Security Market Line - SML

What Does Security Market Line - SML Mean?
A line that graphs the systematic, or market, risk versus return of the whole market at a certain time and shows all risky marketable securities.

Also refered to as the "characteristic line".

Security Market Line - SML
The SML essentially graphs the results from the capital asset pricing model (CAPM) formula. The x-axis represents the risk (beta), and the y-axis represents the expected return. The market risk premium is determined from the slope of the SML.

The security market line is a useful tool in determining whether an asset being considered for a portfolio offers a reasonable expected return for risk. Individual securities are plotted on the SML graph. If the security's risk versus expected return is plotted above the SML, it is undervalued because the investor can expect a greater return for the inherent risk. A security plotted below the SML is overvalued because the investor would be accepting less return for the amount of risk assumed.

Financial Modeling

What Does Financial Modeling Mean?
The process by which a firm constructs a financial representation of some, or all, aspects of the firm or given security. The model is usually characterized by performing calculations, and makes recommendations based on that information. The model may also summarize particular events for the end user and provide direction regarding possible actions or alternatives.

Financial models can be constructed in many ways, either by the use of computer software, or with a pen and paper. What's most important, however, is not the kind of user interface used, but the underlying logic that encompasses the model. A model, for example, can summarize investment management returns, such as the Sortino ratio, or it may help estimate market direction, such as the Fed model.

Modern Portfolio Theory - MPT

What Does Modern Portfolio Theory - MPT Mean?
A theory on how risk-averse investors can construct portfolios to optimize or maximize expected return based on a given level of market risk, emphasizing that risk is an inherent part of higher reward.

Also called "portfolio theory" or "portfolio management theory."

IModern Portfolio Theory - MPT
According to the theory, it's possible to construct an "efficient frontier" of optimal portfolios offering the maximum possible expected return for a given level of risk. This theory was pioneered by Harry Markowitz in his paper "Portfolio Selection," published in 1952 by the Journal of Finance.

There are four basic steps involved in portfolio construction:
-Security valuation
-Asset allocation
-Portfolio optimization
-Performance measuremen
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Option Pricing Theory

What Does Option Pricing Theory Mean?
Any model- or theory-based approach for calculating the fair value of an option.

The most commonly used models today are the Black-Scholes model and the binomial model. Both theories on options pricing have wide margins for error because their values are derived from other assets, usually the price of a company's common stock. Time also plays a large role in option pricing theory, because calculations involve time periods of several years and more. Marketable options require different valuation methods than non-marketable ones, such as those given to company employees.

How stock options should be valued has become an important debate in the past few years because U.S. companies are now required to expense the cost of employee stock options on their earnings statements. For many young companies trading on the stock exchanges today, this expense will be considerable no matter what valuation methods are used. The need for consistent and accurate treatment of this increasing expense provides incentive for the creation of new and innovative solutions to option pricing theory.

Option Pricing Theory

What Does Option Pricing Theory Mean?
Any model- or theory-based approach for calculating the fair value of an option.

The most commonly used models today are the Black-Scholes model and the binomial model. Both theories on options pricing have wide margins for error because their values are derived from other assets, usually the price of a company's common stock. Time also plays a large role in option pricing theory, because calculations involve time periods of several years and more. Marketable options require different valuation methods than non-marketable ones, such as those given to company employees.

How stock options should be valued has become an important debate in the past few years because U.S. companies are now required to expense the cost of employee stock options on their earnings statements. For many young companies trading on the stock exchanges today, this expense will be considerable no matter what valuation methods are used. The need for consistent and accurate treatment of this increasing expense provides incentive for the creation of new and innovative solutions to option pricing theory.

Black Scholes Model

What Does Black Scholes Model Mean?
A model of price variation over time of financial instruments such as stocks that can, among other things, be used to determine the price of a European call option. The model assumes that the price of heavily traded assets follow a geometric Brownian motion with constant drift and volatility. When applied to a stock option, the model incorporates the constant price variation of the stock, the time value of money, the option's strike price and the time to the option's expiry.

Also known as the Black-Scholes-Merton Model.

The Black Scholes Model is one of the most important concepts in modern financial theory. It was developed in 1973 by Fisher Black, Robert Merton and Myron Scholes and is still widely used today, and regarded as one of the best ways of determining fair prices of options.

There are a number of variants of the original Black-Scholes model.

