Introduction to Financial Economics ECON 174/272
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Questions and Answers

What is the primary goal of utility theory?

To study individuals' attitudes toward risk and their choices about consumption and savings.

What are some major constructs of financial economics? (Select all that apply)

  • Valuation of financial assets (correct)
  • Time management
  • Financial markets and instruments (correct)
  • Healthcare decisions

    • Financial economics is primarily concerned with the allocation of resources in financial markets.

    True

    What is discounting in financial economics?

    <p>Decision making over time that recognizes the present value of future money.</p> Signup and view all the answers

    What are index funds?

    <p>Passively managed funds</p> Signup and view all the answers

    How is the gain or loss of an investment typically expressed?

    <p>Percentage rate of return</p> Signup and view all the answers

    According to financial economics, an investment's rate of return is inversely related to its ________.

    <p>price</p> Signup and view all the answers

    What are some examples of underlying assets? (Select all that apply)

    <p>Bonds</p> Signup and view all the answers

    Diversification can completely eliminate all risks in a portfolio.

    <p>False</p> Signup and view all the answers

    Match the following investment types with their descriptions:

    <p>Stocks = Ownership shares in corporations that provide a share in future profits Bonds = Debt contracts promising fixed future payments Mutual funds = Pools of investor money used to buy a portfolio of stocks or bonds</p> Signup and view all the answers

    Derivatives are financial instruments that take their value from the prices of underlying assets.

    <p>True</p> Signup and view all the answers

    A forward contract involves two parties agreeing to buy and sell a certain amount of the underlying commodity or financial asset at a pre-specified price at a specified __________ in the future.

    <p>time</p> Signup and view all the answers

    What is the main purpose of options in the financial market?

    <p>managing risks</p> Signup and view all the answers

    Match the following terms with their definitions:

    <p>Compound Interest = Describes how investments increase in value through compounded interest Limited Liability = Limits the potential losses of shareholders in corporations Mutual Funds = Maintain professionally managed portfolios of stocks or bonds</p> Signup and view all the answers

    What is the primary focus of financial economics?

    <p>Financial investments made by individuals and firms</p> Signup and view all the answers

    Economic investment always involves paying for new additions to a nation's capital stock.

    <p>True</p> Signup and view all the answers

    Define present value in the context of financial economics.

    <p>Present value is the current worth of future returns or costs, calculated based on a discount rate.</p> Signup and view all the answers

    ______ is the fundamental trade-off that investors consider in financial economics.

    <p>Risk and return</p> Signup and view all the answers

    Match the following financial concepts with their descriptions:

    <p>Time Value of Money (TVM) = A sum of money having different values at different points in time Efficient Market Hypothesis (EMH) = Suggests that financial markets efficiently reflect all relevant information Options and Derivatives = Financial instruments with values derived from an underlying asset Agency Theory = Examines the relationship between principals and agents in financial decision-making</p> Signup and view all the answers

    What is the role of stock market agents?

    <p>To facilitate transactions between investors and borrowers</p> Signup and view all the answers

    Who are the providers of funds?

    <p>All of the above</p> Signup and view all the answers

    Financial intermediaries are not necessary in a world of perfect financial markets.

    <p>True</p> Signup and view all the answers

    Financial intermediaries provide _______________ by monitoring costs, liquidity, and risk.

    <p>unique functions</p> Signup and view all the answers

    What is the main advantage of financial intermediaries in terms of risk management?

    <p>All of the above</p> Signup and view all the answers

    What is the role of commercial banks in the transmission of monetary policy?

    <p>To act as a primary channel for implementing monetary policy</p> Signup and view all the answers

    Financial intermediaries can add value to the market.

    <p>True</p> Signup and view all the answers

    What is the main reason for financial intermediation?

    <p>All of the above</p> Signup and view all the answers

    What is adverse selection?

    <p>A situation where borrowers may understate their credit risk, leading to market failure</p> Signup and view all the answers

    Moral hazard occurs when borrowers take _______________ risks after receiving a loan.

    <p>excessive</p> Signup and view all the answers

    What is the channeling of funds?

