financial economics chapter 17 mcgraw-hill/irwin copyright © 2009 by the mcgraw-hill companies,...
TRANSCRIPT
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 market17-2
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 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 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 yearsX
( 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
NorwaySwitzerland
LuxembourgJapanChile
ChinaMexico
United StatesIndonesia
IndiaGhana
NigeriaIraq
ZimbabweSomalia
0 20 40 60 80 100
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
compensatesfor risk
Compensate investors for:•Time preference•Nondiversifiable risk
Average expected
rate of return= if + risk premium
17-12
The Security Market Line
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)
17-13
The Security Market Line
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
Risk levels determine average expected rates of return
Y
17-14
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
17-15
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
Y2
A Before Increase
A After Increase
SML 2
Y1
17-16
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