Introduction_Fall2011 - Investments and Security Markets...

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Investments and Security Markets George Korniotis 514J Jenkins Building University of Miami Coral Gables, FL 33124 Email: [email protected] Phone: (305) 284-5728. Fall 2011
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Lecture Notes 1 Investment Theory: Introduction Covers BKM, Chapters 1 and 2 (Partially). Main Topics 1. Introduction 2. Why do people invest? 3. What role does financial markets play in the growth of the economy? 4. Main goal of investment 5. Risk versus uncertainty; Gambling versus investing 6. Theoretical foundations FIN 320 Lecture Notes, Korniotis, Fall 2011 Page 1
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1. Introduction: A Thought Exercise To understand the importance of financial markets and investments, imagine a world in which there are no financial markets and people are not allowed to invest. How would such an economy operate? Micro-Level (Investors) No financial institutions that would allow lending and borrowing. There will be no loans, no credit cards. Cash only economy. Can save only using cash (a “financial instrument” with small negative return = inflation rate). Difficult to smooth consumption. Macro-Level (Firms, Economy) Entrepreneurial activities would not be encouraged and rewarded and therefore public companies would not exist. Resources may not channeled to economic activities that need them the most. Slower economic growth. Social welfare reduced. Overall financial markets provide the “plumbing” for a well func- tioning economy. FIN 320 Lecture Notes, Korniotis, Fall 2011 Page 2
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What is an investment? Sacrifice something of value now (i.e., commit some resources now), expecting to benefit from it in the future. Why? You would only make this sacrifice if the benefit from future consumption is expected to be higher than the benefit of consuming now. For example, we want to save for retirement while young and employed. This goal can be achieved by purchasing financial assets. Financial assets: claims on real assets such as land, buildings, technology, machinery, knowledge, human capital, etc. The holder of the financial asset gets a part of the cash flow generated by these real assets. There are three factors that are likely to influence an individual’s investment decisions. Risk Aversion: T-bills, Bonds, Stocks, Index funds, ETFs, Ac- tive mutual funds, Options, etc. Investment Horizons: Short term versus long term capital gains. Taxes: Dividends versus capital gains. FIN 320 Lecture Notes, Korniotis, Fall 2011 Page 3
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2. Why do people invest? To smooth consumption: People do not like sudden shocks and wish to maintain a constant (and, hopefully, an increasing) standard of living. The desired consumption level might be determined by the aver- age past consumption level (“internal habit”) or the consumption level of the neighbors or peers (“external habit”). People’s consumption needs vary with age.
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