PowerPoint Presentation by Charlie Cook Copyright © 2004 South-Western. All rights reserved. Chapter 7 The Theory of Portfolio Choice

Copyright © 2004 South-Western. All rights reserved.7–2 Fundamental Issues 1.What is a financial portfolio? 2.What are the key determinants of portfolio choice? 3.What is the distinction between idiosyncratic risk and market risk? 4.How does holding international financial instruments make a portfolio more diversified? 5.What are the special risks of holding international financial instruments?

Copyright © 2004 South-Western. All rights reserved.7–3 Saving and Wealth Saving:  The act of forgoing consumption that permits individuals to expand their capability to consume in the future.  A flow measure of the amount added to an individual’s total accumulated savings from one point time to another. Wealth:  An individual’s total resources: accumulated financial savings (financial wealth), nonfinancial resources (durable goods), and human capital.

Copyright © 2004 South-Western. All rights reserved.7–4 Financial Portfolios Portfolio:  The group of financial instruments held by an individual, which together make up the individual’s financial wealth.  Fundamental determinants of portfolio choice:  Individual wealth  Expected asset returns  Asset liquidity  Information costs  Asset Risk

Copyright © 2004 South-Western. All rights reserved.7–5 Aggregate Portfolio Allocations of U.S. Households Figure 7–1 SOURCE: Flow-of-Funds Accounts, Board of Governors of the Federal Reserve System, June, 2002.

Copyright © 2004 South-Western. All rights reserved.7–6 Factors That Influence Portfolio Choice Table 7–1 Effect of an Increase in Factor Factoron Desired Asset Holdings WealthIncrease Expected asset returnIncrease Asset liquidityIncrease Information costsDecrease Asset riskDecrease

Copyright © 2004 South-Western. All rights reserved.7–7 Fundamental Determinants of Portfolio Choice: Wealth Individual Wealth  A key determinant of any individual’s portfolio of financial assets is the person’s total wealth. Wealth elasticity of demand:  The percentage change in the quantity of an asset demanded by an individual divided by a given percentage change in the individual’s wealth.

Copyright © 2004 South-Western. All rights reserved.7–8 The Wealth Elasticity of Asset Demand Necessity asset:  An asset with a wealth elasticity of demand < 1, which implies that an individual increases holdings of the asset less than proportionately in response to a given proportionate increase in wealth. Luxury asset:  An asset with a wealth elasticity of demand > 1, which indicates that an individual raises holdings of the asset more than proportionately in response to a given proportionate increase in wealth.

Copyright © 2004 South-Western. All rights reserved.7–9 Asset Risk Risk aversion:  The preference, other things being equal, to hold assets whose returns exhibit less variability. Measuring risk:  Statistical variance—a summary statistic that indicates how widely actual values of an asset’s return tend to vary relative to the expected return.  Mean-variance analysis—the evaluation of trade- offs between financial assets’ expected returns and variances of returns.

Copyright © 2004 South-Western. All rights reserved.7–10 International Diversification Idiosyncratic risk:  Risk that is unique to a particular financial instrument; also known as nonsystematic risk. Diversification:  Holding a mix of financial instruments with returns that normally do not move together. Market risk:  Risk that is common to all financial assets within a portfolio; also called systematic risk.

Copyright © 2004 South-Western. All rights reserved.7–11 Subprime Mortgage Lending Figure 7–2 SOURCE: Federal Deposit Insurance Corporation.

Copyright © 2004 South-Western. All rights reserved.7–12 Portfolio Diversification Beta:  A measure of the sensitivity of a financial instrument’s expected return to changes in the value of all financial instruments in a market portfolio  Calculated as the percentage change in the value of a financial instrument resulting from a 1% change in the value of all financial instruments in the portfolio.

Copyright © 2004 South-Western. All rights reserved.7–13 Risks of Holding International Financial Instruments Foreign exchange risk:  The potential for the value of a foreign-currency- denominated financial instrument to vary because of exchange rate fluctuations. Transaction risk:  A foreign exchange risk arising from the possibility that the proceeds from trading a financial instrument may change as a result of exchange rate variations.

Copyright © 2004 South-Western. All rights reserved.7–14 Risks of Holding International Financial Instruments (cont’d) Translation risk:  A foreign exchange risk resulting from altered home-currency values of foreign-currency- denominated financial instruments caused by fluctuations in exchange rates. Economic risk:  A foreign exchange risk that stems from the possibility that exchange rate movements can affect the discounted present value of future streams of income.

Copyright © 2004 South-Western. All rights reserved.7–15 Risks of Holding International Financial Instruments (cont’d) Country risk:  The potential for returns on international financial instruments to vary because of uncertainties concerning possible changes in political and economic conditions within a nation.

Copyright © 2004 South-Western. All rights reserved.7–16 Types of Foreign Exchange Risk Table 7–2 Type of RiskHow Risk Exposure Arises Transaction riskCommitment to a future transaction denominated in a foreign currency. Translation riskConversion of values of foreign-currency- denominated assets and liabilities into home-currency units. Economic riskChanges in underlying asset returns and, thus, discounted future income streams, resulting from exchange rate variations.

Copyright © 2004 South-Western. All rights reserved.7–17 The Stock Market Participation Rate and the Share of Stocks Held by the Richest 10 Percent of Stockholders Figure 7–3 SOURCES: Hui Guo, “Stockholding Is Still Highly Concentrated,” Federal Reserve Bank of St.Louis National Economic Trends, June 2001; Federal Reserve Survey of Consumer Finances (various issues), Board of Governors of the Federal Reserve System; and authors’ estimates.

Copyright © 2004 South-Western. All rights reserved.7–18 Portions of Household Assets Allocated to Stocks and Real Estate, by Wealth Percentile Figure 7–4 SOURCES: Joseph Tracey and Henry Schneider, “Stocks in the Household Portfolio,” Federal Reserve Bank of New York Current Issues in Economics and Finance 7 (April 4,2001); Federal Reserve Survey of Consumer Finances (various issues), Board of Governors of the Federal Reserve System.