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Econ 109 Class Page

- Econ Home Page:http://www.econ.ucsb.edu

- 12617 F 9:00-9:50 AM Jalama Lab, Phelps 1517
- MCL 12625 M 2:00-2:50 PM Miramar Lab, Phelps 1526
- 12633 M 7:00-7:50 PM Miramar Lab, Phelps 1526
- 12641 W 8:00-8:50 AM Miramar Lab, Phelps 1526
- 12658 T 6:30- 7:20 PM Miramar Lab, Phelps 1526
- 12666 F 1:00-1:50 PM Ledbetter Lab, Phelps 1530

Checking Instructional Computing Lab Scedules

http://www.ic.ucsb.edu/faculty/labs/

Lecture Outline

- Guidelines for personal financial well-being
- Bonds
- Stocks
- Choosing an efficient portfolio
- The best portfolio for you
- Making Your Wealth Grow
- Where does the long run growth in stocks come from? Growth in corporate profits (net earnings), which in turn depends on the economy doing well

Macroeconomics and the US Economy

5. Thursday, Oct. 10, Lecture Five: "Capital Asset Pricing Model"

Tracking asset markets and the US economy

capital asset pricing model

Growth rate of your personal wealth

Value of a share of stock

The impact of business cycles on corporate profits

Reading Assignment:

O’Sullivan and Sheffrin, Ch. 20, “Measuring a Nation’s Production and

Income” emphasis: measuring the ouput of the economy, circular flow

O’Sullivan and Sheffrin, Ch. 21, “Unemployment and Inflation”

Problems O & S Text

p. 434: 1, 5, 6, 7, 8, 9,10,11

p. 450: 1, 2, 3, 4, 5, 6, 7, 8

Tuesday, Oct. 22 , 25 minute QUIZ, You will need scantron sheet

and #2 pencil.

Part I

- Guidelines for Personal Finance, Summary
- Life is Risky, How to Cope?
- Risk from the Economy, e.g. inflation
- Market Risk, e.g. stocks, bonds, real estate

Guidelines for Personal Finance

- Keep you expenditures within your means
- pay off your credit card debt
- Save 10% of your income
- pay yourself first
- Diversify your investments
- cash, for emergencies
- housing, to build wealth and provide shelter
- treasury bonds, as a safe investment
- stock index fund, for growing your wealth

Life is Risky; How to Cope?

- Protect against inflation
- don’t put all your money in cash or checking
- hedge your bets, don’t bet on just one market but diversify among markets
- real estate
- bonds
- stocks
- hedge your bets, diversify within markets
- laddering bonds
- stock index fund

Inflation

Http://stats.bls.gov/eag/eag.us.htm

$41,500

30-Year Mortgage Rate of Interest

Http://research.stlouisfed.org/fred2/

Dow Jones Industrials Index

http://www.quicken.com

per Year

Part II

- Choosing among investment options, the efficient portfolio
- example: six UC investment funds
- tradeoff: the higher the rate of return, the higher the risk
- called Markowitz Portfolio Analysis
- Choosing the best portfolio for you

Example: UC Funds

- Suppose you invest up to $10,000 per year in a tax sheltered 403(b) plan
- you have to save $10,000, but you would have to pay income taxes if you took it as income
- UC investment alternatives
- guaranteed insurance contract(GIC)
- savings fund
- money market fund
- bond fund
- stock index fund
- multi-asset fund

Investment Concepts

- monthly return for June 2001 on an asset
- price(June) - price(May) + dividends
- price(June) - price(May): capital gain(loss)
- dividends(interest): income from stocks(bonds)
- monthly rate of return for June 2001
- [price(June) - price(May) + dividends]/price(May)
- in %, multiply by 100
- annual rate: multiply by 12

Example: UC Funds/Mutual Funds

- Sources of information on UC funds
- monthly, quarterly, annual, etc. rates of return
- internet: http://atyourservice.ucop.edu
- Notice, a publication of the UC Academic Senate
- Source of Information on Mutual Funds
- quarterly
- The Wall Street Journal, Mutual Funds Quarterly Review, e.g. extra section in July 3, 1997 Journal

Insurance

steady at a rate of return of about 0.6 per month or 7.2% per year

does not vary much

never negative

Equity

rate of return varies a lot from month to month

range of rates of return from about plus 9% in Mar. ‘00 to minus 13% in Aug ‘98

can turn negative: 29 months out of 72

UC Funds: Equity Vs. InsuranceEfficient Portfolio: Most Return for Given Risk

This frontier shows the efficient (best)

options for investing, the first step

of the economic paradigm

Efficient Portfolio: Most Return for Given Risk

Slope is the second step of the paradigm, determining values: Market Price of Risk: 0.1% return per month for every 1% of variability per month

Your portfolio should be on the efficient frontier

- But where on the frontier?
- depends on your taste for reward and risk
- reward, i.e. the mean rate of return is a good
- risk is a bad

Economic Paradigm: Valuation of Mean Return and Risk

Assumption: Mean Return is Good, Risk is Bad: U =U(M,R)

better

Mean

Return,

M

worse

B

C

Iso - Preference Curves

A

Risk, R

Prefer B to A; Prefer B to C

Efficient Portfolio: Most Return for Given Risk

Investor A: very risk averse

Efficient Investment Portfolio

Investor B: not very risk averse

Part III How do you make your nest egg grow?

