How to Build an Investment Portfolio 10/1/2014 6:40:00 PM

Determinants of Portfolio Choice(asset demand)

The savers wealth
o increase in wealth generally increase the quantity demanded for most financial
assets
The expected rates of return from different investors
o the return expected on an asset during a future period
ER = [(Probability of event 1 occurring) x (Value of event 1)] +
[(Probability of event 2 occurring)x(Value of event 2)]
The degrees of risk in different investments
o risk is the degree of uncertainty in the return on an asset
3 types of Investors
most investors are risk aversechoose the asset with the lower
risk when the two assets have the same expected return
risk-loving investors who prefer to hold risky assets with the
possibility of maximizing returns
risk-neutral investors decision on the basis of expected
returns, ignoring risk
your time horizon is an important factor in deciding this
Younger = portfolio based on maximizing expected
returnslimited concern about the variability of returns
Older=reduce risk by selecting safe assets to earn an
expected return after inflation of about zero
o black swana rare event that has a large impact on the economy
this event may have affects the conventional measure of risk
WSJ: unique events that take place that have a significantly adverse
effect on returns
The liquidity of different investments
o The greater an assets liquidity, the more desirable the asset is to investors.
The costs of acquiring information about different investments
o All else being equal, investors will accept a lower return on an asset that has
lower costs of acquiring information
Desirable characteristics of financial asset cause the quantity of the asset demanded
by investors to increase, vice versa

Diversificationdividing wealth among many different assets to reduce risk
Market (systematic) riskrisk that is common to all assets of a certain type
o Changes in stock returns as a result of the business cycle
Idiosyncratic (unsystematic) riskrisk that pertains to a particular asset (or a firm)
rather than to the market as a whole.

D&S Model to Find Market Interest Rates for Bonds10/1/2014 6:40:00 PM
The bond market approach (bonds as the good)useful when considering how the factors
affecting the demand and supply for bonds affect the interest rate.

when price of bond is above 960 excess supply of bonds and the price of the bonds
will drop; when the price of the bond is below 960 excess demand for bonds and the
price of the bond will rise.
If the price of bonds changes move ALONG the demand /supply curve so we have
a change in the quantity demanded/supplied
If any other relevant variable changes, then the demand/supply curve shifts so we
have a change in demand/ supply
o Relevant variables that shift DEMAND curve for bonds
Wealth
Expected return on bonds
Risk
Liquidity
Information costs
o Relevant variables that shift SUPPLY curve for bonds
Expected pretax profitability of physical capital investments
Expected inflation
Business taxes
Government borrowing
The market for loanable funds approach (funds as the good) is useful when considering how
changes in the demand and supply of funds affect the interest rate.

THE REST IS WRITTEN DOWN
Bond Market Model and Changes in Interest Rate
Ex. of using the bond market model to explain changes in interest rates:
The movement of interest rates over the business cycle.
The Fisher effectmovement of interest rates in response to changes in inflation
Why do interest rates fall during recessions?
An economic downturn reduces household wealth and thus decreases the demand for
bonds.
The fall in expected profitably reduces the lenders supply for bonds
The bond prices increase when the interest rates fall
The Fisher Effect
Indicates that the nominal interest ratechanges point-for-point with changes in the
expected inflation rate
Implies that
o Higher inflation rates result in higher nominal interest rates
o Changes in expected inflation can lead to changes in nominal interest rates
before a change in actual inflation occurs.