1. © 2006 Thomson Business and Professional Publishing. All rights reserved. T H I R D E D I T I O N PowerPoint Presentation by Charlie Cook The University of West Alabama Finding the Best Mix of Financial Instruments— The Theory of Portfolio Choice and Efficient Markets Chapter 7 Unit II Financial Markets and Instruments

2. © 2006 Thomson Business and Professional Publishing. 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.How are the prices of financial instruments determined in efficient markets?

3. © 2006 Thomson Business and Professional Publishing. 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.

4. © 2006 Thomson Business and Professional Publishing. All rights reserved.7–4 Saving and Wealth Not all forms of wealth are tradable however, such as your human capital: Thus financial wealth focuses just on the part of your wealth that you hold as financial instruments, such as stocks, bonds, mutual funds, etc. Wealth is a stock variable: measured at a point in time. Why do we save? In a sense, saving is delayed consumption: we save now to expand our ability to consume later.

5. © 2006 Thomson Business and Professional Publishing. All rights reserved.7–5 Financial Portfolios Portfolio:  The group of financial instruments held by an individual, which together make up the individual’s financial wealth.

6. © 2006 Thomson Business and Professional Publishing. All rights reserved.7–6 Aggregate Portfolio Allocations of U.S. Households Figure 7–1 SOURCE: Flow-of-Funds Accounts, Board of Governors of the Federal Reserve System, June, 2005.

7. © 2006 Thomson Business and Professional Publishing. All rights reserved.7–7 Financial Portfolios Fundamental determinants of portfolio choice:  Individual wealth  Expected asset returns  Asset liquidity  Information costs  Asset Risk

8. © 2006 Thomson Business and Professional Publishing. All rights reserved.7–8 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.

9. © 2006 Thomson Business and Professional Publishing. All rights reserved.7–9 Wealth elasticity of demand E w = %  Quantity Demanded of an asset %  Individual’s wealth Note, this is very similar to the income elasticity of demand you should have studied in microeconomics.

10. © 2006 Thomson Business and Professional Publishing. All rights reserved.7–10 Wealth elasticity of demand Consider two students: the Prince has $100,000 in financial wealth, the pauper has $1,000. Assume the pauper keeps $500 in a checking account, $500 in a savings account. The Prince keeps$20,000 in a checking account, and 80,000 in a savings account. Both win $1,000. For the pauper, this mean a 100% rise in financial wealth: for the prince, only a 1% rise.

11. © 2006 Thomson Business and Professional Publishing. All rights reserved.7–11 Assume the pauper puts 250 into the checking account, the rest (750)into savings. Thus he raised his checking account by 50% (from 500 to 750), and he raised his savings account by 150% (from 500 to 1250) Thus for the checking asset, his E w = 50% =.5 and for the savings asset its E w = 150 = 1.5 100% 100 Say the prince puts 100 into checking, 900 into savings. His checking account went from 20,000 to 20,100, a one-half of one percent increase (.5%). His savings went from 80,000 to 80,900, a 1.125% increase. E w =.5% =.5 and for the savings asset its E w = 1.125% = 1.125 1% 1% In both cases, the E w for checking accounts is less than one, and for savings accounts is greater than 1.

12. © 2006 Thomson Business and Professional Publishing. All rights reserved.7–12 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.

13. © 2006 Thomson Business and Professional Publishing. All rights reserved.7–13 The Wealth Elasticity of Asset Demand In general, less wealthy individuals have a higher wealth elasticity of demand for many financial assets.

14. © 2006 Thomson Business and Professional Publishing. All rights reserved.7–14 Factors affecting portfolio choice Expected Asset Returns: all else equal, we often choose assets with the highest expected return. Asset Liquidity: in some cases, people sacrifice a higher rate of return in exchange for assets that are easier to sell and thus more liquid. Information costs: Information is asymmetric: people who issue financial instruments have info that the buyers do not.More costly it is to gather info, less desirable an instrument is.

15. © 2006 Thomson Business and Professional Publishing. All rights reserved.7–15 Asset Risk Risk aversion:  The preference, other things being equal, to hold assets whose returns exhibit less variability.  Most people are somewhat risk averse, but some are risk lovers.

16. © 2006 Thomson Business and Professional Publishing. All rights reserved.7–16 Asset Risk 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.

