1. INVESTMENTS | BODIE, KANE, MARCUS ©2011 The McGraw-Hill Companies 4751 - Financial Economics Summer 2011

2. INVESTMENTS | BODIE, KANE, MARCUS ©2011 The McGraw-Hill Companies 4751 - Financial Economics My Name: Rene Schwengber Today: –Syllabus –Introduction BKM chapter 1

3. INVESTMENTS | BODIE, KANE, MARCUS ©2011 The McGraw-Hill Companies Syllabus Grade from 3 sources (each worth 1/3) average homework First exam (July 1 st, in class) Second exam (July 22 nd, in class) Homework’s typed and stapled otherwise cap maximum grade at 75% I will not accept emailed homeworks. If you can’t submit homework in due date in class, talk to me first.

4. INVESTMENTS | BODIE, KANE, MARCUS ©2011 The McGraw-Hill Companies Webpage and other content Our webpage is http:www.econ.umn.edu/~schwe227 (click on teaching) Our required book is BKM. –We will also use other books for content that required more depth.

5. INVESTMENTS | BODIE, KANE, MARCUS ©2011 The McGraw-Hill Companies Other Office Hours: –Tu/We 3:30-4:30pm, and by appointment.

6. INVESTMENTS | BODIE, KANE, MARCUS ©2011 The McGraw-Hill Companies Intro Investment (noun) current commitment of money or other resources in the expectation of reaping future benefits –Intertemporal allocation of resources Time (for “risk-free” investments) Uncertainty (Risky) Examples of risky investment? –College, House Example of risk-free investment? –Treasury Bills –Really(?)

7. INVESTMENTS | BODIE, KANE, MARCUS ©2011 The McGraw-Hill Companies Real Assets Versus Financial Assets Real Assets –Determine the productive capacity and net income of the economy –Examples: Land, buildings, machines, knowledge used to produce goods and services Financial Assets –Claims on real assets

8. INVESTMENTS | BODIE, KANE, MARCUS ©2011 The McGraw-Hill Companies Financial Assets Three types: 1.Fixed income or debt Income stream determined (ex-ante) by formula 2.Common stock or equity Represent ownership on a corporation (think of it: claims on a Black-Box that produces Income Streams) 3.Derivative securities Income is determined/derived from other assets such as bonds or stock prices.

9. INVESTMENTS | BODIE, KANE, MARCUS ©2011 The McGraw-Hill Companies Financial Assets vs. Real Assets polling Which type of assets do you think is most important in an economy? –Real assets. How important do you think financial assets are in a modern well functioning economy? –Very ______ Not that much ______

10. INVESTMENTS | BODIE, KANE, MARCUS ©2011 The McGraw-Hill Companies Class vote How important financial assets are in a modern well functioning economy? ____ “Very” vs. ____ “Not that much” Let’s hear this 4minutes clip. http://hhei.umn.edu/videos/video3.html About in 3’40’’ to 5’30”

11. INVESTMENTS | BODIE, KANE, MARCUS ©2011 The McGraw-Hill Companies Example: Dutch East India Company As mentioned in the video. Financial assets are important in a well functioning economy since they provide some means on how to best allocate resources at any given time. Consider the Dutch East India Company example. –Chartered company –Founded in 17 th century defunct almost in 19 th century –Fist company to issue Stock (financial asset)

12. INVESTMENTS | BODIE, KANE, MARCUS ©2011 The McGraw-Hill Companies Example: Dutch East India Company Consider the Dutch East India Company What is a stock? Stock or equity is a claim of ownership on a firm. Payoff of exploration was potentially very big (high gains) but so was its risk (e.g. loss ship) Idea: Spread risk by financing more than one expedition at once. Many claim this was one of the major force behind the Dutch growth in maritime power in that period (and believe, the growth and power of this mega-coroporation was every big)

13. INVESTMENTS | BODIE, KANE, MARCUS ©2011 The McGraw-Hill Companies Investment Example The goal of investing in simple: –Maximize (today and future) utility while allocating current resources into real and financial assets. Assume agents value streams of daily consumption. –(c1, c2, c3, c4) (a vector) gives Utility U(c1, c2, c3, c4) (a number) E.g.: Stream 1: (1,1,1,97) vs. Stream 2 (25,25,25,25) –Which would you rank higher? Most would prefer the 2 nd stream of consumption This type of question is studied under the label “Theory of Choice (under uncertainty)”. We will spend some time talking about it

14. INVESTMENTS | BODIE, KANE, MARCUS ©2011 The McGraw-Hill Companies Financial Markets and the Economy Information Role: Capital flows to companies with best prospects Consumption Timing: Use securities to store wealth and transfer consumption to the future

15. INVESTMENTS | BODIE, KANE, MARCUS ©2011 The McGraw-Hill Companies Financial Markets and the Economy (Ctd.) Allocation of Risk: Investors can select securities consistent with their tastes for risk Separation of Ownership and Management: With stability comes agency problems

16. INVESTMENTS | BODIE, KANE, MARCUS ©2011 The McGraw-Hill Companies General problem A well-developed economy with financial markets provides: intertemporal allocation of resources Insurance –against bad shocks –decreased volatility You can think of a financial assets as the means of decreasing the friction on resource allocation in the economy

17. INVESTMENTS | BODIE, KANE, MARCUS ©2011 The McGraw-Hill Companies The Investment Process Asset allocation –Choice among broad asset classes Security selection –Choice of which securities to hold within asset class –Security analysis to value securities and determine investment attractiveness

18. INVESTMENTS | BODIE, KANE, MARCUS ©2011 The McGraw-Hill Companies Markets are Competitive Risk-Return Trade-Off Efficient Markets –Active Management Finding mispriced securities Timing the market

19. INVESTMENTS | BODIE, KANE, MARCUS ©2011 The McGraw-Hill Companies Markets are Competitive (Ctd.) –Passive Management No attempt to find undervalued securities No attempt to time the market Holding a highly diversified portfolio

20. INVESTMENTS | BODIE, KANE, MARCUS ©2011 The McGraw-Hill Companies Next Class We will review basic concepts from basic probability theory. Read Chapter 1 from BKM (focus on 1.1 to 1.5) Read Chapter 2 of Theory of Value (link in class webpage)