10/7/ Financial Economics Chapter 17

10/7/ 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

10/7/ 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) t X dollars in t years

10/7/ 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

10/7/ 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

10/7/ 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

10/7/ 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)

10/7/ 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

10/7/ 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

10/7/ 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

10/7/ Risk Investors never know with total certainty what those future payments will be Many factors affect an investment’s future payments

10/7/ 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 10/7/

10/7/ 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 diversified as possible 10/7/

10/7/ 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.) 10/7/

10/7/ 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 way a compensation for risk 10/7/

10/7/ 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

10/7/ An increase in the risk-free rate