17. © 2006 Thomson Business and Professional Publishing. All rights reserved.7–17 Factors That Influence Portfolio Choice Effect of an Increase in Factor Factoron Desired Asset Holdings WealthIncrease Expected asset returnIncrease Asset liquidityIncrease Information costsDecrease Asset riskDecrease Table 7–1

18. © 2006 Thomson Business and Professional Publishing. All rights reserved.7–18 Portfolio Choice Leads to a question: if people dislike risk, and like higher returns, why might they hold some financial wealth in risky and/or low return assets? One answer is people like to diversify their portfolios, which helps reduce the overall level of risk.

19. © 2006 Thomson Business and Professional Publishing. All rights reserved.7–19 Domestic and 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. Diversification can help reduce idiosyncratic risk. Market risk:  Risk that is common to all financial assets within a portfolio; also called systematic risk.

20. © 2006 Thomson Business and Professional Publishing. All rights reserved.7–20 Market risk Market risk can be due to say, a recession, that might affect a wide range of financial instruments. Diversification cannot eliminate market risk.

21. © 2006 Thomson Business and Professional Publishing. All rights reserved.7–21 Net Portfolio Returns and Trading Turnover Rates Figure 7–2 SOURCE: Brad Barber and Terrance Odean, “Trading Is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors,” Journal of Finance 55 (April 2000): 773–806.

22. © 2006 Thomson Business and Professional Publishing. All rights reserved.7–22 Portfolio Diversification within and across Borders Beta: Identifying Assets with Diversifiable Risks  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.  A lower beta indicates more diversifiable risk that can be reduced by holding diversified portfolios: higher beta the opposite.

23. © 2006 Thomson Business and Professional Publishing. All rights reserved.7–23 Portfolio Diversification within and across Borders International Portfolio Diversification  One reason (among others) for holding financial instruments issued overseas is the desire to achieve international portfolio diversification.  A recession in the US for example, does not always mean other parts of the world are in recession as well.

24. © 2006 Thomson Business and Professional Publishing. All rights reserved.7–24 The Efficient-Markets Hypothesis Recall the formula for bond prices from chapter 4: P = C 1 / ( 1 + r ) 1 + C 2 / ( 1 + r ) 2 + … + C n / ( 1 + r ) n + F / ( 1 + r ) n Price will have to reflect peoples expectations of future market interest rates.

25. © 2006 Thomson Business and Professional Publishing. All rights reserved.7–25 The Efficient-Markets Hypothesis Efficient-markets hypothesis:  A theory that stems from the application of the rational expectations hypothesis to financial markets.  It states that equilibrium prices of and returns on financial instruments should reflect all past and current information plus traders’ understanding of how market prices and returns are determined.  In general, by this theory, the price of any asset should reflect traders forecast of the returns of the asset.

26. © 2006 Thomson Business and Professional Publishing. All rights reserved.7–26 The Expected Price of a Financial Instrument P e :  The expected average, or mean value, of the market price. P f :  The forecast value for the market price. P f = P e  When all traders form their individual forecasts rationally, their forecasts typically will correspond to the average market price.

27. © 2006 Thomson Business and Professional Publishing. All rights reserved.7–27 The Efficient-Markets Hypothesis P e is the average or mean price: based on supply and demand factors, and people’s expectations of market factors as a while: also called the market expectation of the financial instruments price.

28. © 2006 Thomson Business and Professional Publishing. All rights reserved.7–28 The Efficient-Markets Hypothesis P f is the forecast price by traders of the instrument. Should use all relevant information of factors that affect the price of the instrument. Thus the forecast price should typically be as good as the average price, because otherwise traders would seek better information and use this in their forecast.

29. © 2006 Thomson Business and Professional Publishing. All rights reserved.7–29 The Efficient-Markets Hypothesis Thus traders forecasts should conform to the mean price so that P f = P e

30. © 2006 Thomson Business and Professional Publishing. All rights reserved.7–30 Actual And Forecast Prices Of Financial Instruments Actual price ( P ):  Reflects random factors that could not be anticipated in advance. Market price ( P e ) and Forecast ( P f ) price :  The financial instrument’s average price ( P e ) plus an unpredictable random component (e):

31. © 2006 Thomson Business and Professional Publishing. All rights reserved.7–31 Can People Beat the Market? In an efficient financial market, there should be no unexploited opportunities for traders to earn higher returns.  Unpredictable changes can of course occur  Persistent/predictable (fundamental) changes are known to all and thus the price reflects this info. Unexploited information offers only temporary advantage.