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Financial Economics Financial Economics-studies investor preferences & hoe they affect the trading &pricing of financial assets

like stock, bonds & real state. Two most important investor preference are: -desire for high rates of return; -dislike of risk & uncertainty. Economic Investment-refers either to paying for a new addition to the capital stock or new replacements for capital stock that has worn out. Financial Investment-refers to either buying an asset or building an asset in the expectation of financial gain. Present Value-is the presentday value or worth of returns or cost that are expected to arrive in the future. Compound Interest-it describes how quickly an investment increases in value when interest is paid or compounded not only on the original amount but also on all the interest payments that have been previously made. Formula:(equation 1) X dollar today=X dollar in t years (1+i) Where: X dollar today-is the value of money at present. X dollar in t years- is the value of money at future time. i -is the interest rate. t - time The Present Value Model-rearranging the equation 1 to make it easier to transform future amount of money into present amount of money Formula:(equation 2) (X dollars today)/(1+i)^t =X dollars in t years OR X dollars in t years =X dollar today(1+i)^(-t) Three Features of Investment They require that investors pay some price to acquire them They give their owners the chance to receive future payments The future payments are typically risky Popular Investments Stocks Bonds Mutual Fund STOCKS : certificate of ownership It is the interest of the owners of a corporation. It is divided into shares, with each share representing a portion of the total ownership interest. Major Classes of Corporate Stock Common Stock A stock issued by a corporation which represents a real equity capital. It has a residual claim (after debts have been paid) to earnings and assets, and which carries the risk of business success or failure. Preferred Stock A stock which has a claim on assets before common stock, in the event that the firm is insolvent; and it also has a prior claim to dividends up to a specified amount or rate. It gives preferred stockholder the right to receive their stated dividends before any earnings can be distributed to common stockholders. * limited liability rule limits the risk involved in investing in corporations and encourages investors to invest in stock by capping their potential losses at the amount that they paid for their shares. * dividends is a distribution of corporate income to its shareholders on a pro rata basis. BONDS : certificate of indebtedness A formal unconditional promise made under seal to pay a specified sum of money at a determinable future date, and to make periodic interest payments at a stated rate until the principal sum is paid. Kinds f Bonds Government Bonds Are those issued by the government in its own currency to finance its activities.

Corporate Bonds Are those issued by the private corporations to finance their long-term funding requirements. * if the price of the bond is higher than the par value, it is said to be bought at a premium. * if the price of the bond is lower than the par value, it is said to be bought at a discount. * if the price of the bond is equal to the face value, it is called par bond. Bond Yields Is essentially the amount or percentage of return that an investor can anticipate to receive from a bond issue within a specified period. Yield to Maturity is the rate of return that an investor would earn if he bought at its current market price and held until maturity. Yield to Call is the rate of return that an investor would earn if he bought a callable bond at its market price and held it until the call date given that the bond was called on the call date. Current Yield is the annual interest payment on a bond divided by the current price. MUTUAL FUNDS Is a company that maintains a professionally managed portfolio, or collection, of their stocks or bonds. RETURN is the total gain or loss experienced on an investment over a given period of time; calculated by dividing the assets cash distributions during the period, plus change in value, by its beginning-of-period investment value. Rate of Return = (cash inflow + market value) cost of investment cost of Investment Arbitrage- happens when investors try to take advantage and profit from situations where two identical or nearby identical assets have different rates of return. Risk-refers to the fact that investors never know with total certainty what those future payments will turn out to be. Diversification-is the name given to strategy of investing in a large number of investment in order to reduce the overall risk to the entire portfolio. Two component of Diversification Diversifiable risk-(idiosyncratic risk) is the risk that is specific to a given investment and that can be eliminated by Diversification. Non- Diversifiable risk-(systemic risk) pushes all investment in the same direction at the same time, so that there is no possibility of using good effects to offset bad effect. Comparing Risky Investment Two standard measures of return and risk 1.Average Expected rate of return-is the probability weighted average of the investments possible future rate of return. *probability weighted average-means that each of the possible future rate of return is multiplied by its probability before being added together to obtain the average. 2.Beta-popular statistics that measures risk. -relative measure of non- diversifiable risk Es = rf + Bs(Emkt - rf) Where: rf = the risk-free rate Bs = the beta of the investment Emkg = the expected return of the market Es = the expected return of the investment Relationship of risk and average expected rates of return *risk levels and average expected rates of return are positively related -the more risky an investment is the higher its average expected rates of return will be. The risk-free rate of return. Time preference-refers to the fact that because people tend to be impatient, they typically prefer to consume things in the present than in the future. The Security market Line

Security Market Line Which indicates how this compensation is determined for all assets no matter what their respective risk levels happen to be. A line that shows the average expected rate of return of all financial investments at each level of nondiversifiable risk, the latter measured by beta. Any investments average expected rate of return has to be sum of two parts one that compensates for the preference and another that compensates for risk. That is, Average expected = rate that compensates for rate of return time preference + rate that compensates for risk Compensates for time preference The human tendency for people, because of impatience, to prefer to spend and consume in the present rather than save and wait to spend and consume in the future; this inclination varies in strength among individuals. Average expected = if+ rate that compensates rate of return for risk Compensates for risk The uncertainty as to the actual future returns of a particular financial investment or economic investment. Average expected rate of return = if +risk premium Risk premium - the interest rate above the risk-free interest rate that must be paid and received to compensate the lender or investor for risk. THE SECURITY MARKET LINE The Security Market Line shows the relationship between averages expected rates of return and risk levels that must hold for every asset or portfolio trading in the financial markets. Each investments average expected rate of return is the sum of the risk-free interest rate that compensates for time preference as well as a risk premium that compensates for the investments level risk. The Security Market Lines upward slope reflects the fact that investors must be compensated for higher levels of risk with higher average expected rates of return. RISK LEVELS DETERMINE AVERAGE EXPECTED RATES OF RETURN The Security Market Line can be determining an investments average expected rate of return based on its risk level. Investments having a risk level of beta=X will have an average expected rate of return Y percent per year. This average expected rate of return will compensate investors for time preference in addition to providing them exactly the right sized risk premium to compensate them for dealing with a risk level of beta=X. ARBITRAGE AND THE SECURITY MARKET LINE Arbitrage pressures will tend to more any asset or portfolio that lies off of the Security Market Line back onto the Security Market Line. For instance, asset A has an average expected rate of return that exceeds the average expected rate of return Y that the Security Market Line tells us is necessary to compensate investors for time preference and for dealing with risk level beta=X. as a result, asset A will become very popular and many investors will rush to buy it. This will drive its price up and (because prices and average expected rate of return are inversely related) drive its average expected rate of return down. Arbitrage will continue to happen until point A moves vertically down onto the SML. Arbitrage also will cause asset C, whose average expected rate of return is too low, to move up vertically onto the SML because as investors begin sell asset C (because its average expected rate of return is too low), its price will fall, thereby raising its average expected rate of return. AN INCREASE IN THE RISK-FREE RATE The risk-free interest rate set by the Federal Reserve is the SMls vertical intercept. Consequently, if the Federal Reserve increases the risk-free interest rate, the SMLs vertical intercept will move up. This rise in the risk-free interest rate will result in a decline in all asset prices and thus an increase in the average expected rate of return on all asset. So the SML will shift up parallel from SML1 to SML2. Here, asset A with risk level beta=X sees its average expected rate of return rise from Y1 to Y2.