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Lecture 1-Principles of Financial Economics

Real assets produce goods and services, while financial assets are claims on real assets. There are three main types of financial assets: fixed income, common stock, and derivative securities. Financial markets allow for consumption timing, risk allocation, and the separation of ownership and management. They also facilitate the flow of capital to companies and information sharing. The investment process involves asset allocation across broad asset classes and security allocation within each class. The main players in the financial system are households, businesses, and governments. Financial intermediaries bring lenders and borrowers together through financial innovation and derivatives.

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101 views15 pages

Lecture 1-Principles of Financial Economics

Real assets produce goods and services, while financial assets are claims on real assets. There are three main types of financial assets: fixed income, common stock, and derivative securities. Financial markets allow for consumption timing, risk allocation, and the separation of ownership and management. They also facilitate the flow of capital to companies and information sharing. The investment process involves asset allocation across broad asset classes and security allocation within each class. The main players in the financial system are households, businesses, and governments. Financial intermediaries bring lenders and borrowers together through financial innovation and derivatives.

Uploaded by

80tek
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We take content rights seriously. If you suspect this is your content, claim it here.
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Lecture 1: Introduction

Real Assets Versus Financial Assets

 Real Assets
– Determine the productive capacity and net
income of the economy
– Examples: Land, buildings, machines,
knowledge used to produce goods and
services

 Financial Assets
– Claims on real assets
Financial Assets

 Three types:
1. Fixed income or debt
2. Common stock or equity
3. Derivative securities
Financial Markets and the Economy

 Consumption timing
 Allocation of risk
 Separation of ownership and management
Financial Markets and the Economy

 Information Role: Capital flows to


companies with best prospects

 Consumption Timing: Use securities to


store wealth and transfer consumption to
the future
Financial Markets and the
Economy (Ctd.)

 Allocation of Risk: Investors can select


securities consistent with their tastes for
risk

 Separation of Ownership and


Management: With stability comes
agency problems
The Investment Process (1)

 An investor’s portfolio is simply his collection of


investment assets.
 Once the portfolio is established, it is updated or
‘rebalanced’ by:
- Selling existing securities and using the proceeds to
buy new securities
- Investing in additional funds to increase portfolio size
- Selling securities to decrease the size of the portfolio
The Investment Process (2)

 Investments assets: stocks, bonds, real


estate, commodities
 Investors make two types of decisions in
constructing their portfolios
-Asset allocation
-Portfolio allocation
Asset Allocation vs Security
Allocation

 The asset allocation decision is the choice


among the broad class of assets
 Security allocation is the decision of which
particular securities to hold within each asset
class.
Clients of the Financial System

 The Household Sector


 The Business Sector
 The Government Sector
The Players

 Business Firms– net borrowers


They raise capital now to pay for investments in plant and
equipment. The income generated by those real assets
provides the returns to investors to purchase the securities
issued by the firm.
 Households – net savers
They purchase the securities issued by firms that need to
raise funds.
 Governments – can be both borrowers and savers
The Role of the Financial System

 Financial Intermediation
Small size of households makes direct investment difficult.
Financial intermediaries bring lenders and borrowers
together.
Examples of financial intermediaries: banks, investment
companies, insurance companies, credit unions.
Financial intermediaries issue their own securities to raise
funds to purchase securities of other corporations
The Players (Ctd.)

 Financial Intermediaries: Pool and invest funds


– Investment Companies
– Banks
– Insurance companies
– Credit unions
Financial Innovation and Derivatives

 Securitization of mortgages
 Collateralized mortgage obligation
Response to Taxation and Regulation

 Financial Innovation and Security Creation


may be viewed as a natural market response
to unfulfilled investor needs.
 Creation of Eurodollar market

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