Net Present Value of an Investment Project
The Net present value (NPV) of a project refers to the present value of all cash inflows minus the present value of all cash outflows, evaluated at a given discount rate. The difference between the two represents the income generated…
Effective Annual Rate of Interest (EAR)
The effective annual rate of interest (EAR) refers to the rate of return earned by an investor in a year, taking the effects of compounding into account. Remember, compounding is the process by which invested funds grow exponentially as a…
Present and Future Values
Future Values The Future Value (FV) of a Single Sum of Cash Flow The Future Value (FV) of a single sum of money is the future amount of money invested today at a given interest rate (r) for a specified…
Portfolio of Risk-free and Risky Assets
By combining a portfolio of risky assets with a risk-free asset, we can improve the return-risk characteristics of the portfolio and realize a better trade-off. This combination is called the capital allocation line (CAL). The proportion of allocation to risky…
Capital Allocation Line (CAL) and Capital Market Line (CML)
We form a capital allocation line when we combine a risky asset portfolio with a risk-free asset. This represents the allocation between risk-free and risky assets based on investor risk preferences. The capital market line is a special case of…
Systematic and Non-systematic Risks
Systematic risk is inherent in the overall market and cannot be avoided. Non-systematic risk is limited to a particular asset class or security and can be avoided through appropriate portfolio diversification. Systematic Risk When you invest in a market, you face…
Return Generating Models
A return-generating model can provide investors with an estimate of the return of a particular security given certain input parameters. The most general form of a return-generating model is a multi-factor model. In its simplest form, the multi-factor model is…
Beta Explained
Beta is a measure of systematic risk. Statistically, it depends on the degree of correlation between a security and the market. Calculating Beta We begin with the single index model using realized returns constructed as follows: $$ R_i – R_f…
Capital Asset Pricing Model (CAPM)
The Capital Asset Pricing Model (CAPM) provides a linear relationship between the expected return for an asset and the beta. The Security Market Line (SML) represents CAPM on a graph. As opposed to the Capital Market Line (CML), where the…
