Chapter34 - mcc75691_ch34_687-705.indd Page 687 5:43:51 AM...

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34 IN THIS CHAPTER YOU WILL LEARN: 1 The idea of present value and why it is critical in making fi nancial decisions. 2 About the most popular investments: stocks, bonds, and mutual funds. 3 How investment returns compensate for being patient and for bearing risk. 4 About portfolio diversifi cation and why it implies that investors can focus on nondiversifi able risk when evaluating an investment opportunity. 5 Why higher levels of nondiversifi able risk are associated with higher rates of return. 6 Why even professionals have a hard time trying to “beat the market.” Financial economics studies investor preferences and how they affect the trading and pricing of financial assets like stocks, bonds, and real estate. The two most important investor preferences are a desire for high rates of return and a dislike of risk and uncertainty. This chapter will explain how these preferences interact to produce a strong positive relationship between risk and return: the riskier an investment, the higher its rate of return. This positive relationship compensates investors for bearing risk. And it is enforced by a powerful set of buying and selling pressures known as arbitrage, which ensures consis- tency across investments so that assets with identical levels of risk generate identical rates of return. As we will demonstrate, this consistency makes it extremely difficult for anyone to “beat the market” by finding a set of investments that can generate high rates of return at low levels of risk. Instead, investors are stuck with a trade-off: If they want higher rates of return, they must accept higher levels of risk. On average, higher risk results in higher returns. But it can also result in large losses, as it did for investors in subprime mortgage loans in late 2007 and in 2008. ±Financial±Economics± 687
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PART EIGHT Money, Banking, and Monetary Policy 688 ±Financial±In vestment± Financial economics focuses its attention on the invest- ments that individuals and firms make in the wide variety of assets available to them in our modern economy. But before proceeding, it is important for you to recall the difference between economic investment and financial investment. Economic investment refers either to paying for new additions to the capital stock or new replacements for capi- tal stock that has worn out. Thus, new factories, houses, retail stores, construction equipment, and wireless net- works are all good examples of economic investments. And so are purchases of office computers to replace computers that have become obsolete as well as purchases of new com- mercial airplanes to replace planes that have served out their useful lives. In contrast, financial investment is a far broader, much more inclusive concept. It includes economic investment and a whole lot more. Financial investment refers to either buying an asset or building an asset in the expecta- tion of financial gain. It does not distinguish between new assets and old assets. Purchasing an old house or an old fac-
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Chapter34 - mcc75691_ch34_687-705.indd Page 687 5:43:51 AM...

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