chapter sixteen physical capital and financial markets

Chapter Sixteen

Physical Capital and Financial

Markets

Copyright © Houghton Mifflin Company. All rights reserved. 16 | 2

Physical Capital

• Physical capital – Refers to all machines, factories, oil tankers, and other physical resources used in the production of goods and services.

• Depreciation – The decrease in an asset’s value over time; for capital, it is the amount by which physical capital wears out over a given period of time.


Financial Capital

• Financial Capital – Funds used by firms to start up or expand; used to purchase, rent or build physical capital.

• Debt Contract – A contract in which a lender agrees to provide funds today in exchange for a promise from the borrower, who will repay that amount plus interest at some point in the future.


• Equity Contract – Shares of ownership in a firm; payments to the owners of the shares depend on the firm’s profits.

• Owners of the shares benefit from equity contracts when the firm issues dividends, or when the value of the shares increase.

Financial Capital (cont’d)


Stock Prices and Rates of Return

• Return – The income received from the ownership of an asset; for a stock, the return is the dividend plus capital gain.

• Capital Gain – The increase in the value of an asset through an increase in its price.

• Capital Loss - The decrease in the value of an asset through a decrease in its price.


• Rate of return – The return on an asset stated as a percentage of the price of the asset.

• Dividend yield – The dividend stated as a percentage of the price of the asset.

Stock Prices and Rates of Return (cont’d)


Rate of Return Example:

• If a stock was purchased one year ago for $160 and sold today for $180 (and it also gave the stockholder $10 in dividends during this period), then the rate of return (ROR) equals:

%75.18100160

10160180

ROR



Dividend Yield Example:

• From the previous example, the dividend yield equals:

%25.6100160

10DY



• Earnings – The accounting profits of a firm.

• Price-earnings ratio – The price of a stock divided by its annual earnings per share.



• Coupon – The fixed amount that a borrower agrees to pay to the bondholder each year.

• Maturity Date – The date when the principal on a loan is to be paid back.

• Face Value – The principal that will be paid back when a bond matures.

Bond Prices and Rates of Return


Coupon, Face Value, and Maturity Date:

• Example: Suppose that a ten-year bond has a face value of $10,000 and matures on January 2016. The holder of the bond will receive a coupon of 5 percent of the face value every year. The holder of the bond in this case will get $500 every January until 2016 (including 2016) and will also get the $10000 face value in January 2016.

Bond Prices and Rates of Return (cont’d)


• Yield – The annual rate of return on a bond if the bond were held to maturity.

• Note: The price of a bond and its yield should be negatively related. A higher bond price will result in a lower yield, while a lower bond price results in a higher yield.

• Table 16.1 illustrates the relationship between the bond price and the yield of assets with different times to maturity.



• From Table 16.1, we can see that the price of the bond is calculated as the net present value of the stream of coupons received plus the net present value of the face value. With bonds that mature very far into the future, the bond price (P) is equal to the coupon (R) divided by the yield (i), or:

i

RP



Risk vs. Return

• Expected return – The return on an uncertain investment calculated by weighting the gains or losses by the probability that they will occur.

• Expected return does not give information regarding the variability of the return. For example, a bank deposit that pays 5 percent interest gives the same expected return as an asset that has a 50 percent chance of a zero return and a 50 percent chance of a 10 percent return.


• Equilibrium risk-return relationship – The positive relationship between the risk and the expected rate of return of an asset, derived from the fact that, on average, risk-averse investors who take on more risk must be compensated with a higher return.

• Figure 16.4 shows an example of an equilibrium relationship between risk and return.

Risk vs. Return (cont’d)


The Equilibrium Relationship Between Return and Risk

Figure 16.4


• From Figure 16.4, assets with higher risk (like in pt. D) should be compensated with a higher return. Lower risk assets (like pt. A) should have a lower return.

• From Figure 16.4, if any two assets, A and B, have the same return but one has more risk (asset B), then the price of B will drop and its return will rise until it gets to the equilibrium.




• Portfolio diversification – Spreading the collection of assets owned in order to limit exposure to risk.

