Financial Economics
Chapter 17
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Financial Investment
 Economic investment
 Paying for new additions to the capital stock or new
replacements for capital stock that has worn out
 Examples: new factories, houses, retail stores,
construction equipment, & wireless networks
 Financial investment
 Includes economic investment
 Buying an asset or building in the expectation of
financial gain
 Does not distinguish between old & new assets
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Present value
 Present-day value or worth of returns or costs
that are expected to arrive in the future
 Compound interest
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Describes how quickly an investment
increases in value when interest is paid
X Dollars today = (1+i)tX dollars in t years
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Present value model
 Simply rearranges compound interest formula
to transform future amounts of money into
present amounts of money
 See equation (2) on page 336
 The asset’s price should exactly equal the
total present value of all of the asset’s future
payments
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Applications
 Take the money & run?
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Winners of state lotteries are typically paid
their winnings in equal installments spread out
over 20 years
Some people (ex. Elderly) want money now
because they may not live long enough to
collect all payments
Swap with private financial company
Present value is used to determine the value
of the lump sum that lottery winners receive
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Salary caps & deferred compensation
 Upper limits on the total amount of money
that each team can spend on salaries during
a given season
 Player contracts are typically for multiple
seasons
 Players are asked to defer some of their
contract to later years so the team will be
within the salary cap
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Some popular investments
 Stocks
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Ownership shares in a corporation
Able to vote at shareholder meetings
Limited liability
Dividends
Capital gains
 Bonds
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Debt contracts that are issued most frequently by
governments & corporations
Seller must pay interest
Possibility of default on bond
Bonds are more predictable than stocks (highly volatile
because they depend on profits)
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Popular investments (cont.)
 Mutual funds
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A company that maintains a professionally
managed portfolio (collection of stocks/bonds)
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Index funds
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Portfolios selected to exactly match a stock or
bond index (i.e. S&P 500)
Actively vs. passively managed funds
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 Calculating investment returns (percentage
rate of return)
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Percentage gain or loss (relative to buying
price) over a given period of time
 Asset prices and rates of return
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Inversely related
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Arbitrage
 Happens when investors try to take advantage and
profit from situations where two identical or nearly
identical assets have different rates of return
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Simultaneously sell the asset with the lower return &
buy asset with higher return
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Problem: prices of two companies will change – and
with them, the rates of return on the two companies
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Convergence will happen. Rates of return will be equal
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Risk
 Investors never know with total certainty what
those future payments will be
 Many factors affect an investment’s future
payments
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Diversification
 Strategy of investing in a large number of
investments
 Reduces overall risk of your portfolio
 “Don’t put all your eggs in one basket”
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 Diversifiable risk
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Risk that is specific to a given investment
Can be eliminated by diversification
 Nondiversifiable risk
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Pushes all investments in the same direction
at same time
No possibility of using good effects to offset
bad effects
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Comparing risky investments
 Average expected rate of return
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Probability weighted average of the
investment’s possible future rates of return
 Probability weighted average
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Each of the possible future rates of return is
multiplied by its probability
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 Beta
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Relative measure on nondiversifiable risk
Measures how the nondiversifiable risk of a given
asset or portfolio of assets compares with that of
the market portfolio
 Market portfolio
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Name given to a portfolio that contains every
asset available in financial markets
Useful standard of comparison because it’s as
diversified as possible
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Relationship of risk & average
expected rates of return
 Investors dislike risk
 Risk & uncertainty causes investors to pay higher
prices for less-risky assets & lower prices for morerisky assets
 Asset prices & average expected rates of return are
inversely related
 Less risky assets will have lower average expected
rates of return than more risky assets
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 Risk levels & average expected rates of
return are positively related
 Think of higher average expected rates of
return as being a form of compensation
 This affects all assets (stocks, bonds, real
estate, etc.)
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The risk-free rate of return
 Short-term U.S. government bonds are
considered to be risk-free
 Almost no chance that the U.S. government
will not be able to repay these loans on time
& in full
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 Time preference
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People tend to be impatient
Prefer to consume things in the present rather
than future
 Risk-free interest rate
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Rate of return earned by short-term U.S.
government bonds
Rate of return that they generate is not in any
way a compensation for risk
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Security market line
 Indicates how compensation is determined for all assets no
matter what their respective risk levels happen to be
 An investment’s average expected rate of return has to be sum
of two parts: One that compensates for time preference
 Another that compensates for risk
 Compensation for time preference is = to risk-free interest
rate
 Risk premium
 Rate that compensates for risk
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An increase in the risk-free rate
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