Chapter 34 - Financial economics. After studying this chapter you will be able to understand: Describe the idea of present value and explain why it is critical in making financial decisions; identify and distinguish between the most common financial investments: stocks, bonds, and mutual funds; discuss how investment returns compensate for being patient and for bearing risk;...
Chapter 34 Financial Economics McGrawưHill/Irwin Copyrightâ2009byTheMcGrawưHillCompanies,Inc.Allrightsreserved Chapter Objectives Present value and making financial decisions • Stocks, bonds, and mutual funds • Investment returns, patience, and risk • Portfolio diversification: nondiversifiable risk and rates of return • Beating the market 34-2 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 34-3 Present Value • Present day value of future returns or costs • Compound interest – Earn interest on the interest X dollars today=(1+i)tX dollars in t years • $100 today at 8% is worth: – $108 in one year – $116.64 in two years 34-4 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: X ( + i) t dollars today = X dollars in t years 34-5 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 34-6 Popular Investments • Three features – Pay to acquire – Chance to receive future payment – Some risk • Stocks – Bankruptcy – Limited liability rule – Capital gains – Dividends 34-7 Applications • Bonds – More predictable than stocks • Mutual funds – Portfolio – Index funds – Actively or passively managed • Calculating investment returns • Asset prices and rates of return • Arbitrage 34-8 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 34-9 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 34-10 Investment Risks Composite Risk Rating 2008, higher number is less risky 20 40 60 80 100 Norway Switzerland Luxembourg Japan Chile China Mexico United States Indonesia India Ghana Nigeria Iraq Zimbabwe Somalia Source: The International Country Risk Guide 34-11 The Security Market Line Compensate investors for: •Time preference •Nondiversifiable risk Average expected rate of return Average expected rate of return = = Rate that compensates for time preference if + + Rate that compensates for risk risk premium 34-12 Average expected rate of return The Security Market Line Market Portfolio Security Market Line A Risk-free Asset (i.e., a short-term U.S Government bond) Risk Premium for The Market Portfolio’s Risk Level of beta=1.0 if Compensation For Time Preference Equals if 1.0 Risk Level (beta) 34-13 The Security Market Line Average expected rate of return Risk levels determine average expected rates of return Security Market Line Y Risk Premium for This Asset’s Risk Level of beta = X if Compensation For Time-Preference Equals if X Risk Level (beta) 34-14 The Security Market Line Average expected rate of return Arbitrage and the security market A Y Security Market Line B C X Risk Level (beta) 34-15 The Security Market Line Average expected rate of return An increase in the risk-free rate SML SML Y2 A After Increase Y1 A Before Increase X Risk Level (beta) 34-16 Index Funds Beat 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 34-17 Key Terms • • • • • • • • • • • • • • • • economic investment financial investment compound interest present value stocks bankrupt limited liability rule capital gains dividends bonds default mutual funds portfolios index funds actively managed funds passively managed funds • percentage rate of return • arbitrage • risk • diversification • diversifiable risk • nondiversifiable risk • average expected rate of return • probability weighted average • beta • market portfolio • time preference • risk-free interest rate • Security Market Line • risk premium 34-18 Next Chapter Preview… Extending the Analysis Of Aggregate Supply 34-19 ... portfolio • time preference • risk-free interest rate • Security Market Line • risk premium 3 4- 18 Next Chapter Preview… Extending the Analysis Of Aggregate Supply 3 4- 19 ... Time-Preference Equals if X Risk Level (beta) 3 4- 14 The Security Market Line Average expected rate of return Arbitrage and the security market A Y Security Market Line B C X Risk Level (beta) 3 4- 15... Beta 3 4- 9 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