Transcript Introduction to Economics

Introduction to Economics
Linking Personal Investment with the
US Economy
Macroeconomics
Llad Phillips
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Part Two
Macroeconomics and the US Economy
5. Tuesday, Oct. 13, 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, “The Big Ideas in Macroeconomics”
emphasis: measuring the ouput of the economy, unemployment, inflation
O’Sullivan and Sheffrin, Ch. 21, “Behind the Economic Statistics”
Problems O & S Text
p. 420: 1, 2, 3, 4, 5, 6, 7, 8
p. 441: 1, 2, 3, 4, 5, 6, 7, 8
Thursday, Oct. 15 , 25 minute QUIZ, You will need scantron sheet
and #2 pencil.
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Outline: Lecture Five
Tracking Asset Markets and the US
Economy
 Growth Rate of Personal Wealth

 the
importance of savings relative to rate of
return on wealth

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
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Your Stocks
Market
Indices
corporate earnings(profits)
The Economy
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UC Funds: Monthly Rate of Return
8
6
2
97.05
97.03
97.01
96.11
96.09
96.07
96.05
96.03
96.01
-2
95.11
0
95.09
Rate
4
Equity
Insurance
-4
-6
Year:Month
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UC Funds Monthly Rate of Return
0.7
0.6
0.4
0.3
Insurance
Money Market
Savings
0.2
0.1
97.05
97.03
97.01
96.11
96.09
96.07
96.05
96.03
96.01
95.11
0
95.09
Rate
0.5
Year:Month
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UC Funds: Monthly Rates of Return
8
Bond
Equity
Multi-Asset
6
2
97.05
97.03
97.01
96.11
96.09
96.07
96.05
96.03
96.01
-2
95.11
0
95.09
Rate
4
-4
-6
Year:Month
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Two Kinds of Assets
low rate of returnlow variability
 want high rate of
return return on
average
 want low variability

 predictable
high return-high
variability
 want high rate of
return on average
 want low variability

average
return
Dilemma: which kind of asset to hold?
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Investment Principles or Maxims
 Don’t
hold
put all of your eggs in one basket
a diversified portfolio
 cash
 bonds
 stocks
 real
estate
advantage
of a mutual 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
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Measures of Average Rate of Return and Variability: Mean & Std. Dev.
Date
Bond
95.09
95.1
95.11
95.12
96.01
96.02
96.03
96.04
96.05
96.06
96.07
96.08
96.09
96.1
96.11
96.12
97.01
97.02
97.03
97.04
97.05
97.06
standard deviation
mean
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Equity
Insurance
2.66
2.4
3.9
2.83
-0.51
-5.42
-0.63
-0.75
0.78
1.68
0.34
0.35
4.21
7
5.56
-4.16
0.04
1.35
-3.59
2.23
2.59
2.75
4
-0.26
4.07
-0.13
3.32
2.35
-0.24
1.6
2.56
-0.12
-5.01
2.33
4.59
0.39
7.69
-1.25
4.59
0.42
-2.33
4.09
6.16
3.5
0.64
0.66
0.64
0.66
0.64
0.6
0.64
0.61
0.63
0.61
0.63
0.63
0.61
0.63
0.61
0.62
0.62
0.56
0.64
0.6
0.62
0.6
3.00
1.16
2.95
1.92
0.02
0.62
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Distribution of Monthly Rates of Return, UC Equity
Fund, Sept. '95- Aug. '98
6
5
3
2
Aug. ‘98
1
7
5
3
1
-1
-3
-5
-7
-9
-11
0
-13
Number
4
Monthly Rate
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Mean Returns & Standard Deviations
UC Funds: Mean Return Vs. Risk (Standard Deviation)
2.00
Equity
1.80
1.60
Mean Return
1.40
1.20
Multi-Asset
Bond
1.00
0.80
0.60
Insurance
Savings
0.40
Money Market
0.20
0.00
0.00
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0.50
1.00
1.50
2.00
Standard Deviation
2.50
3.00
3.50
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Efficient Investment Portfolio
UC Funds: Mean Return Vs. Risk (Standard Deviation)
2.00
Equity
1.80
1.60
Mean Return
1.40
1.20
Multi-Asset
Bond
1.00
0.80
0.60
Insurance
Savings
0.40
Money Market
0.20
0.00
0.00
0.50
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1.00
1.50
2.00
Standard Deviation
2.50
3.00
3.50
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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
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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
A
Iso - Preference Curves
Prefer B to A; Prefer B to C
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Risk, R
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Efficient Investment Portfolio
UC Funds: Mean Return Vs. Risk (Standard Deviation)
2.00
Investor A: very risk averse
1.80
Equity
1.60
Mean Return
1.40
1.20
Multi-Asset
Bond
1.00
0.80
0.60
Insurance
Savings
0.40
Money Market
0.20
0.00
0.00
0.50
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1.00
1.50
2.00
Standard Deviation
2.50
3.00
3.50
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Efficient Investment Portfolio
UC Funds: Mean Return Vs. Risk (Standard Deviation)
2.00
Investor B: not very risk averse
Equity
1.80
1.60
Mean Return
1.40
1.20
Multi-Asset
Bond
1.00
0.80
0.60
Insurance
Savings
0.40
Money Market
0.20
0.00
0.00
0.50
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1.00
1.50
2.00
Standard Deviation
2.50
3.00
3.50
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Efficient UC Investment Portfolio
 f*insurance
where
contract + (1-f)*equity fund
f can range from zero to one
example:
50:50, i.e one half of your nest egg
is invested in the Insurance Contract and the
other half is invested in the Equity Fund.
• mean return: 1/2 *0.62 + 1/2*1.92 = 1.27 % per
month
• expected risk(standard deviation: 1/2*0.02 +
1/2*3.02 =1.52
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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) ?
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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
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asset pricing model
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Monthly Rates of Return: UC Index Fund, S&P500
8
UC Equity
S&P 500
6
2
97.05
97.03
97.01
96.11
96.09
96.07
96.05
96.03
96.01
-2
95.11
0
95.09
Percent
4
-4
-6
Date
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Variation of Rewards: UC Index Fund Vs. S&P 500
8
96.11
6
UC Index
4
2
0
-6
-4
-2
0
2
4
6
8
-2
y = 0.8127x + 0.0474
2
R = 0.8727
-4
96.07
-6
S&P 500
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
Capital Asset Pricing Model
return to an asset varies with the return to
the market
 if
the relationship is perfect, R2 =1, and all the
risk in the asset is market risk
 if the relationship is nonexistent, R2 =0, and all
of the risk is asset specific

