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Financial Economics

Financial Economics

Raise your hand if you would like to make money without working. If you raised your hand, you are not alone! People all over the world make money every day without working. How do they do it? By investing! It may seem easy to buy stock in a company and just sit back and think the money is going to roll in, but it's not that easy. As with anything, to succeed in investing, you need to know what you are doing. Economists, financial analysts, stock brokers, and many other financial professionals know what they are doing because they understand financial economics. If you are ready to learn more about financial economics and how it can help you to make money without working, read on!

Financial Economics Money Growth StudySmarterFig. 1 - Money Growth

Definition of Financial Economics

The definition of financial economics is the study of the preferences of investors and how they impact the trading and pricing of financial assets like bonds, stocks, and mutual funds. The two main investor preferences are a high rate of return and the least amount of risk and uncertainty as possible.

Financial economics focuses on the investments that firms and individuals make. By knowing investor preferences, as well as the interest rate and time frame of an investment, investors can use financial economics to accurately price assets in the market and choose the ones that best fit their needs.

Financial economics is the study of the preferences of investors and how they impact the trading and pricing of financial assets.

Financial assets include stocks, bonds, mutual funds, and real estate.

Let's take a look at some of the principles of financial economics.

Principles of Financial Economics

There are several principles of financial economics. These include the time value of money, compound interest, present value, rate of return, arbitrage, and risk.

Let's take a look at each of these in turn, and then see how investors use this information to compare risky assets and compute expected returns.

Principles of Financial Economics: Time Value of Money

The first principle of financial economics is the time value of money, which is the opportunity cost of receiving money in the future as opposed to today. Money is more valuable the sooner it is received because it can then be invested and earn compound interest.

The time value of money is the opportunity cost of receiving money later rather than sooner.

Financial Economics Time Value of Money StudySmarterFig. 2 - Time Value of Money

Principles of Financial Economics: Compound Interest

Compound interest is the second principle of financial economics. Compound interest is interest earned on the original amount invested and the interest already received. The interest rate and the frequency at which it compounds (daily, monthly, quarterly, yearly) determines how fast an investment increases in value over time.

Compound interest is interest earned on the original amount invested and the interest already received.

Take a look at the following equation:

\(\hbox{Equation 1:}\)

\(\hbox{Ending value} = \hbox{Beginning Value} \times (1 + \hbox{interest rate}) \)

\(\hbox{If} \ C_0=\hbox{Beginning Value,}\ C_1=\hbox{Ending Value, and} \ i=\hbox{interest rate, then:} \)\(C_1=C_0\times(1+i)^t\)

\(\hbox{for 1 year}\ t=1\ \hbox{, but t can be any number of years or periods}\)

Thus, if we know the beginning value of the investment, the interest rate, and the number of compounding periods, we can easily use Equation 1 to calculate the ending value of the investment.

Principles of Financial Economics: Present Value

This brings us to the third principle of financial economics - present value. Present value is the present-day value of future cash flows (earnings or costs).

By rearranging Equation 1, we can also calculate \(C_0\) if we know \(C_1\):

\(C_0= \frac {C_1} {(1+i)^t}\)

More generally, for any given number of years t, the equation is:

\(\hbox{Equation 2:}\)

\(C_0= \frac {C_t} {(1+i)^t}\)

This is the general Present Value formula.

Present value is the present-day value of future cash flows.

By applying this formula to all expected future cash flows of an investment and summing them up, investors can accurately price assets in the market. For a risk-free asset, the appropriate price is the present value of future expected returns. Pricing risky assets is a bit more complicated.

To learn more, read our explanation about Present Value!

Principles of Financial Economics: Rate of Return

The fourth principle of financial economics is the rate of return. The rate of return is the percentage change in the value of an asset compared to the original price paid. If \(P_0\) is the purchase price and \(P_t\) is the price \(t\) years later, then the rate of return is calculated using the following equation:

\(\hbox{Equation 3:}\)

\(\hbox{Rate of return}= \frac {P_t-P_0} {P_0}\)

The rate of return is the percentage change in the value of an asset compared to the original price paid

Stating returns on an investment in percentage terms rather than dollar or other currency terms allows investors and analysts to compare performance across all different kinds of assets and asset classes.

