Topic 8 Financial Economics Financial Investment Economic investment

Topic 8 Financial Economics

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

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 –$116. 64 in two years –$125. 97 in three years

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:

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

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

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

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

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

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 company

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

Investment Returns

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)

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

The Security Market Line Expected rate of return Market Portfolio Security Market Line A Risk-free Asset (i. e. , a short-term U. S. Government bond) Risk Premium for The Market Portfolio’s Risk Level of beta=1. 0 if Compensation For Time Preference Equals if 0 1. 0 Risk Level (beta)