Define and explain investment decisions in the Capital Market with respect to expected returns, discounted cash flow, and classical utility theory. Give specific examples.
A capital market is part of the financial system which aims at raising capital through the selling of binds, shares and other long-term investments. They offer various financial instruments that enable the agents to the economy to price, pool and exchange risk. The capital market generally comprises of long-term investments which include; stock, mortgages, corporate bonds, municipal bonds and the long-term treasury bonds.
Currently, individuals or organization operating in the capital markets are faced with a range of challenges which includes; capital constraints, derivatives reforms, reduced proprietary risk-taking and the commoditization of products. Despite all these challenges, those who are required to make these decisions ought to balance risks and returns. There is the need for every individual or making a decision to anticipate how their decision will not only affect their entity but also the economic environment. To come up with a realistic decision, the policy should ensure that they put certain elements into considerations. The elements include; expected returns, discounted cash flow and make use of the classical utility theory (Acharya " Matthew, p58).
Making decisions on the basis of discounted cash flows
Discounted cash flow is an important concept which is used in financial decision making. The concept can be applied in any situation where money is to be paid at one point and received at another point. The concept quantifies and assesses disbursement and receipts form a certain project. When making any decision in the capital market using this concept, one ought to evaluate the worth of the investment and its benefit. Compare if what is to be earned form the investment is of worth when based on the current interest rates and inflation.
Example: You are offered an investment opportunity whereby you invest $1000 today and receive $500 at the end of each of the next two years, followed by $550 to be earned in the third years. If one would otherwise earn 10% per year of that money, should the investor undertake the investment opportunity?
NPV = -1000 + (500/1.10) + [ 500/ (1.10)2] + [550/(1.10)3 = $280.99
The NPV is $280.99 illustrating a positive value which means that if the investor takes this project, after the three years, he or she will get an extra $280.99. The total value of the investment will amount to $1,280.99. The illustration is an example of how an investor ought to evaluate the cost of a project or investment and ensure that the benefit always exceeds the cost.
Making a financial decision based on the expected returns
In the capital market, an investor makes use of the expected return to evaluate the potential loss or gain from investing a capital in a certain security or asset. The expected return on any investment is the value expected of the probability distribution of the possible returns that investors can acquire. Expected return is used by the investors to choose between alternative investments.
Example: the table below provides the probability distribution for stock A and B
State
Probability
Return on stock A
Return on stock B
1
20%
50%
5%
2
30%
30%
10%
3
30%
10%
15%
3
20%
-10%
20%
The expected return on stock A and B will be;
Stock A = 0.2(50%) + 0.30 (30%) + 0.30(10%) + 0.25 (-10%) = 20%
Stock B = 0.2(5%) + 0.30 (10%) + 0.30(15%) + 0.25 (20%) = 12.5%
Stock A offers 20% whereas stock B offers 12.5% meaning that stock A offers a larger expected return than stock B and it is the most preferable investment to venture in. the only disadvantage of using option is that it does not consider the time value of money.
Making decisions on the basis of classical utility theory
When decisions are made using the classical utility theory, the individual or group to make the decision, choose to consume at the level giving them the highest level of satisfaction. The highest utility value is based on the budget constraint of the investor. For any investor to make a decision while investing, he or she chooses between foregoing consumption now for consumption sometimes to come.
At point A there is no any form of investment t because the investor is assumed to have all the excess cash consumed at that particular moment. When the investor chose to invest or save, he or she will do that at the highest point which gives him or her highest utility. All this is the classical theory of investment. As per the above graph, the highest level of utility is depicted by the indifference curve U4. Any investor will consider this level over that of the indifference curve U1 and U2 the problem is that U4 is attainable; meaning that the investor ought to consider the investment level within the budget line which is U3.
Define and explain the dialectic process with respect to money and financial innovation. Give some specific historical examples.
The dialectic process is the art of investigating the truth of opinions especially to those that are contradicting. Dialectic in finance is a process involving change which through action and reactions from opposing forces. The term is used to describe the process that is used by the mind so as to gain the truth and reality. The society, in general, has been burdened up with tensions and contradictions which is between subjects and object to knowledge, nature, and mind, freedom and authority, self and other, faith and knowledge. Thus dialect process is used to interpret these tensions into absolute knowledge.
The dialect process has been applied by various regulatory bodies to come up with unified regulations to monitor trade and money. For example, money has assumed various forms throughout history and has evolved through the dialectic process to its current forms. First, there was the commodity money; use of valuable metal such as silver and gold. It was universally accepted and qualified to be used as money. During this time, money was bulkier and making it difficult and insecure for transportation. The challenge facilitated the adoption of a lighter form of money, hence the development of paper currency firstly known as Fiat money. Notably, the paper money is light and universally accepted as a means of payment (Adrian et al, p659).
Apart from the paper money, new forms of payment through the dialect process have been developed which are more convenient and ensures safety. The new modes of payment included the use of cheques and electronic payment and Bitcoins. Little effort is used to make payment using these modes of money transfer.
Moreover, the dialect process was used by the regulatory bodies to harmonize rules that were to be used in the financial fields. According to history, the first and the second bank in the United States only acted as fiscal agents to collect deposits and they were required to facilitate payments by the treasury departments. By then, the central banks never had the authority to regulate the behaviors of an individual bank or even set reserves. Many reforms have been done on these institutions through the dialect process as a result of certain challenges that were arising during the normal performance (Adrian et al, p623).