One thing to note is that, all else equal, for fixed-income assets (assets with constant cash flows), the higher the price paid for an asset, the lower the rate of return. That is because the same numerator (the cash flow) will be divided into a bigger denominator, resulting in a lower rate of return.

Principles of Financial Economics: Arbitrage

The fifth principle of financial economics is arbitrage. Arbitrage is the buying and selling of assets that lead to an equalizing of the average expected rates of return on identical or very similar assets. Let's break this down a bit.

Suppose there are two companies, Company A and Company B. Everything between them is nearly identical except for their rates of return. Let's say company A currently has a rate of return of 10% while Company B has a rate of return of 20%. What do you suppose investors in Company A will do?

All else equal, they would rather invest in Company B, so they will sell their shares in Company A, pushing down the price and increasing the rate of return. Meanwhile, greater demand for Company B shares will push up its price and decrease its rate of return.

This will continue until the rates of return are identical, which should be the case since everything else about the companies is the same. Thus, if an asset is mispriced in the market, it won't take long for savvy investors to find it and make a quick profit, but the opportunity may be very short-lived, as in a matter of minutes or even seconds.

Arbitrage is the buying and selling of assets that lead to an equalizing of the average expected rates of return on identical or very similar assets.

To learn more, read our explanation about Arbitrage!

Principles of Financial Economics: Risk

The sixth principle of financial economics is risk. Risk is defined as the uncertainty about future payments from investments. Although there is a risk that the future will be worse than expected, there is also a risk that the future will be better than expected. Even so, investors try to reduce the amount of risk they are exposed to as much as possible.

Risk is the uncertainty about future payments from investments.

Things that could make an investment risky include company management, industry problems, the economic outlook, a change in government policy, a change in interest rates, the weather, natural disasters, and so on. Any investment where future payments are not guaranteed to be paid should be considered risky, but some investments are certainly riskier than others.

Financial Economics Risk StudySmarterFig. 3 - Risk

One important way investors can reduce their risk is through diversification, which is the process of buying different kinds of assets in different categories with different risk levels.

If you held stock in only Company A and they had a bad year and the price plunged, you would not be very happy. However, if along with Company A you also had Company B and Company C in your portfolio, and they had average years, only one-third of your portfolio would suffer. Furthermore, if Company B and Company C had good years and their stock prices increased, your diversified portfolio would likely show a net increase, as the price increases of Company B and Company C outweighed the price decrease of Company A. That's diversification.

The type of risk that can be diversified away in this manner is called diversifiable risk (or idiosyncratic risk).

Diversifiable risk (idiosyncratic risk) is specific to each investment and can be diversified away in a well-diversified portfolio.

Still, even if you had a well-diversified portfolio, there is still some risk associated with the portfolio. Let's say all three of these companies are in the same country and the economy enters a recession. Regardless of how well diversified your portfolio is, all three of these companies feel the impact of a recession, and in that case, all three stock prices will fall at the same time.

Or let's say there is a corporate profit tax increase or an increase in interest rates. Most likely, these changes will affect all three companies in the same way. Thus, there is some risk that cannot be diversified away, and this is called non-diversifiable risk (or systemic risk).

Non-diversifiable risk (systemic risk) is the type of risk that cannot be diversified away.

One important thing to note is that all of an investment's diversifiable risk can be diversified away. This means that when choosing new investments for a portfolio that is already diversified, investors need only worry about non-diversifiable risk, which they can then compare to the potential returns to determine if the investment would be a wise choice.

To learn more, read our explanation about Risk!

Principles of financial economics: Comparing Risky Assets

So how do economists and financial analysts compare risky assets to determine which ones to add to a portfolio? They use two measures: the average expected rate of return and beta.

