17 Financial Economics McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Financial Investment Economic investment New additions or replacements to the capital stock Financial investment Broader than economic investment Buying or building an asset for financial gain New or old asset Financial or real asset LO1 17-2

Present Value Present day value of future returns or costs Compound interest Earn interest on the interest X dollars today=(1+i) t X dollars in t years $100 today at 8% is worth: $108 in one year $ in two years $ in three years LO1 17-3

Present Value Model Calculate what you should pay for an asset today Asset yields future payments Asset’s price should equal total present value of future payments The formula: dollars today = X dollars in t years X ( 1 + i) t LO1 17-4

Applications Take the money and run Lottery jackpot paid over a number of years Calculating the lump sum value Salary caps and deferred compensation Calculating the value of deferred salary payments LO1 17-5

Popular Investments Wide variety available to investors Three features Must pay to acquire Chance to receive future payment Some risk in future payments LO2 17-6

Stocks Represents ownership in a company Bankruptcy possible Limited liability rule Capital gains Dividends LO2 17-7

Bonds Debt contracts issued by government and corporations Possibility of default Investor receives interest LO2 17-8

Mutual Funds Company that maintains a portfolio of either stocks or bonds Currently more than 8,000 mutual funds Index funds Actively managed funds Passively managed funds LO2 17-9

Mutual Funds 10 Largest Mutual Funds, February 2010 Fund Name*Assets Under Management, Billions PIMCO Total Return Institutional$122.9 SPDR Trust I 70.2 American Funds Growth A 64.4 Vanguard Funds Total Stock Index Investor 59.6 American Funds Capital Income Builder A 56.2 Fidelity Contrafund 55.5 American Funds Capital World Growth and Income A 53.1 American Funds Income A 48.5 Vanguard 500 Index Investor 47.9 American Funds Investment Company of America A 47.6 * The letter A indicates funds that have sales commissions and are generally purchased by individuals through their financial advisors. Source: Lipper, a Thomson Reuters company LO

Calculating Investment Returns Gain or loss stated as percentage rate of return Difference between selling price and purchase price divided by purchase price Future series of payments also considered into return Rate of return inversely related to price LO

Arbitrage Buying and selling process to equalize average expected returns Sell asset with low return and buy asset with higher return at same time Both assets will eventually have same rate of return LO

Risk Future payments are uncertain Diversification Diversifiable risk Specific to a given investment Nondiversifiable risk Business cycle effects Comparing risky investments Average expected rate of return Beta LO

Risk Risk and average expected rates of return Positively related The risk-free rate of return Short-term U.S. government bonds Greater than zero Time preference Risk-free interest rate LO

Investment Risks Luxembourg (1) Norway (2) Brunei (3) Germany (9) Netherlands (16) China (28) Japan (31) United States(36) India (61) Egypt (81) Russia (101) Venezuela (127) Congo (138) Somalia (139) Zimbabwe(140) Source: International Country Risk Guide, July 2009, © The PRS Group, Inc, Composite Risk Rating LO

The Security Market Line Average expected rate of return = Rate that compensates for time preference + Rate that compensates for risk Compensate investors for: Time preference Nondiversifiable risk Average expected rate of return = ifif + risk premium LO

The Security Market Line LO4 Security Market Line Market Portfolio i f Average expected rate of return Risk Level (beta) Compensation For Time Preference Equals i f Risk Premium for The Market Portfolio’s Risk Level of beta=1.0 A Risk-free Asset (i.e., a short-term U.S. Government bond) 17-17

The Security Market Line Risk levels determine average expected rates of return LO4 Security Market Line ifif Average expected rate of return Risk Level (beta) 0 X Compensation For Time-Preference Equals i f Risk Premium for This Asset’s Risk Level of beta = X Y 17-18

The Security Market Line Security Market Line Average expected rate of return Risk Level (beta) 0 X Arbitrage and the security market Y A B C LO

The Security Market Line SML 1 Average expected rate of return Risk Level (beta) 0 X An increase in the risk-free rate A Before Increase A After Increase SML 2 Y1Y1 LO5 Y2Y

SML: Applications Fed’s expansionary monetary policy led to lower interest rates SML shifted downward Slope of SML increased due to increased investor risk-aversion Stocks fell LO

Index Funds Versus Actively Managed Funds Choice of actively or passively managed mutual funds After costs, index funds outperform actively managed by 1% per year Role of arbitrage Management costs are significant Index funds are boring – no chance to exceed average rates of return LO