Chapter 34: Financial Economics

Financial investment

Either buying an asset or building an asset in the expectation of financial gain

Economic investment

Either to paying for new additions to the capital stock or new replacements for capital stock that has worn out

Present value

The present-day value, or worth, of returns or costs that are expected to arrive in the future

Compound interest

How quickly an investment increases in value when interest is paid, or compounded, not only on the original amount invested but also on all interest payments that have been previously made

Stocks

Ownership shares in a corporation

Bankrupt

Unable to make timely payments on their debts

Limited liability rule

Limits the risks involved in investing in corporations and encourages investors to invest in stocks by capping their potential losses at the amount that they paid for their shares

Capital gains

Investors sell their shares in the corporation for more money than they paid for them

Dividends

Equal shares of the corporation’s profits

Bonds

Debt contracts that are issued most frequently by governments and corporations

Default

The corporation or government that issued the bond will fail to make the bond’s promised payments

Popular investments

________ are stocks, bonds, and mutual funds.

Mutual fund

A company that maintains a professionally managed portfolio

Portfolio

A collection of either stocks or bonds

Index funds

Portfolios are selected to exactly match a stock or bond index

Actively managed funds

Have portfolio managers who constantly buy and sell assets in an attempt to generate high returns

Passively managed funds

Assets in their portfolios are chosen to exactly match whatever stocks or bonds are contained in their respective underlying indexes

Percentage rate of return

The percentage gain or loss (relative to the buying price) over a given period of time, typically a year

Arbitrage

When investors try to take advantage and profit from situations where two identical or nearly identical assets have different rates of return

Risk

The fact that investors never know with total certainty what those future payments will turn out to be

Diversification

The strategy of investing in a large number of investments in order to reduce the overall risk to the entire portfolio

Diversifiable risk

The risk that is specific to a given investment and that can be eliminated by diversification

Non-diversifiable risk

Pushes all investments in the same direction at the same time so that there is no possibility of using good effects to offset bad effects

Average expected rate of return

The probability weighted average of the investment’s possible future rates of return

Probability weighted average

Each of the possible future rates of return is multiplied by its probability expressed as a decimal (so that a 50 percent probability is .5 and a 23 percent probability is .23) before being added together to obtain the average

Financial investment

Either buying an asset or building an asset in the expectation of financial gain

Economic investment

Either to paying for new additions to the capital stock or new replacements for capital stock that has worn out

Present value

The present-day value, or worth, of returns or costs that are expected to arrive in the future

Compound interest

How quickly an investment increases in value when interest is paid, or compounded, not only on the original amount invested but also on all interest payments that have been previously made

Stocks

Ownership shares in a corporation

Bankrupt

Unable to make timely payments on their debts

Limited liability rule

Limits the risks involved in investing in corporations and encourages investors to invest in stocks by capping their potential losses at the amount that they paid for their shares

Capital gains

Investors sell their shares in the corporation for more money than they paid for them

Dividends

Equal shares of the corporations profits

Bonds

Debt contracts that are issued most frequently by governments and corporations

Default

The corporation or government that issued the bond will fail to make the bonds promised payments

Mutual fund

A company that maintains a professionally managed portfolio

Portfolio

A collection of either stocks or bonds

Index funds

Portfolios are selected to exactly match a stock or bond index

Actively managed funds

Have portfolio managers who constantly buy and sell assets in an attempt to generate high returns

Passively managed funds

Assets in their portfolios are chosen to exactly match whatever stocks or bonds are contained in their respective underlying indexes

Percentage rate of return

The percentage gain or loss (relative to the buying price) over a given period of time, typically a year

Arbitrage

When investors try to take advantage and profit from situations where two identical or nearly identical assets have different rates of return

Risk

The fact that investors never know with total certainty what those future payments will turn out to be

Diversification

The strategy of investing in a large number of investments in order to reduce the overall risk to the entire portfolio

Diversifiable risk

The risk that is specific to a given investment and that can be eliminated by diversification

Non-diversifiable risk

Pushes all investments in the same direction at the same time so that there is no possibility of using good effects to offset bad effects

Average expected rate of return

The probability weighted average of the investments possible future rates of return

Probability weighted average

Each of the possible future rates of return is multiplied by its probability expressed as a decimal (so that a 50 percent probability is .5 and a 23 percent probability is .23) before being added together to obtain the average

Beta

Measures how the non-diversifiable risk of a given asset or portfolio of assets compares with that of the market portfolio

Market portfolio

The name given to a portfolio that contains every asset available in the financial markets

Time preference

Because people tend to be impatient, they typically prefer to consume things in the present rather than in the future

Risk-free interest rate

The rate of return that they generate is not in any way a compensation for risk

Security Market Line

Any investments average expected rate of return has to be the sum of two parts-one that compensates for time preference and another that compensates for risk

Risk premium

The rate that compensates for risk

Beta

Measures how the non-diversifiable risk of a given asset or portfolio of assets compares with that of the market portfolio

Market portfolio

The name given to a portfolio that contains every asset available in the financial markets

Time preference

Because people tend to be impatient, they typically prefer to consume things in the present rather than in the future

Risk-free interest rate

The rate of return that they generate is not in any way a compensation for risk

Security Market Line

Any investment’s average expected rate of return has to be the sum of two parts—one that compensates for time preference and another that compensates for risk

Risk premium

The rate that compensates for risk