Macro Economics Chapter 35

What are Characteristics of bonds?

1) Bonds are less risky investments. A key difference between stocks and bonds is that bonds are more predictable. The future payments are fixed as to the amount and time. The default risk depends on the type of bond. There are government bonds and corporate bonds. Bonds issued by governments are much safer as the likelihood the government will fail is remote. 2) Like stocks, you also make money but at a much smaller rate of return. Lots of old people invest in bonds because they don't want to lose their retirement savings if a corporation fails.

What are characteristics of stocks?

1) Higher risk than bonds because you can lose your investment. Limited Liability One key advantage to owning stock is that it provides the owners with what's called limited liability, meaning the most they can lose is the amount they paid for their stock. Creditors cannot come after the owners if the company goes bankrupt owing more than the value of the assets. 2) You Get Dividends Owners also get to share in the financial gains of the firm. When the business makes money, it will distribute some of the earnings to the owners through dividends. Owners also make money through capital gains. As the value of the business increases, the value of the owners' shares increases and they are able to sell their shares for more than they paid. Note: The most famous example is of the guy who originally invested in Apple and sold his share for something like $20,000 a few years later. That stock would be worth $3 billion today.

What is the difference between actively managed funds and passively managed funds?

Actively managed funds have portfolio managers who constantly buy and sell assets in an attempt to generate high returns, whereas passively managed funds have assets tied to the underlying index that the fund follows.

What is arbitrage?

Arbitrage is the process by which profit-motivated investors buy and sell assets in an attempt to equalize the average expected rates of return on similar assets. By going through this process, the investor is able to minimize the risk involved and the process will bring both assets into equilibrium where the returns are the same. This process allows investors to invest with confidence and therefore enables the market to function in an efficient manner.

What is beta?

Beta is a relative measure of nondiversifiable risk. It compares the risk of a given asset with that of a market portfolio, which contains every asset available in the financial markets. Even with diversification there will always be risk involved in investing. Nondiversifiable risk cannot be eliminated. The business cycle is an example of nondiversifiable risk. There is no way to diversify away the risk that the entire economy may collapse. Investors typically use the average expected rate of return or beta to evaluate risk. The average expected rate of return is the probability weighted average of the investment's possible future rates of return. While this can provide investors with the information on the rate, it does not address the risk of actually earning that rate. That can be measured by what is called beta.

What are bonds?

Bonds are considered debt securities and are traded the same as stocks.

What is the difference between a Financial investment and an economic investment?

Financial investments can either be financial assets such as stocks or bonds or real assets like land, buildings, or equipment. Economic investment refers to buying new additions to the capital stock or new replacements for worn-out capital stock.

What are mutual funds and how do they reduce risk?

Mutual funds are very popular because they help to distribute investor risk. They consist of a mix of both stocks and bonds. Lots of people buy mutual funds because they have managers and then you don't have to follow the stock prices as closely, you just trust your manager to manage your portfolio. Mutual funds can tailor the portfolio to satisfy the desires of the investors. Index funds are designed so that their portfolios exactly match a specific stock or bond index, which is something that follows the performance of a particular group of stocks or bonds.

What does it mean to diversify?

One way to minimize risk is to diversify, which is a strategy of investing in a large number of investments to reduce the overall risk to the entire portfolio. The old adage "don't put all your eggs in one basket" still holds up today. Investing is much like gambling. In the world of investing, the risk simply refers to the idea that an outcome lacks total certainty. The outcome could be good or bad, you just don't know. How much risk an individual is able to handle is a personal choice. Some investors enjoy the excitement that comes with a lot of risk and others prefer to take the safe route.

What is present value of money and why is it always less than the future value of money?

Present value is one of the most useful concepts in business. Understanding the time-value of money helps to explain why keeping all of your cash in your mattress is not a good idea. You can make interest on your money. X dollars today=(1+i)tX dollars in t years $100 today at 8% is worth: $108 in one year $116.64 in two years $125.97 in three years

What are stocks?

Stocks represent ownership shares in a company or equity. There is a risk that if the company fails, the investor will lose his investment.

What is compound interest?

With compound interest, you earn interest on the interest. Example: Interest compounds monthly on a $100 furniture loan at 8% interest. In one month, you owe $108. In two months, you owe 8% of $108, or $116.84, etc. This is how the furniture store makes money.