Financial Economics Chapter 17 McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

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 17-2

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 17-3

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 17-4

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: dollars today = X dollars in t years X ( 1 + i) t 17-5

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 17-6

Popular Investments Three features –Pay to acquire –Chance to receive future payment –Some risk Stocks –Bankruptcy –Limited liability rule –Capital gains –Dividends 17-7

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 17-8

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 17-9

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 17-10

Investment Risks Norway Switzerland Luxembourg Japan Chile China Mexico United States Indonesia India Ghana Nigeria Iraq Zimbabwe Somalia Source: The International Country Risk Guide Composite Risk Rating 2008, higher number is less risky 17-11

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 17-12

The Security Market Line 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) 17-13

The Security Market Line 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 Risk levels determine average expected rates of return Y 17-14

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 17-15

The Security Market Line SML 1 Average expected rate of return Risk Level (beta) 0 X An increase in the risk-free rate Y2Y2 A Before Increase A After Increase SML 2 Y1Y

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 17-17

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 17-18

Next Chapter Preview… Extending the Analysis Of Aggregate Supply 17-19