Average expected rate of return

The average expected rate of return is the weighted average of expected returns, with the weights being the probability that a certain return will occur.

For example, if an investment has a 60% probability of having a 10% return and a 40% probability of having a 20% return, then the average expected rate of return is as follows:

\(\hbox{Average expected rate of return}=0.6\times10\%+0.4\times20\%=6\%+8\%=14\%\)

Beta

Beta is a statistic that measures the non-diversifiable risk of a portfolio relative to the market portfolio, which is a portfolio that contains every financial asset available in the market. Since the market portfolio contains every available asset, it is useful for comparing the non-diversifiable risk of an asset or portfolio, as all the diversifiable risk has been eliminated.

The market portfolio's beta is equal to 1. A beta below 1 means an asset or portfolio is less risky than the market, and a beta above 1 means it is more risky than the market. An asset with a beta of 0.2 has one-fifth the non-diversifiable risk of the market, while an asset with a beta of 2.0 has twice the non-diversifiable risk of the market. Similarly, the asset with a beta of 2.0 has 10 times the non-diversifiable risk as the asset with a beta of 0.2. Thus, beta allows comparison to both the market and other assets and portfolios regarding risk.

A fundamental truth about risk and return is that riskier assets have lower prices and provide higher average expected rates of return than less risky assets. Since investors dislike risk, they need to be compensated for buying riskier assets, and this compensation comes in the form of higher average expected returns. This is true for all assets of any type in any market.

However, there is one asset with a different risk profile. Short-term U.S. Treasury bills have maturities between 4 and 52 weeks. Since there is virtually no chance the U.S. government will default on its interest payments in such a short period of time, these assets are considered risk-free. Still, they don't pay zero percent interest, as one might expect. The interest rate paid on these assets is to compensate for time preference, or the inclination of people to want to consume today versus in the future. In order to compensate investors for giving up their money, even for a short period of time, these assets still need to pay at least a little bit of interest. But there is still the risk that the Federal Reserve will change interest rates, which affects not only the risk-free rate, but also the prices of all other assets.

Principles of Financial Economics: Security Market Line

Although U.S. Treasury bills only compensate for time preference, all other assets must compensate for both time preference and non-diversifiable risk.

In equation form:

\(\begin{align}& \hbox{Average expected rate of return} = \\& =\hbox{rate to compensate for time preference}\ + \\& + \hbox{rate to compensate for non-diversifiable risk}\end{align}\)

The rate to compensate for time preference is the risk-free rate Rf, and the rate that compensates for non-diversifiable risk is called the risk premium. Thus the equation becomes:

\(\hbox{Average expected rate of return}=R_f+\hbox{risk premium}\)

Now, the risk premium will depend on how large the asset's beta is. A higher beta requires a higher risk premium. If we create a graph with the x-axis being beta and the y-axis being the average expected rate of return, and plot two points (one with a beta of 0 and one with a beta of 1.0, and draw a line between the two points, we get what is called the Security Market Line (SML).

See Figure 4 below. At the point where beta is 0, the average expected rate of return is simply the risk-free rate. At the point where beta is 1.0, we have the average expected rate of return of the market portfolio, which consists of the risk-free rate plus the risk premium. As you can see, the risk premium is larger for higher beta assets and lower for lower beta assets.

Financial Economics Security Market Line StudySmarterFig. 4 - Security Market Line

In financial economics, the risk premium is defined as the asset's beta multiplied by the expected return on the market portfolio minus the risk-free rate.

Thus, the SML in equation form is:

\(\hbox{Equation 4:}\)\(E(R_i)=R_f+\beta_i\times[E(R_M)-R_f]\)Where:\(E(R_i)\) - average expected rate of return on asset i\(R_f\) - the risk-free rate\(\beta_i\) - asset's beta\(E(R_M)\) - expected return on the market portfolio

All assets in the market lie somewhere on the SML. If an asset isn't on the SML, arbitrage will quickly move it back onto the SML. If two assets with the same beta have different average expected rates of return, investors will sell the lower returning asset, thus reducing its price and increasing its expected return, and buy the higher returning asset, thus increasing its price and reducing its expected return. This will continue until all assets with the same beta have the same average expected rate of return, thus all lying on the SML.