- Do you need to take risks and get a super high rate of return?
- not if your ratio of savings to wealth is high
- Strategy for the Long Run: Buy and Hold a Stock Index Fund

per Year

Invest in A Stock Index Fund

- Exponential Growth
- Historically: 20th Century, 11% per year
- Since 1986: 13% per year
- Betting that history will repeat itself

Two Ways to Grow Your Wealth

- Savings: increases your wealth
- rate of return: adds to your wealth
- Combine these two for rapid growth

Rate of Growth of Personal Wealth

savings, s

increase

in wealth, w

+

Stock of

wealth, w

+

yield, r*w

rate of

return, r

rate of growth of wealth, w/w rate of return, r + savings/wealth

w/w r + s/w

Younger Years

income & savings are lower

wealth is smaller

ratio of savings to wealth may be high

savings is most important, rate of return less so

example

income of $60,000

savings of $6,000

wealth of $50,000

ratio of savings to wealth of 0.12

Older Years

wealth accumulates

ratio of savings to wealth falls

rate of return on wealth becomes more important

example

income of $100,000

savings of $20,000

wealth of $500,000

ratio of savings to wealth of 0.04

Relative Importance of Savingsrate of growth of wealth, w/w

w/w r + s/w

rate of return

on wealth, r

12%

8%

4%

0

ratio of

savings to

wealth, s/w

4%

8%

12%

Rate of Growth of Personal Wealth

- If the rate of return, r, on wealth is zero
- then the only source of growth in wealth is savings: w/w = s/w
- i.e. the only change in wealth, w, is savings: w = s
- If savings is zero
- then the only source of growth in wealth is rate of return, r, and wealth will grow exponentially at the rate r: w/w = r

SummaryHow to Cope: Simplify

Investment Strategy:

Buy and Hold

Step 1: Save

Step 2: Diversify, i.e keep a cash

reserve, buy a house, hold some treasury bonds,invest in

stock index fund with IRA or

401 k.

Using the Economic Paradigm

to maximize return for a given

risk level

Investment Principles or Maxims

- Don’t put all of your eggs in one basket
- hold a diversified portfolio
- cash
- bonds
- stocks
- real estate
- advantage of a mutual fund or stock index fund
- instead of holding one stock, e.g. Coca-Cola, you hold a bundle of stocks
- Choose the asset with the highest reward for a given level of risk

Part IV

- Value of a share of stock
- depends on the stream of expected future net earnings per share
- The Impact of the Business Cycle on Corporate Profits

Tracking Assets and Markets

- What is the relationship between the monthly rate of return on the UC Index Fund and an index of the stock market, such as the Standard and Poor’s Index of 500 Stocks (S&P 500) ?

Example: The UC Index Fund and the Standard & Poor’s 500

- mean rate of return on the UC Index Fund varies with the mean rate of return on Standard & Poor’s Index of 500 Stocks
- capital asset pricing model

Sources of Information: stock prices

- Daily Quotes
- Business Section of Los Angeles Times
- Wall Street Journal
- Internet graphics
- http://bigcharts.marketwatch.com/
- http://www.quicken.com/investments

Where does the growth in financial wealth come from?

- What is the relationship between financial markets and the economy?

Corporate profits after taxes

- doubled from $160 billion in early 1987 to $320 billion in early 1994
- doubling in about seven years implies an average rate of growth of about 10% per year
- this rate of growth is comparable to the 11% rate of growth in the Dow since 1986

Economic Concept

- present value of a stream of expected future net earnings, or profits, per share
- PV(t) = ENE(t) + ENE(t+1)/(1+i)
- may know this year’s net earnings, NE(t)
- your expectations of the future affect your best guess for next year, ENE(t+1)
- at an interest rate of 7%, $1.07 next year is equivalent to a $1 this year
- to compare dollar values for different years, they have to be discounted to a common year
- PV(t) = ENE(t) + ENE(t+1)/(1+i) + ENE(t+2)/(1+i)2 + ...

Income-Expense Statement for an Individual

Income

Expenditure

Savings

Income-Expense Statement for a Business Firm

Gross Revenue

Cost

Profit

(net revenue, net earnings)

Market

Indices

corporate earnings(profits)

Index of Leading Economic Indicators

Gross Domestic Product

Unemployment Rate

The Economy

Labs : Resources for Economists on the Internet

http://rfe.wustl.edu/

The US Business Cycle

- expansions, or recoveries, the period from trough to peak, tend to last a lot longer than recessions, the period from peak to trough

US Business Cycle

- Note the long expansions in the eighties and the nineties
- is there a new economic regime or order?
- are business cycles a relic of the past?
- Note the long expansion in the sixties
- economists then talked about “fine tuning” the economy
- then came along the problems of the seventies
- a couple of recessions
- inflation

capital asset pricing model

market risk

asset specific risk

stock’s beta,

moving average

exponential growth

Dow Jones Industrials

present value

net earnings per share

expectations

discount factor

corporate profits after taxes

business cycle

peak

trough

index of leading indicators

Summary-Vocabulary-Concepts
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