Topic 8 Financial Economics

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

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

4 Present Value 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:

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

6 Instruments of Investment Wide variety available to investors Three features – Must pay to acquire – Chance to receive future payment – Some risk in future payments

7 Stocks – Represents ownership in a company – Bankruptcy possible – Limited liability rule – Capital gains – Dividends

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

9 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

10 Mutual Funds 10 Largest Mutual Funds, February 2010 * 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

11 Other Financial Assets Currencies Commodities (wheat, petroleum, copper, other basic resources and agricultural goods) Derivatives  Forward  Futures  Options  Swaps Investing in real estate

12 Investment Returns

13 Risk and Return Future price and income are uncertain Diversifiable risk – Specific to a particular asset Nondiversifiable risk – Market risk Investing in risky assets will only get compensated for nondiversifiable risk – Expected rate of return – Beta (correlation between a risky asset and the market portfolio)

14 Risk and Return Risk and 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

15 The Security Market Line Expected rate of return Risk Level (beta) 0 Risk Premium for The Market Portfolio’s Risk Level of beta=1.0 Compensation For Time Preference Equals i f Security Market Line Market Portfolio A Risk-free Asset (i.e., a short-term U.S. Government bond) i f 1.0