Two things can alter the SML. First, if the Federal Reserve changes interest rates, the risk-free rate will change, thus shifting the SML up or down. Second, if investors become more risk averse, the slope of the SML will become steeper, while if investors become less risk averse, the slope of the SML will become flatter. This is why investors pay close attention to the Federal Reserve's actions as well as economic trends, because they greatly impact asset prices and average expected rates of return.

To learn more, read our explanation about the Security Market Line!

Financial Economics Examples

Let's take a look at some financial economics examples. We will cover examples of compound interest, asset pricing, rate of return, and average expected rate of return.

Example 1 - Compound Interest

\(\hbox{If} \ C_0=\hbox{Beginning Value,} \ C_t=\hbox{Ending Value, and} \ i=\hbox{interest rate, then:} \)

\(C_t=C_0 \times (1 + i)^t \)

\(\hbox{If} \ C_0=$1,000, \ i=5\%, \hbox{and} \ t=10 \hbox{ years, what is the value of the investment} \)\(\hbox{after 10 years?} \)

\(C_{10}=$1,000 \times (1 + 0.05)^{10}=$1,628.89 \)

Example 2 - Pricing an asset using the present value equation

\(\hbox{The simple present value equation is:} \)

\(C_0=\frac{C_t} {(1 + i)^t} \)

\(\hbox{If} \ C_t=$1,000, i=8\%, \hbox{and} \ t=5 \hbox{ years, what is the present value of this asset?} \)

\(C_0=\frac{$1,000} {(1 + 0.08)^5}=$680.58 \)

Example 3 - Pricing an asset with multiple cash flows using the present value equation

\(\hbox{The present value equation can also be used to price an asset} \) \(\hbox{with multiple cash flows.} \)

\(\hbox{Let's look at an asset with different cash flows over 3 years.} \)

\(\hbox{Suppose} \ C_1 = $50, C_2 = $50, C_3 = $1,050, \hbox{and} \ i = 10\%, \hbox{then:} \)

\(C_0=\frac{C_1} {(1 + i)^1} + \frac{C_2} {(1 + i)^2} + \frac{C_3} {(1 + i)^3} \)

\(C_0= \frac{$50} {(1.1)} + \frac{$50} {(1.1)^2} + \frac{$1,050} {(1.1)^3} = $875.66 \)

Example 4 - Calculating a simple rate of return

\(\hbox{If we know the purchase price} \ P_0 \hbox{ and the sale price} \ P_t \hbox{ of an asset,} \)\(\hbox{we can calculate the rate of return.} \)

\(\hbox{Rate of Return =} \frac{P_t - P_0} {P_0} \)

\(\hbox{Suppose you purchased an asset for } $100 \hbox{ and sold it for } $140. \)\(\hbox{What is the rate of return?} \)

\(\hbox{If} \ P_0 = $100, \hbox{ and} \ P_t = $140, \hbox{then:} \)

\(\hbox{Rate of Return}= \frac{$140 - $100} {$100} = \frac{$40} {$100} = 40\% \)

Example 5 - Calculating the average expected rate of return using the Security Market Line

\(\hbox{We can calculate the average expected rate of return for an asset using} \)\(\hbox{ the Security Market Line equation if some other information is known.} \)

\(\hbox{The equation is:} \)

\(R_i = R_f + \beta \times (R_M - R_f) \)

\(\hbox{If} \ R_f = 1\%, \beta = 2, \hbox{and} \ R_M = 8\%, \) \(\hbox{what is the average expected rate of return for this asset?} \)