Arbitrage Pricing Theory - APT

What Does Arbitrage Pricing Theory - APT Mean?
An asset pricing model based on the idea that an asset's returns can be predicted using the relationship between that same asset and many common risk factors. Created in 1976 by Stephen Ross, this theory predicts a relationship between the returns of a portfolio and the returns of a single asset through a linear combination of many independent macro-economic variables.

Arbitrage Pricing Theory - APT
The arbitrage pricing theory (APT) describes the price where a mispriced asset is expected to be. It is often viewed as an alternative to the capital asset pricing model (CAPM), since the APT has more flexible assumption requirements. Whereas the CAPM formula requires the market's expected return, APT uses the risky asset's expected return and the risk premium of a number of macro-economic factors. Arbitrageurs use the APT model to profit by taking advantage of mispriced securities. A mispriced security will have a price that differs from the theoretical price predicted by the model. By going short an over priced security, while concurrently going long the portfolio the APT calculations were based on, the arbitrageur is in a position to make a theoretically risk-free profit
.

Arbitrage Pricing Theory - APT

What Does Arbitrage Pricing Theory - APT Mean?
An asset pricing model based on the idea that an asset's returns can be predicted using the relationship between that same asset and many common risk factors. Created in 1976 by Stephen Ross, this theory predicts a relationship between the returns of a portfolio and the returns of a single asset through a linear combination of many independent macro-economic variables.

Arbitrage Pricing Theory - APT
The arbitrage pricing theory (APT) describes the price where a mispriced asset is expected to be. It is often viewed as an alternative to the capital asset pricing model (CAPM), since the APT has more flexible assumption requirements. Whereas the CAPM formula requires the market's expected return, APT uses the risky asset's expected return and the risk premium of a number of macro-economic factors. Arbitrageurs use the APT model to profit by taking advantage of mispriced securities. A mispriced security will have a price that differs from the theoretical price predicted by the model. By going short an over priced security, while concurrently going long the portfolio the APT calculations were based on, the arbitrageur is in a position to make a theoretically risk-free profit
.

Model Risk

What Does Model Risk Mean?
A type of risk that occurs when a financial model used to measure a firm's market risks or value transactions does not perform the tasks or capture the risks it was designed to.

Model risk is considered a subset of operational risk, as model risk mostly affects the firm that creates and uses the model. Traders or other investors who use the model may not completely understand its assumptions and limitations, which limits the usefulness and application of the model itself.

Any model is a simplified version of reality, and with any simplification there is the risk that something will fail to be accounted for.

The use of financial models has become very prevalent in the past decades, in step with advances in computing power, software applications and new types of financial securities. The Long Term Capital Management debacle was attributed to model risk - in this case, a small error in the fund's computer models was made larger by several orders of magnitude because of the highly leveraged trading strategy LTCM employed.

Black Box Model Mean

What Does Black Box Model Mean?
A computer program into which users enter information and the system utilizes pre-programmed logic to return output to the user.

The "black box" portion of the system contains formulas and calculations that the user does not see nor need to know to use the system. Black box systems are often used to determine optimal trading practices. These systems generate many different types of data including buy and sell signals.

Country Risk Premium - CRP

What Does Country Risk Premium - CRP Mean?
The additional risk associated with investing in an international company rather than the domestic market. Macroeconomic factors such as political instability, volatile exchange rates and economic turmoil causes investors to be wary of overseas investment opportunities and thus require a premium for investing. The country risk premium (CRP) is higher for developing markets than for developed nations.

The CAPM can be adjusted to reflect the additional risks of international investing by adjusting the model for the CRP.

R_e = R_f + β(R_m – R_f + CRP)

As expected by general financial theory, investors seeking to invest into a region such asZimbabwe must be compensated with greater expected returns.

Cost Of Equity

In financial theory, the return that stockholders require for a company. The traditional formula for cost of equity (COE) is the dividend capitalization model:

A firm's cost of equity represents the compensation that the market demands in exchange for owning the asset and bearing the risk of ownership.

he capital asset pricing model (CAPM) is another method used to determine cost of equity.

CAPM

A model that describes the relationship between risk and expected return and that is used in the pricing of risky securities.

The general idea behind CAPM is that investors need to be compensated in two ways: time value of money and risk. The time value of money is represented by the risk-free (rf) rate in the formula and compensates the investors for placing money in any investment over a period of time. The other half of the formula represents risk and calculates the amount of compensation the investor needs for taking on additional risk. This is calculated by taking a risk measure (beta) that compares the returns of the asset to the market over a period of time and to the market premium (Rm-rf).

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