    <p>The process of matching surplus funds from savers to deficits incurred by borrowers</p> Signup and view all the answers

    What is the term used to describe the risk that can be eliminated in a diversified portfolio?

    <p>Diversifiable risk</p> Signup and view all the answers

    What is the term used to describe the probability weighted average of an investment's possible future rates of return?

    <p>Average expected rate of return</p> Signup and view all the answers

    Investors tend to pay higher prices for less risky assets and lower prices for more risky assets.

    <p>True</p> Signup and view all the answers

    Beta is a relative measure of ______.

    <p>nondiversifiable risk</p> Signup and view all the answers

    Match the following financial instruments with their descriptions:

    <p>Equity Instruments = Represent ownership in a company. Debt Instruments = Represent a loan or an obligation to repay borrowed capital. Derivative Instruments = Derive their value from an underlying asset, index, or rate. Real Assets = Represent ownership or claims on physical assets such as real estate or commodities.</p> Signup and view all the answers

    What can unethical behavior lead to for individuals?

    <p>All of the above</p> Signup and view all the answers

    Ethical conduct involves balancing self-interest with the consequences for other people.

    <p>True</p> Signup and view all the answers

    What is a key ingredient for fostering trust of investors in capital markets?

    <p>Ethical culture</p> Signup and view all the answers

    Ethics ultimately benefits society by facilitating the efficient allocation of ______.

    <p>resources</p> Signup and view all the answers

    What are the two main types of financial instruments?

    <p>Cash instruments and derivative instruments</p> Signup and view all the answers

    Debt-based financial instruments typically last for more than a year.

    <p>True</p> Signup and view all the answers

    ______ represent ownership of an asset.

    <p>Equity-based financial instruments</p> Signup and view all the answers

    Match the following: Asset Classes and Examples

    <p>Short-term debt-based financial instruments = T-bills and commercial paper Long-term debt-based financial instruments = Bonds Equity-Based Financial Instruments = Stocks Foreign Exchange Instruments = Currency futures</p> Signup and view all the answers

    Define a derivative in the context of financial instruments.

    <p>A securitized contract whose value is derived from underlying assets like stocks or bonds.</p> Signup and view all the answers

    What are the two categories of economic agents in the financial system?

    <p>Surplus and deficit spending units</p> Signup and view all the answers

    Who are the suppliers of surplus funds to the financial system?

    <p>Individuals, groups, or organizations with excess funds</p> Signup and view all the answers

    The financial system provides an enabling environment for economic growth and development.

    <p>True</p> Signup and view all the answers

    Commercial banks are the most relevant financial institutions in Nigeria to encourage and mobilize __________.

    <p>savings</p> Signup and view all the answers

    Match the financial instrument with its example:

    <p>Treasury bills = Short-term debt securities issued by the government Insurance companies = Provide risk mitigation through insurance policies Primary Mortgage Institutions = Offer mortgage loans for property purchases Bureau de change = Facilitate currency exchange services</p> Signup and view all the answers

    What is the role of the Central Bank of Nigeria in regulating the financial system?

    <p>Regulation of financial institutions</p> Signup and view all the answers

    What are some factors that affect the evolution of the investment industry?

    <p>Market forces</p> Signup and view all the answers

    What does financial ethics refer to in the context of general ethics?

    <p>Subset of general ethics</p> Signup and view all the answers

    Ethical norms are not crucial for maintaining stability and harmony in social life.

    <p>False</p> Signup and view all the answers

    What concept refers to maintaining consistency between one's words and deeds?

    <p>Integrity</p> Signup and view all the answers

    Study Notes

    Introduction to Financial Economics

    • Financial economics is the study of how individuals and institutions acquire, save, and invest money.
    • It is concerned with building models to derive testable or policy implications from acceptable assumptions.
    • The subject is usually applied to investment decisions, particularly in financial markets, but it also has close links to the parts of microeconomics connected with insurance and saving.

    Background and Objectives

    • Individuals make decisions to determine their consumption in future time periods, and most have income that varies over their lives.
    • Consumers can smooth consumption expenditure by transferring resources between time periods.
    • The primary goal of financial economics is to understand and explain the mechanisms that drive financial markets, asset prices, and the overall allocation of capital in an economy.