\(R_i = 1\% + 2 \times (8\% - 1\%) = 1\% + 2 \times 7\% = 1\% + 14\% = 15\% \)

Scope of Financial Economics

The scope of financial economics includes many ways for investors to assess investments for the risk and expected rates of return. Understanding the concept of the time value of money helps to understand the concept of compound interest. Understanding compound interest helps to understand how to calculate the present value of cash flows, and thereby the price of an asset. Once we know the beginning and ending price of an asset, we can calculate the rate of return. Arbitrage helps to understand that identical assets should have the same average expected rates of return. Understanding the two types of risk helps to calculate the average expected rate of return for a given risk level. With a given risk level and the average expected rate of return known, investors can then use this data to compare risky assets and choose the ones that best fit their needs.

Armed with all of this information, investors have many assets they can choose from to add to their portfolios. Some of the most common investments are stocks, bonds, and mutual funds. All three of these types of investments share three characteristics:

  • Investors must pay a market-determined price to acquire them
  • Owners receive future payments
  • Future payments are usually risky

Let's now take a closer look at each of these common assets in detail.

Scope of Financial Economics: Bonds

Bonds are fixed-income investments issued by companies and governments that pay interest over time plus the principal (initial investment) that is repaid at maturity. The maximum gain is the interest payments plus any gain in price if it is sold before maturity, while the maximum loss is the difference between the purchase price and sale price if sold at a loss, or any principal and interest that isn't covered in bankruptcy. Gains come from interest payments and any increase in the price of the bond upon sale. Investors can sell at any time. The main risks are default and bankruptcy (investors may not get their entire principal back if asset sales can't cover debts). Bonds are more predictable than stocks because the amount and timing of interest payments are known, as is the maturity date.

Scope of Financial Economics: Stocks

Stocks are shares of ownership in a company. Investors are entitled to a share of the company's earnings and votes at shareholder meetings about management, operations, and company direction. The maximum gain is unlimited, while the maximum loss is the entire investment (limited liability rule - investors don't have to cover losses beyond their initial investment in case of bankruptcy). Gains come from periodic dividend payments and capital gains, which is an increase in the share price. Investors can sell at any time. The main risks are a decline in the share price and bankruptcy (bondholders are paid first in bankruptcy, if there is nothing left after bondholders are paid shareholders get nothing). Stocks are less predictable than bonds because they depend on profits, which are volatile due to changes in the business cycle, management, and government policy.

Scope of Financial Economics: Mutual Funds

Mutual funds are a portfolio of stocks and/or bonds. Fund managers generally stick to one or a few categories (i.e. technology or airlines). Index funds track a certain group of stocks or bonds. Actively managed funds involve asset managers buying and selling assets frequently to generate high returns. With passively managed funds, assets are chosen to track an underlying index, so there is very little buying and selling with these funds. The maximum gain is unlimited, and the maximum loss is the entire investment, but this is rare due to diversification within the portfolio, and would only happen if the fund company itself went out of business.

Thus, the scope of financial economics encompasses the analysis of risk and return for assets, then applying that analysis to choose investments that will hopefully grow in value over time and provide financial security for investors in the future.

Financial Economics Stocks StudySmarterFig. 5 - Stocks

Financial economics vs monetary economics?

When comparing financial economics vs monetary economics, you will find that, although they are very different, there is a link between them.

Financial economics is the analysis of assets based on risk and return and the choosing of assets for a portfolio. Some of the main principles in financial economics are the time value of money, compound interest, present value, rate of return, arbitrage, and risk. These concepts and measures are used to analyze the average expected rate of return of an asset and its associated risk. This then allows investors to make well-informed decisions on which assets to include in their portfolios.

In contrast, monetary economics is the study of money. It looks at the functions of money, the creation of money, components of the money supply, the Federal Reserve system, and the financial system. It also includes understanding fractional reserve banking, the Federal Reserve's balance sheet, and the money multiplier. Furthermore, monetary economics includes learning about the goals and tools of monetary policy, the control of interest rates, and the effects of monetary policy on GDP and inflation.

