18. Financial Assets and Asset Prices

What to do with savings?

Deposit in a bank

Bonds

Shares (equity)

Property

Fine art, wine

What is a bond?

An IOU issued by a government or company

Investor gives bond issuer their money and the issuer agrees to pay the money back later and pay some interest

What can bond owners do with bonds?

Sell to another investor via financial markets

How often do prices for bonds change?

Daily

Principal

Initial amount loaned to bond issuer

Maturity

Amount of time left until final repayment of principal and/or interest of the bond

Coupon Payments

Occasional interest payments made by the bond issuer to bond holders

Zero Coupon bond

Bond that only pays out a sum on the day the bond matures

Duration

Weighted average of the times until the various payments are made

T-Bills

Short term government bonds (<1 year)

Shares

Another way firms can raise money

Investors give money to the firm and in return get shares which entitle them to partial ownership of the firm

Why do people usually buy shares from other investors than directly from the firm?

Shares are widely traded on financial markets

How do companies issuing risky assets overcome risk aversion

Offer higher average returns than returns available on safe assets

Does risk aversion differ across groups?

Yes, eg. Women and older people are more risk averse

What does the issuer defaulting mean?

Why does the issuer default?

Financial difficulties - they are not able to pay back

When do shares pay off for investors?

Company makes enough profits to make dividends

What happens to shares if a company goes bankrupt?

Shares become worthless

Who gets paid first when a company is wound up?

Debts to bond holders, then shareholders

Are bonds or shares riskier?

Shares

Which investments pay the best?

In the long run, stocks/equities

The equity premium puzzle

Excess return on equities over bonds and bills can’t be explained by risk differences alone

Two main factors influencing share price

Future profits, risk

Explain future profits

Expected future dividend payments generated from profits. If profits are expected to go high, share price should be high

Explain risk as a factor influencing share price

Riskiness of companies business. If there is a lot of uncertainty about the company’s future profits, this will tend to reduce the share price

Price-earnings ratios

Ratio of total value of all firms shares to its current earnings

What happens to P/E ratio if profits are expected to grow at a fast rate?

Rise

What does higher risk do to P/E ratios?

Reduce

What are share price indices?

Several indices to summarise how the stock market as a whole is doing

What are the most famous indices in the US?

Dow Jones - index of share prices of 30 well known companies

Standard and Poor’s 500 - based on 500 largest firms by total value of their shares (their market capitalisation)

What is the UK’s most famous index?

FTSE

Who is Robert Schiller?

Publishing P/E ratios for US stock market for many years

Efficient markets hypothesis

Financial markets use all available information in an efficient and rational manner when arriving at prices for assets

Why might market P/E be high?

Investors rationally believed growth prospects were great and risk was low

Bubbles

People buy shares because they expect prices to keep going up but eventually prices crash

Example of a bubble

Dot-com bubble

Explain the Dot-Com bubble

High P/E ratios of late 1990s and early 2000s driven by huge price increases for tech firms

People thought dot com companies would be successful and thought risk was low

Some did become successful but many did not

Does efficient markets hypothesis always apply

No

What is the equivalent of a P/E ratio for property?

Ratio of house prices to rents

What factors drove Irish rise and collapse?

Cheap and easy credit from banks

Tax incentives to encourage property investment

Bubble psychology - need to get on property ladder because prices will keep going up

Were people warned about the housing market crash?

Yes, eg by Morgan Kelly, but these warnings weren’t popular