In symbols
+ rS&P + e
 r is the return
 if  is greater than 1, the asset is riskier than
the market
 e is the residual or error
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 rUC =
Sources of Information: stock prices

Daily Quotes
 Business
Section of Los Angeles Times
 Wall Street Journal

Internet graphics
 http://www.stockmaster.com
 http://www.networth.galt.com
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beta for Apple = 0.67
http://www.stockmaster.com
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http://www.networth.galt.com
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Apple Computer
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How do you make your nest egg grow?

Do you need to take risks and get a high rate
of return?
 not
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if your ratio of savings to wealth is high
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Relative
Importance
of
Savings
 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
Llad
Phillipsof savings to wealth of
 ratio


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

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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
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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
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Years to Double Wealth
Rate of Growth of
Wealth, 100*² w/w
4%
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Years to Double
17.3
8%
8.7
10%
6.9
16%
4.3
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rate of return
on wealth, r
rate of growth of wealth, ∆w/w
∆w/w r + s/w
12%
8%
4%
0
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4%
8%
12%
ratio of
savings to
wealth, s/w
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Where does the growth in
financial wealth come from?

What is the relationship between financial
markets and the economy?
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Index of Dow Jones Industrials, Weekly Closing .
10000.00
9000.00
DJIWKLY
exponential trend
8000.00
7000.00
DJI
6000.00
5000.00
weekly rate of growth = .0023
annual rate of growth = 52*.0023 =.12
10/9/98
4000.00
3000.00
0.0023x
2000.00
1000.00
y = 1601.9e
R2 = 0.933
1/3/86
0.00
0
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100
200
300
400
Week
500
600
700
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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 + ...
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Income-Expense Statement for an Individual
Income
Expenditure
Savings
Income-Expense Statement for a Business Firm
Gross Revenue
Cost
Profit (net revenue, net earnings)
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http://www.globalexposure.com/
Last Ten Years
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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

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Your Stocks
Market
Indices
corporate earnings(profits)
The Economy
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Index of Leading Economic Indicators
Gross Domestic Product
Unemployment Rate
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Index of Leading Indicators
1948-
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Recall Lab One: Resources for Economists on the Internet
http://rfe.wustl.edu/
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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
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US Postwar Expansions
Trough - Peak
Oct. ‘45 - Nov. ‘48
Oct. ‘49 - July ‘53
May ‘54 - Aug. ‘57
April ‘58 - April ‘60
Feb. ‘61 - Dec. ‘69
Nov. 70 - Nov. ‘73
March ‘75 - Jan. ‘80
July’80 - July ‘81
Nov. ‘82 - July ‘90
March ‘91 - ?
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Duration, Months
37
45
39
24
106
36
58
12
92
?, 77+ 90
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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
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Summary-Vocabulary-Concepts








capital asset pricing
model
market risk
asset specific risk
stock’s beta, 
moving average
exponential growth
Dow Jones Industrials
present value
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







net earnings per share
expectations
discount factor
corporate profits after
taxes
business cycle
peak
trough
index of leading
indicators
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