To learn more, read our explanations about Money Creation, the Fractional Reserve System, the Money Multiplier, the Federal Reserve System, Money, and Monetary Policy!

There is a link between these two branches of economics, and that link is the risk-free rate. The risk-free rate is used to determine the average expected rate of return on a given asset with a given beta, which is a measure of risk relative to the market portfolio. Because the risk-free rate itself is impacted by monetary policy, the Federal Reserve can affect asset returns and prices with its actions. In addition, monetary policy impacts the broader economy, which can lead to changes in investors' appetite for risk, and thereby average expected rates of return on assets and asset prices.

Financial Economics - Key takeaways

  • Financial economics is the study of the preferences of investors and how they impact the trading and pricing of financial assets like bonds, stocks, and mutual funds.
  • The two main investor preferences are a high rate of return and the least amount of risk and uncertainty as possible.
  • The principles of financial economics are the time value of money, compound interest, present value, rate of return, arbitrage, and risk.
  • Economists and financial analysts compare risky assets using the average expected rate of return and beta.
  • Financial economics and monetary economics are very different, but they are linked by the risk-free rate that determines average expected rates of return and asset prices.

Frequently Asked Questions about Financial Economics

Financial economics is the study of the preferences of investors and how they impact the trading and pricing of financial assets like bonds, stocks, and mutual funds.

The difference between finance and financial economics is that finance is determining how to fund and account for a company's operations, investing activities, cash flows, and profits, while financial economics is analyzing assets based on risk and return and choosing the appropriate assets to invest in.

The two main areas of financial economics are risk and return.

Eugene Fama is considered the father of financial economics.

We study financial economics so we can understand how to analyze assets and choose the ones that best fit our needs in the hopes of increasing our financial security.

Final Financial Economics Quiz

Question

What is the main idea behind the security market line?

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Answer

The security market line underpins the idea that any asset on the market should compensate the investors for the time value of money and the risk that those assets carry.

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What does the security market line plot?

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The security market line plots the average expected rates of return on assets against their risk levels. It has a positive slope and an intercept at the risk-free rate.

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What is risk premium?

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A risk premium - is the compensation an investor receives for non-diversifiable risk.

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Explain the idea behind an investment's beta?

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A beta of an investment is the degree to which an asset co-moves with the rest of the market.

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What is a market portfolio?

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A market portfolio is a hypothetical portfolio comprised of all the assets in the market. It follows the rule that asset weights in such a portfolio should be proportional to the relative quantity of each asset in the market.

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What is an efficient portfolio?

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An efficient portfolio is a portfolio that is comprised of the market and the risk-free asset.

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What is the security market line equation?

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The security market line is calculated by using the following equation:
\(E(R_i)=r_f+RP=r_f+\beta_i\times(RP_M)=r_f+\beta_i\times[E(R_M)-r_f]\)

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What are the advantages of the security market line?

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It allows for finding the compensation investors would like to receive for the risk they are exposed to when purchasing any asset.

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What are the characteristics of the security market line?

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The security market line has a positive slope and an intercept at the risk-free rate.

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When is a security considered underpriced?

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A security is underpriced if the return it provides for a given level of risk is too high.

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When is a security considered overpriced?

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A security is overpriced if the return it provides for a given level of risk is too low.

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What is arbitrage in the context of SML?

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Arbitrage in the SML context means that overtime securities will be priced to appropriately compensate investors for the risk levels and the time value of money.

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How is the security market line (SML) different from the capital market line (CML)?

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The CML plots the risk premia of efficient portfolios against portfolio standard deviations.
The SML, however, plots the risk premia for individual assets against their risk levels.

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What is arbitrage?

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Arbitrage is when an investor sells an asset with a lower rate of return while concurrently buying a very similar asset that has a higher rate of return so that they can earn a profit.

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What does arbitrage do to the rates of return?

