4751 - Financial Economics Summer 2011

1. 4751 - Financial Economics Summer 2011

2. 4751 - Financial Economics • My Name: Rene Schwengber • Today: • Syllabus • Introduction • BKM chapter 1

3. Syllabus • Grade from 3 sources (each worth 1/3) • average homework • First exam (July 1st, in class) • Second exam (July 22nd, in class) • Homework’s typed and stapled • otherwise cap maximum grade at 75% • I will not accept emailed homeworks. • If you can’t submit homework in due date in class, talk to me first.

4. Webpage and other content • Our webpage is http:www.econ.umn.edu/~schwe227(click on teaching) • Our required book is BKM. • We will also use other books for content that required more depth.

5. Other • Office Hours: • TBA, and by appointment.

6. Intro • Investment (noun) current commitment of money or other resources in the expectation of reaping future benefits • Intertemporal allocation of resources • Time (for “risk-free” investments) • Uncertainty (Risky) • Examples of risky investment? • (list examples) • Example of risk-free investment? • (list examples)

7. Real Assets Versus Financial Assets • Real Assets >____________< • Examples: Land, buildings, machines, knowledge used to produce goods and services • Financial Assets >____________<

8. Financial Assets Three types: Fixed income or debt >____________< Common stock or equity >____________< Derivative securities >____________<

9. Financial Assets vs. Real Assets polling Which type of assets do you think is most important in an economy? Real assets. How important do you think financial assets are in a modern well functioning economy? Very ______ Not that much ______

10. Class vote How important financial assets are in a modern well functioning economy? ____ “Very” vs. ____ “Not that much” Let’s hear this 4minutes clip. http://hhei.umn.edu/videos/video3.html About in 3’40’’ to 5’30”

11. Example: Dutch East India Company • As mentioned in the video. Financial assets are important in a well functioning economy since they provide some means on how to best allocate resources at any given time. • Consider the Dutch East India Company example. • Chartered company • Founded in 17th century defunct almost in 19th century • Fist company to issue Stock (financial asset)

12. Example: Dutch East India Company • Consider the Dutch East India Company • What is a stock? • Stock or equity is a claim of ownership on a firm. • Payoff of exploration was potentially very big (high gains) but so was its risk (e.g. loss ship) • Idea: Spread risk by financing more than one expedition at once. • Many claim this was one of the major force behind the Dutch growth in maritime power in that period (and believe, the growth and power of this mega-coroporation was every big)

13. Investment Example • The goal of investing in simple: • Maximize (today and future) utility while allocating current resources into real and financial assets. • Assume agents value streams of daily consumption. • (c1, c2, c3, c4) (a vector) gives Utility U(c1, c2, c3, c4) (a number) • E.g.: Stream 1: (1,1,1,97) vs. Stream 2 (25,25,25,25) • Which would you rank higher? • Most would prefer the 2nd stream of consumption • This type of question is studied under the label “Theory of Choice (under uncertainty)”. We will spend some time talking about it

14. Financial Markets and the Economy Information Role: >____________< Consumption Timing: >____________<

15. Financial Markets and the Economy (Ctd.) Allocation of Risk: >____________< Separation of Ownership and Management: >____________<

16. General problem • A well-developed economy with financial markets provides: • intertemporal allocation of resources • Insurance • against bad shocks • decreasing volatility • You can think of a financial assets as the means of decreasing the friction on resource allocation in the economy

17. The Investment Process Asset allocation Choice among broad asset classes Security selection Choice of which securities to hold within asset class Security analysis to value securities and determine investment attractiveness

18. Markets are Competitive Risk-Return Trade-Off The will always be risk associated to investments.

19. Markets are Competitive (Ctd.) Efficient Markets Passive Management No attempt to find undervalued securities No attempt to time the market Holding a highly diversified portfolio Active Management Finding mispriced securities Timing the market

20. Last Announcement • Read Chapter 1 from BKM (focus on 1.1 to 1.5) • Read Chapter 2 of Theory of Value (link in class webpage) • We will review basic concepts from basic probability theory. • What time Office Hours works for most?