Chapter 37 _ Financial Economics _ ECON 2020.pdf - \u201cFinancial economics studies investor preferences and how they affect the trading and pricing of

Chapter 37 _ Financial Economics _ ECON 2020.pdf -...

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“Financial economics studies investor preferences and how they affect the trading and pricing of financialassets like stocks, bonds, and real estate. The two most important investor preferences are a desire forhigh rates of return and a dislike of risk and uncertainty. This chapter will explain how these preferencesinteract to produce a strong positive relationship between risk and return: the riskier an investment, thehigher its rate of return. This positive relationship compensates investors for bearing risk. And it is enforcedby a powerful set of buying and selling pressures known as arbitrage, which ensures consistency acrossinvestments so that assets with identical levels of risk generate identical rates of return. As we willdemonstrate, this consistency makes it extremely difficult for anyone to “beat the market” by finding a setof investments that can generate high rates of return at low levels of risk. Instead, investors are stuck with atrade-off: If they want higher rates of return, they must accept higher levels of risk. On average, higher riskresults in higher returns. But it can also result in large losses, as it did for many investors who held riskyassets during the financial crisis of 2007–2008.”37.1 [Financial Investment]: Define financial economics and distinguish between economic investment and financial investment. Economic investmentrefers either to paying for new additions to the capital stock or newreplacements for capital stock that has worn out.Financial investment refers to either buying an asset or building an asset in the expectationof financial gain37.2 [Present Value]: Explain the time value of money and how compound interest can be used to calculate the present value of any future amount of money. The time-value of moneyis the idea that a specific amount of money is more valuable to aperson the sooner it is received, and a person will need to be compensated for waiting to obtain it later.The time-value of money can also be thought of as the opportunity cost of receiving a sum of moneylater rather than earlier.Present value, which is the present-day value, or worth, of returns or costs that are expectedto arrive in the future. The ability to calculate present values is especially useful when investors wishto determine the proper current price to pay for an asset.In fact, the proper current price for any risk-free investment is the present value of its expectedfuture returns. And while some adjustments have to be made when determining the proper price of arisky investment, the process is entirely based on the logic of present value.(1 + i)X0, (1 + i)2X0, (1 + i)3X0. let X0 denote the amount of money at the start of the first year.Xt = (1+i) tX0But notice that the logic of the equality also works in reverse, so that it can also be thought of asshowing that (1 + i)tX0 dollars in t years can be transformed into X0 dollars today.
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