An example of a challenge is the conflict between the president of the second national bank in the united states Nicolas Biddle and Andrew Jackson who was the third president of the united states. The then president of the United States viewed the second national bank to be strong and was a potential threat to the working welfare of an average man. Therefore, he withdrew substantial deposits which rendered the bank as a large private bank (Howlett et al, p72).
Define and explain asymmetric information its impact on adverse selection, moral hazard, conflicts of interest, the separation theorem, and how financial intermediaries play a role.
Asymmetric information happens when one party in a certain transaction posses more information than the other. The asymmetry resulting from information failure creates an imbalance of power in the transactions resulting in a market failure.
Asymmetric information has been a common problem in the financial industry where people managing most of the financial facilities happen to have more knowledge when compared to the investors. Much of what has been happening is that investors entrust the managers who are considered to have more specialization ability and they are paid in return for their services. Information asymmetry arises in this case since the agents are well informed compared to the principals. Asymmetric information results to problems such as moral hazards, adverse selection conflict of interest and separation theorem.
Moral hazards
It is a situation whereby a certain party gets involved in an event that is risky knowing that he or she is protected against the risk and the other involved party will incur the cost. In the capital market, moral hazard problem is realized when an agent indulges in behavior which is perverse which include taking too much risk, shirking and misreporting (Liang, p23).
Adverse selection
Adverse selection occurs when one party have better information when compared to the other one. The problem mostly occurs in the transactions. In capital markets, the problem is realized when the investors struggle with choosing a good manager who will help them maximize return on their wealth.
Conflict of interest
It is a type of a moral hazard arising when an investor has several objectives and as a result, conflicts arise due to those objectives. Conflict of interest lowers the quality of information that is in the financial markets thus making them less efficient.
Separation theorem
Separation theorem is a situation whereby the choice of an investment by a certain firm is separate from the attitude of the owner towards the investments. All the above problems arise from asymmetric information. The agent is said to have more information compared to the investor thus taking a different opinion compared to that of the investor.
The financial intermediaries happen to be the causative agents to all these problems due to information asymmetry. They facilitate this by producing information and multiple financial services to their customers and ensuring that is not detailed.
Define and explain the major theories of interest rate behavior.
The interest rate is proportionate to the loan that the borrower is charged and typically expressed as a manual percentage of the loan that is outstanding. In other terms, an interest rate is the cost of debt-capital or credit that has been annualized, which is computed as a percentage ratio of interest to the principal.
There are several theories of interest rates behaviors which explain the term structure facts. These theories include; the expectation theory, the segmented theory, and the liquidity premium theory.
The expectation theory
The main assumption that is behind this theory is that those who are buying bonds will never prefer the bond maturity of one over the other. Therefore they tend to hold any quantity of bond if the return expected is less compared to that of the other bond having a different maturity. Such bonds are referred to as perfect substitutes.
The segmented market theory
The assumption underlying in this theory is that markets involving different maturity bonds are completely segmented. Thus the interest rate for every bond in the market has a different maturity is determined by the demand and supply of the bond which is not affected by the predictable returns on other bonds which different maturities.
The liquidity premium theory
The above theory depicts bonds with different maturities as substitutes but not perfect substitutes. Most of the individuals will prefer bonds with a short-term yield rather than the long one as they are free of inflation and risks due to interest rates.
Define and explain the functions of money and how it reduces transaction costs - give a numeric example of a barter economy
Money can be defined as anything that is generally accepted as payments for goods and services, or in repayments of debt. Money is also defined in terms of its three functions which it provides. It serves as a medium of exchange, a unit of account and a store of value.
Money is a unit of account
Money is termed as a unit of account because everything that is in the economy is quoted in terms of it. If anything is being sold, the price is quoted in terms of money. Money qualifies to be used as a unit of account for it allows goods and services to be expressed in a way that is understandable and which allow their value to be compared.
Money as a medium of exchange
Money is relied on as a medium of exchange for it can be used to satisfy the unlimited wants and needs. It allows good and services to be traded without applying the barter trade system thus eliminating the need for a double coincidence of wants between the involved parties.
Money as a store of value
Money is referred as an asset whose value can be used now or retrieved at future date.
Money as a standard of deferred payments
Money is used to value debt in that if someone borrows today, they can payback at later date as per the agreeable terms. It is currently being used as a standard for future payments.
The use of money has eliminated the difficulties which were arising as a result of barter trade. The difficulties resulted due to the absence of double coincidence, lack of standard or measurements, lack of subdivision and difficult in storage. Thus, use of money has enhanced both efficiency and better ways of making transactions ensures more security. Money also reduces the transaction costs when compared to barter trade as a result of the few transactions which are involved.
If barter trade was being used as a form of exchange, then, if there are n the individual would be required to know (n2 – n)/ 2 independent exchange ratios between then goods. But this would be different when money is being involved in the trade. The reason is that the trader is only required to know just n – 1 exchange ratios.
Work cited
Acharya, Viral V., and Matthew P. Richardson, eds. Restoring financial stability: how to repair a failed system. Vol. 542. John Wiley " Sons, 2009.
Adrian, Tobias, and Hyun Song Shin. "Money, liquidity, and monetary policy." American Economic Review 99.2 (2009): 600-605.
Howlett, Michael, Michael Ramesh, and Anthony Perl. Studying public policy: Policy cycles and policy subsystems. Vol. 3. Oxford: Oxford University Press, 2009.
Liang, Huang Gui. "Thinking of finance innovation and finance supervision problem under the background of subprime crisis [J]." Special Zone Economy
2 (2009): 020.
