - Market risk affects all companies in the economy and cannot be diversified away. The investor cannot escape market risk and will thus require a risk premium. - The major question for an investor is, "How much market risk does an investment have?" The answer to this question lies in determining the beta: a measure of the market/systematic risk of an asset. - Beta can be used in a financial model called the Capital Asset Pricing Model (CAPM). The CAPM uses market/systematic risk as measured by beta to calculate the risk premium in the opportunity cost/expected rate of return. CAPM: Using the opportunity cost: Unit 7: Lesson 2 Summary Unit 7 Working Words Lesson 1: Understanding diversification Frequency distribution: A representation of the historic returns over a period of time which shows how often each return occurs. Probability distribution: A formula or table of information that gives the potential outcomes and the likelihood of those outcomes. There are two types of probability distributions. Discrete probability distribution: A probability distribution that contains a discrete, or countable, number of observations. Continuous probability distribution: A probability distribution that contains an infinite number of observations, which are analyzed using quantitative measures based on mathematical relationships and calculus. Expected return: The average of the possible realized returns weighted by their probability of occurring Variance: A measure of how the possible realized returns might vary from the expected return. Standard deviation: The square root of the variance. Portfolio: A collection of economic assets.  Diversification: The process of reducing the risk of a portfolio by holding assets whose returns are not perfectly correlated. Joint probability distribution: A probability distribution containing the likelihood of two events occurring together Expected return of a portfolio: The wealth-weighted average of the returns expected from the assets held in the portfolio. Portfolio variance: The combination of the wealth-weighted average of the variances of the two assets and their covariance. Covariance: A statistical measure of the degree to which two rates of return move together. Unique risk: The risk that is unique to an individual company. Unique risk, varying from company to company, is the risk that can be diversified. Market risk: The risk that affects all companies in the economy. Market risk, because it affects all market participants, cannot be diversified away and thus the risk that is relevant for determining the opportunity cost. Lesson 2: Determine the opportunity cost Beta: a measure of the market/systematic risk of an asset: how the asset return varies with the market return, and is thus a measure of the risk that cannot be diversified away. Capital Asset Pricing Model (CAPM): a model that uses market/systematic risk to calculate the opportunity cost/expected rate of return.