    Key Concepts

    • Time: money now is traded for money in the future.
    • Uncertainty (or risk): The amount of money to be transferred in the future is uncertain.
    • Options: one party to the transaction can make a decision at a later time that will affect subsequent transfers of money.
    • Information: knowledge of the future can reduce, or possibly eliminate, the uncertainty associated with future monetary value.

    Utility Theory

    • The primary goal of utility theory is to increase knowledge of individuals' attitudes toward risk and how they make choices about consumption and savings.
    • Utility theory is a branch of microeconomics that studies individuals' attitudes toward risk and how they make choices about consumption and savings.
    • Objectives of utility theory include:
      • Explaining why a person consumes X and saves Y.
      • Identifying how the marginal rate of utility and marginal rate of investment return determine equilibrium of interest rates.
      • Describing the utility functions of risk-averse, risk-neutral, and risk-loving individuals.

    Financial Economics

    • Financial economics is a branch of economics that focuses on the allocation of resources in financial markets.
    • It combines principles from both economics and finance to analyze how individuals, businesses, and governments make decisions regarding the use of financial resources.
    • Financial economics studies the following:
      • Valuation: Determination of the fair value of an asset.
      • Financial markets and instruments: Commodities, stocks, bonds, money market instruments, and derivatives.
    • Financial economics concentrates on decision-making when two considerations are particularly important:
      • Some of the outcomes are risky.
      • Both the decisions and the outcomes may occur at different times.

    Key Components of Financial Economics

    • Asset Pricing: Examines how financial assets are priced in the market.
    • Portfolio Theory: Investigates how investors can construct portfolios to optimize returns while managing risk.
    • Capital Markets: Studies the functioning of financial markets, including stock exchanges and bond markets.
    • Corporate Finance: Analyzes the financial decisions made by companies, including investment decisions, financing strategies, and dividend policies.
    • Behavioral Finance: Integrates insights from psychology into financial economics to understand how psychological factors and biases influence financial decision-making.

    Importance of Financial Economics

    • Financial economics holds significant importance in various aspects of the economy, finance, and decision-making.
    • It aids in the efficient allocation of resources, investment decision-making, risk management, corporate finance, market functioning, and economic policy.
    • Financial economics is essential for understanding the intricate dynamics of financial markets and guiding actions that have far-reaching implications for economies at both micro and macro levels.

    Basic Concepts in Financial Economics

    • Time Value of Money (TVM): The concept that a sum of money has different values at different points in time.
    • Risk and Return: The fundamental trade-off between risk and return.
    • Present Value and Future Value: The current worth of a sum of money and the value of an investment at a specific future date.
    • Capital Budgeting: The process of evaluating and selecting investment projects that involve capital expenditures.
    • Efficient Market Hypothesis (EMH): The idea that financial markets efficiently incorporate and reflect all relevant information.
    • Portfolio Theory: The diversification of investments to optimize returns while minimizing risk.
    • Arbitrage: The process of taking advantage of price differentials in different markets to make a profit with no net investment.
    • Capital Asset Pricing Model (CAPM): A model that describes the relationship between systematic risk and expected return on an asset.### Financial Economics
    • Financial economics focuses on investments made by individuals and firms in various assets available in the modern economy.
    • It involves balancing the need for retained earnings with the expectations of shareholders.

    Dividend Policy

    • The decision-making process by which a company determines the amount of dividends to distribute to shareholders.
    • Involves balancing the company's need for retained earnings with the expectations of shareholders.

    Options and Derivatives

    • Financial instruments whose values are derived from an underlying asset.
    • Understanding options and derivatives is crucial for managing risk and speculation in financial markets.

    Liquidity

    • The ease with which an asset can be bought or sold in the market without affecting its price.
    • Liquidity is a key consideration for investors and is vital for the efficient functioning of financial markets.

    Agency Theory

    • Examines the relationship between principals (such as shareholders) and agents (such as managers) and the challenges arising from divergent interests.
    • Helps in understanding and mitigating agency problems in corporate finance.

    Behavioral Finance

    • Incorporates psychological factors and biases into financial decision-making models.
    • Explores how individual and collective behavior can deviate from traditional economic assumptions.

