Glossary — PM M02: Portfolio Risk and Return (Part 2)

Term	Definition
Capital Market Line (CML)	The CAL formed using the market portfolio as the risky asset: $E (R_{p}) = R_{f} + \frac{E ( R _{m} ) - R _{f}}{σ _{m}} σ_{p}$ . Only efficient portfolios lie on the CML.
Market portfolio	The theoretical portfolio containing all risky assets weighted by their market capitalizations. Lies at the tangency of the CML and the efficient frontier.
Systematic risk	Risk due to economy-wide factors that cannot be diversified away. Measured by beta ( $β$ ). Also called market risk or non-diversifiable risk.
Nonsystematic risk	Firm-specific risk that can be eliminated through diversification. Also called idiosyncratic, unique, or diversifiable risk.
Beta ( $β$ )	A measure of an asset’s systematic risk: $β_{i} = Cov (R_{i}, R_{m}) / σ_{m}^{2}$ . A beta of 1 implies the same systematic risk as the market.
Capital Asset Pricing Model (CAPM)	An equilibrium model: $E (R_{i}) = R_{f} + β_{i} [E (R_{m}) - R_{f}]$ . Only systematic risk is rewarded; unsystematic risk earns no premium.
Security Market Line (SML)	The graphical depiction of the CAPM, plotting $E (R)$ against $β$ . All correctly priced assets and portfolios lie on the SML.
Market model	A regression model: $R_{i} = α_{i} + β_{i} R_{m} + e_{i}$ . An empirical (not equilibrium) tool to estimate beta and alpha.
Market risk premium	The expected excess return of the market over the risk-free rate: $E (R_{m}) - R_{f}$ . The slope of the SML.
Security characteristic line	The regression line of an asset’s excess returns against the market’s excess returns. Its slope is beta; its intercept is alpha.
Sharpe ratio	Risk-adjusted return using total risk: $(R_{p} - R_{f}) / σ_{p}$ . Higher values indicate better risk-adjusted performance.
Treynor ratio	Risk-adjusted return using systematic risk: $(R_{p} - R_{f}) / β_{p}$ . Appropriate when the portfolio is part of a larger diversified holding.
$M^{2}$ (M-squared)	Performance measure that leverages/de-leverages a portfolio to match market risk, then compares returns: $M^{2} = (R_{p} - R_{f}) (σ_{m} / σ_{p}) - (R_{m} - R_{f})$ . Expressed in percentage units.
Jensen’s alpha	The portion of return not explained by CAPM: $α_{p} = R_{p} - [R_{f} + β_{p} (R_{m} - R_{f})]$ . Positive alpha indicates outperformance.
Homogeneity of expectations	CAPM assumption that all investors agree on expected returns, variances, and covariances for all assets.
Lending portfolio	A portfolio on the CML between $R_{f}$ and the market portfolio; investor lends at the risk-free rate (allocates some wealth to the risk-free asset).
Borrowing portfolio	A portfolio on the CML beyond the market portfolio; investor borrows at the risk-free rate to invest more than 100% in the market portfolio.
Fama-French three-factor model	Multi-factor model adding size (SMB) and value (HML) factors to the market factor: $E (R_{i}) - R_{f} = β_{mkt} (R_{m} - R_{f}) + β_{SMB} \cdot SMB + β_{HML} \cdot HML$ .

See Also