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