17

Financial Economics

McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

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

LO1 17-2

Present Value

• Present day value of future returns or costs

• Compound interest• Earn interest on the interestX dollars today=(1+i)tX dollars in t

years• $100 today at 8% is worth:

• $108 in one year• $116.64 in two years• $125.97 in three years

LO1 17-3

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 yearsX

( 1 + i)t

LO1 17-4

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

LO1 17-5

Popular Investments

• Wide variety available to investors• Three features

• Must pay to acquire• Chance to receive future payment• Some risk in future payments

LO2 17-6

Stocks

• Represents ownership in a company

• Bankruptcy possible• Limited liability rule• Capital gains• Dividends

LO2 17-7

Bonds

• Debt contracts issued by government and corporations

• Possibility of default

• Investor receives interest

LO2 17-8

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

LO2 17-9

Mutual Funds

• 10 Largest Mutual Funds, February 2010

Fund Name* Assets Under Management, Billions

PIMCO Total Return Institutional $122.9

SPDR Trust I 70.2

American Funds Growth A 64.4

Vanguard Funds Total Stock Index Investor 59.6

American Funds Capital Income Builder A 56.2

Fidelity Contrafund 55.5

American Funds Capital World Growth

and Income A

53.1

American Funds Income A 48.5

Vanguard 500 Index Investor 47.9

American Funds Investment Company of America A 47.6

* The letter A indicates funds that have sales commissions and are generally purchased by individuals through their financial advisors.

Source: Lipper, a Thomson Reuters companyLO2 17-10

Calculating Investment Returns

• Gain or loss stated as percentage rate of return

• Difference between selling price and purchase price divided by purchase price

• Future series of payments also considered into return

• Rate of return inversely related to price

LO2 17-11

Arbitrage

• Buying and selling process to equalize average expected returns

• Sell asset with low return and buy asset with higher return at same time

• Both assets will eventually have same rate of return

LO3 17-12

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

LO3 17-13

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

LO3 17-14

Investment Risks

Luxembourg (1)Norway (2)Brunei (3)

Germany (9)Netherlands (16)

China (28)Japan (31)

United States(36)India (61)

Egypt (81)Russia (101)

Venezuela (127)Congo (138)

Somalia (139)Zimbabwe(140)

0 20 40 60 80 100

Source: International Country Risk Guide, July 2009, © The PRS Group, Inc, http://www.Prsgroup.com/icrg.aspx

Composite Risk Rating

LO3 17-15

The Security Market Line

Average expected

rate of return=

Rate that compensates

for time preference

+Rate that

compensatesfor risk

Compensate investors for:• Time preference• Nondiversifiable risk

Average expected

rate of return= if + risk premium

LO4 17-16

The Security Market Line

LO4

Security MarketLineMarket

Portfolio

if

Ave

rag

e ex

pec

ted

rat

e o

f re

turn

Risk Level (beta)

0 1.0

CompensationFor Time PreferenceEquals if

Risk Premium forThe Market Portfolio’sRisk Level of beta=1.0

A Risk-free Asset(i.e., a short-term U.S.Government bond)

17-17

The Security Market Line

• Risk levels determine average expected rates of return

LO4

Security MarketLine

if

Ave

rag

e ex

pec

ted

rat

e o

f re

turn

Risk Level (beta)

0 X

CompensationFor Time-PreferenceEquals if

Risk Premium forThis Asset’s RiskLevel of beta = X

Y

17-18

The Security Market Line

Security MarketLine

Ave

rag

e ex

pec

ted

rat

e o

f re

turn

Risk Level (beta)

0 X

• Arbitrage and the security market

Y

A

B

C

LO5 17-19

The Security Market Line

SML 1

Ave

rag

e ex

pec

ted

rat

e o

f re

turn

Risk Level (beta)

0 X

• An increase in the risk-free rate

A Before Increase

A After Increase

SML 2

Y1

LO5

Y2

17-20

SML: Applications

• Fed’s expansionary monetary policy led to lower interest rates

• SML shifted downward

• Slope of SML increased due to increased investor risk-aversion

• Stocks fell

LO5 17-21

Index Funds Versus 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 – no chance to exceed average rates of return

LO5 17-22