• Figure 16.5 shows how the risk of a portfolio drops as the number of stocks in the portfolio increases.



Figure 16.5


• From Figure 16.5, the level of systematic risk does not decrease once the number of US or international stocks in the portfolio exceeds 25 stocks. Systematic risk is the risk that is left behind after diversification.

• Systematic risk – The level of risk in market assets that investors cannot reduce by diversification.



Efficient Market Theory

• Efficient Market Hypothesis – The idea that markets adjust rapidly enough to eliminate profit opportunities immediately.

• Stock profit opportunities will easily be wiped out as more will rush to buy the stock and raise its price. If investors believe that losses are forthcoming, they will sell the stock and lower the price.


The Foreign Exchange Market

• Foreign Exchange Market – A market in which one currency (such as the Japanese yen) can be exchanged for another currency (such as the US dollar).

• Exchange Rate – The number of units of a foreign currency that one unit of domestic currency can buy. For example, one US dollar (the domestic currency) could buy 114.4 Japanese yen (the foreign currency) on January 24, 2006.


• Depreciation – The US dollar depreciates against another currency if it takes more dollars to buy another currency or if it takes less foreign currency to buy a US dollar.

• Appreciation – The US dollar appreciates against another currency if it takes less dollars to buy another currency, or if it takes more foreign currency to buy a US dollar.

The Foreign Exchange Market (cont’d)


• Variables that Affect a Country’s Exchange Rate:

1) People’s expectations of rates of return from holding one currency compared with another.

For example, if investing in Canadian bonds is more profitable than investing in US bonds, then more US investors will need more Canadian dollars, and the Canadian dollar will gain value.



2) The prices of goods and services in one country compared to another.

• For example, if the US experiences very high inflation, then more Americans may find it cheaper to buy goods from Canada. This increases demand for Canadian goods and thereby increases demand for the Canadian dollar. The US dollar weakens as a result.



Differences in the Price of Goods and Services in Different Countries

• Purchasing Power Parity – The theory that exchange rates are determined in such a way that the prices of goods in different countries are the same when measured in the same currency.

• For example, suppose an apple in the US costs US$0.60. If the apple is sold in Canada and the exchange rate is US$1 = C$2, then the apple must be priced: C$1.20.


Differences in the Price of Goods and Services in Different Countries

Purchasing Power Parity implies:

*PPE Where: E is the exchange rate (expressed as yen per dollar)P is the average price in the US (the home country)P* is the average price in Japan (foreign country)


PPP example:• If the average price in the US is $10, and the

exchange rate between the US and Japan is ¥100 = $1, then the average price in the Japan must be:

*P¥1000

*10$1$

¥100

P

Differences in the Price of Goods and Services in Different Countries (cont’d)


• One result of PPP, is that in the long run countries with higher inflation rates than the US will experience a currency depreciation against the US dollar. Countries with lower inflation rates than the US will experience a currency appreciation against the US dollar.



• Figure 16.6 shows that Australia, Canada, Mexico, and the UK had higher inflation rates than the US and they all depreciated against the US dollar (during the period 1975-1995). Japan, on the other hand, had a lower inflation than the US, and the yen appreciated against the US dollar.



Purchasing Power Parity, 1970-2004

Figure 16.6


• Figure 16.7 illustrates the correlation between the inflation differential between the US and Japan, and the US$ - Japanese ¥ exchange rate between 1974-1994. The higher inflation rate in the US between 1978-1984 resulted in a stronger yen during that period.



Links Between Rates of Return and the Exchange Rate

Figure 16.7


Key Terms

• Depreciation• Debt contract• Equity contract• Return• Capital gain• Capital loss• Rate of return• Dividend yield


• Earnings• Price-earning ratio• Coupon• Maturity date• Face value• Yield• Expected return• Equilibrium risk-return relationship

Key Terms (cont’d)


• Portfolio diversification

• Systematic risk

• Efficient market hypothesis

• Foreign exchange market

• Exchange rate

• Purchasing power parity

Key Terms (cont’d)

chapter sixteen physical capital and financial markets

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