    Financial Investment

    • Refers to buying or building an asset with the expectation of generating a financial gain.
    • Distinguished from economic investment, which refers to paying for new additions to the nation's capital stock.

    Present Value

    • The present-day value, or worth, of returns or costs that are expected to arrive in the future.
    • Calculated using the formula: FV = PV / (1 + i)^t

    Compound Interest

    • The process of going from today's value, or present value (PV), to future value (FV).
    • Compound interest describes 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.

    Derivative Assets

    • Financial instruments that take their value from the prices of one or more other assets.
    • Examples include options, futures, and forwards.

    Stocks

    • Represent the claim of the owners of a firm.
    • Entitle shareholders to vote in the election of directors and other matters, as well as receive a share of future profits or distributions.

    Bonds

    • Issued by anyone who borrows money (firms, governments, etc.).
    • Promise to pay fixed sums of cash in the future.
    • Holders have an IOU (I owe you) from the issuer, but no corporate ownership privileges.

    Default

    • The possibility that a corporation or government will fail to make bond payments.
    • A key risk faced by bondholders.

    Mutual Funds

    • A company that maintains a professionally managed portfolio of either stocks or bonds.
    • Purchased by pooling the money of many investors.

    Index Funds

    • Portfolios selected to exactly match a stock or bond index.
    • Examples include the Standard & Poor's 500 Index and the Lehman 10-Year Corporate Bond Index.

    Actively Managed Funds and Passively Managed Funds

    • Actively managed funds: portfolio managers constantly buy and sell assets in an attempt to generate high returns.
    • Passively managed funds (index funds): assets chosen to exactly match a particular index.

    Calculating Investment Returns

    • Percentage rate of return: the percentage gain or loss (relative to the buying price) over a given period of time, typically a year.
    • Calculated as the gain or loss divided by the purchase price.

    Asset Prices and Rates of Return

    • An investment's rate of return is inversely related to its price.
    • The higher the price, the lower the rate of return.

    Arbitrage

    • The process of taking advantage of situations where two identical or nearly identical assets have different rates of return.
    • Involves simultaneously selling the asset with the lower rate of return and buying the asset with the higher rate of return.### Arbitrage and Rates of Return
    • T4me and TSTG are two identical companies with different rates of return (10% and 15%, respectively)
    • Investors will shift from T4me to TSTG, causing the prices of the two companies to change and their rates of return to converge
    • As investors sell T4me shares, its supply increases, causing its share price to fall and its rate of return to rise
    • Meanwhile, as investors buy TSTG shares, its price rises, causing its rate of return to fall
    • This arbitrage process continues until both companies have the same rate of return

    Diversification and Risk

    • Diversification reduces the overall risk of a portfolio by spreading investments across many assets
    • It eliminates diversifiable risk (idiosyncratic risk) but not non-diversifiable risk (systemic risk)
    • Examples of diversifiable risk include the demand for soda pop versus mineral water
    • Non-diversifiable risk includes the business cycle, which affects all investments simultaneously

    Financial Investments and Risk

    • Financial investments include stocks, bonds, and mutual funds
    • Risk refers to the uncertainty of future payments
    • Diversification is a strategy to reduce risk by investing in many assets
    • Beta is a measure of non-diversifiable risk relative to the market portfolio
    • Average expected rate of return is a measure of the probability-weighted average of possible future rates of return
    • The relationship between risk and average expected rate of return is positive: higher risk investments have higher average expected rates of return

    Financial Markets and Instruments

    • Financial markets include capital, money, derivatives, foreign exchange, and commodity markets
    • Financial instruments include equity, debt, derivative, money market, foreign exchange, and commodity instruments
    • Examples of financial instruments include stocks, bonds, options, futures, and currency pairs
    • Hybrid instruments combine characteristics of different types of financial instruments

    Financial Intermediaries

    • Financial intermediaries (FIs) channel funds from suppliers of capital to demanders of capital
    • Examples of FIs include commercial banks, credit unions, insurance companies, finance companies, and mutual funds
    • FIs provide essential functions, including:
      • Monitoring and reducing risk
      • Providing liquidity and facilitating trading
      • Enhancing the efficiency of credit allocation

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