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Financial Economics

Chapter 17

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Financial Investment

Economic investment Paying for new additions to the capital stock or new

replacements for capital stock that has worn out Examples: new factories, houses, retail stores,

construction equipment, & wireless networks

Financial investment Includes economic investment Buying an asset or building in the expectation of

financial gain Does not distinguish between old & new assets

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Present value

Present-day value or worth of returns or costs that are expected to arrive in the future

Compound interest Describes how quickly an investment

increases in value when interest is paid X Dollars today = (1+i)tX dollars in t years

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Present value model

Simply rearranges compound interest formula to transform future amounts of money into present amounts of money

See equation (2) on page 336

The asset’s price should exactly equal the total present value of all of the asset’s future payments

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Applications

Take the money & run? Winners of state lotteries are typically paid

their winnings in equal installments spread out over 20 years

Some people (ex. Elderly) want money now because they may not live long enough to collect all payments

Swap with private financial company Present value is used to determine the value

of the lump sum that lottery winners receive

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Salary caps & deferred compensation

Upper limits on the total amount of money that each team can spend on salaries during a given season

Player contracts are typically for multiple seasons

Players are asked to defer some of their contract to later years so the team will be within the salary cap

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Some popular investments Stocks

Ownership shares in a corporation Able to vote at shareholder meetings Limited liability Dividends Capital gains

Bonds Debt contracts that are issued most frequently by

governments & corporations Seller must pay interest Possibility of default on bond Bonds are more predictable than stocks (highly volatile

because they depend on profits)

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Popular investments (cont.)

Mutual funds A company that maintains a professionally

managed portfolio (collection of stocks/bonds)

Index funds Portfolios selected to exactly match a stock or

bond index (i.e. S&P 500)

Actively vs. passively managed funds

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Calculating investment returns (percentage rate of return) Percentage gain or loss (relative to buying

price) over a given period of time

Asset prices and rates of return Inversely related

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Arbitrage

Happens when investors try to take advantage and profit from situations where two identical or nearly identical assets have different rates of return

Simultaneously sell the asset with the lower return & buy asset with higher return

Problem: prices of two companies will change – and with them, the rates of return on the two companies

Convergence will happen. Rates of return will be equal

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Risk

Investors never know with total certainty what those future payments will be

Many factors affect an investment’s future payments

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Diversification

Strategy of investing in a large number of investments

Reduces overall risk of your portfolio

“Don’t put all your eggs in one basket”

Diversifiable risk Risk that is specific to a given investment Can be eliminated by diversification

Nondiversifiable risk Pushes all investments in the same direction

at same time No possibility of using good effects to offset

bad effects

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Comparing risky investments

Average expected rate of return Probability weighted average of the

investment’s possible future rates of return

Probability weighted average Each of the possible future rates of return is

multiplied by its probability

Beta Relative measure on nondiversifiable risk Measures how the nondiversifiable risk of a given

asset or portfolio of assets compares with that of the market portfolio

Market portfolio Name given to a portfolio that contains every asset

available in financial markets Useful standard of comparison because it’s as

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Relationship of risk & average expected rates of return Investors dislike risk

Risk & uncertainty causes investors to pay higher prices for less-risky assets & lower prices for more-risky assets

Asset prices & average expected rates of return are inversely related

Less risky assets will have lower average expected rates of return than more risky assets

Risk levels & average expected rates of return are positively related

Think of higher average expected rates of return as being a form of compensation

This affects all assets (stocks, bonds, real estate, etc.)

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The risk-free rate of return

Short-term U.S. government bonds are considered to be risk-free

Almost no chance that the U.S. government will not be able to repay these loans on time & in full

Time preference People tend to be impatient Prefer to consume things in the present rather

than future

Risk-free interest rate Rate of return earned by short-term U.S.

government bonds Rate of return that they generate is not in any

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Security market line Indicates how compensation is determined for all assets no

matter what their respective risk levels happen to be

An investment’s average expected rate of return has to be sum of two parts: One that compensates for time preference Another that compensates for risk Compensation for time preference is = to risk-free interest

rate

Risk premium Rate that compensates for risk

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An increase in the risk-free rate