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It equalizes the rates of return between two assets and eventually eliminates any room for future low-risk financial gain. 

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What is a rate of return?

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The rate of return is the percentage change in the value of an asset. It is the profit that an investor can expect to earn on their investment over a given time period. 

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What type of relationship do asset prices and rates of return have?

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They have an inverse relationship. As one rises, the other decreases. 

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What is pure arbitrage?

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Arbitrage that has no risk. 

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What is another name for risk arbitrage?

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Merger arbitrage. 

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What is an event-driven trading strategy?

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A trading strategy where the investor only profits if a specific event occurs such as the purchase of a company. 

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If you buy a shirt for cheap in a big city and go to your small village and sell it for twice what you bought it, what type arbitrage is this?

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Retail arbitrage.

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What are three types of arbitrage?

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Pure arbitrage, retail arbitrage, and risk arbitrage.

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True/False: Prices have to be identical or at least similar for there to be an arbitrage opportunity.

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False. 

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True/False: People engage in arbitrage to equalize prices. 

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False. 

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What is a futures contract?

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A futures contract is an agreement to complete a transaction at a set date in the future at a predetermined price.

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What are three risks of arbitrage?

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The buyer falling through, improper execution, and fluctuations in the exchange rate.

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Why would fluctuations in the exchange rate be an issue for an arbitrager?

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It could cause the arbitrageur to lose the margin of profit they were expecting if the value of their currency falls and it either makes purchasing the good more expensive or it means that it will be sold at a cheaper price in the other currency.

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Is arbitrage legal?

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Yes, it is even encouraged as it serves to promote efficiency in the market by reducing price discrepancies between similar goods.

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Define Financial Economics

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The definition of financial economics is the study of the preferences of investors and how they impact the trading and pricing of financial assets like bonds, stocks, and mutual funds.

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What are the two main investor preferences studied in Financial Economics?

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The two main investor preferences are a high rate of return and the least amount of risk and uncertainty as possible. 

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Question

By knowing investor preferences, as well as the _____ _____ and _____ _____ of an investment, investors can use financial economics to accurately price assets in the market and choose the ones that best fit their needs.

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interest rate, time frame

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Which of the following is not a principle of Financial Economics?

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fiscal policy

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Which of the following is considered the opportunity cost of receiving money in the future as opposed to today? 

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Answer

Time value of money

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Question

Why is money more valuable the sooner it is received?


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Money is more valuable the sooner it is received because it can then be invested and earn compound interest.

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Compound interest is interest earned on the original amount invested and the interest already received.

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True

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The _____ _____ and the _____ at which it compounds determines how fast an investment increases in value over time. 

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interest rate, frequency

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Present value is the present-day value of future _____ _____.

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cash flows

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What is the general present value formula?

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\(C_0= \frac {C_t} {[1+i]^t}\)

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For a risk-free asset, the appropriate price is the present value of future expected returns. 

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True

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The percentage change in the value of an asset compared to the original price paid is the 

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rate of return

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The higher the price paid for an asset, the _____ the rate of return.

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Answer

lower

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_____ is the buying and selling of assets that lead to an equalizing of the average expected rates of return on identical or very similar assets. 

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Answer

Arbitrage

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If an asset is mispriced in the market, it will likely take _____ for savvy investors to find it and make a quick profit.

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Answer

seconds

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Risk is defined as the _____ about future payments from investments.

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uncertainty

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The process of buying different kinds of assets in different categories with different risk levels is called _____.

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diversification

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_____ risk is specific to each investment and can be diversified away in a well-diversified portfolio.

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Answer

Idiosyncratic

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_____ risk is the type of risk that cannot be diversified away.

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Systemic

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All of an investment's diversifiable risk can be diversified away. 

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True

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Economists and financial analysts compare risky assets to determine which ones to add to a portfolio by using the average expected rate of return and _____.

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Answer

beta

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The average expected rate of return is the _____ average of expected returns.

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Answer

weighted

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