We examine models for determining the value of various financial assets (for example, bonds and stocks) and show how changes in expected earnings or in the interest rate affect the current price of these assets. The book discusses industry and macroeconomics analyses. In particular, it shows how a change in interest rates may affect the value of individual stocks, as well as an individual’s portfolio composition. Throughout the book there is an emphasis on market globalization, the gain from international diversification, and the effect of the currency exchange rate on return in overseas investments.

    Generally, academics and practitioners agree on the effects on stock and bond prices of changes in the most important factors. For example, almost all agree that when the Federal Reserve cuts interest rates more than expected, or when it announces no increase in the interest rate when such an increase is expected , the overall stock market will go up. If the Federal Reserve cuts interest rates less than expected, the overall stock market will go down. Such an overall rise in the stock market or in an individual security is called a rally. Note that the factor must change by more than expected to influence prices. The current price reflects investors’ best estimates of future changes in the factors Thus, when the Federal Reserve cuts interest rates by more than expected, the present value of future cash flows such as dividends increases, and so do stock prices.

    Investors routinely observe that when a firm announces greatest-than-expected quarterly earnings and dividends, the stock price of the firm goes up. The only questionable issue is the extent to which such news will or should affect prices. Indeed, the valuation models presented in the chapters that follow attempt to evaluate both stock and bond prices and the effect of various levels of interest rates and dividends on these prices.

    Because there is general agreement on the effect of the main factors on security prices, it would seem that the investor’s task should be very simple. If investors know, for example, the tomorrow the Federal Reserve will cut interest rates, investors should invest in stocks today and enjoy the stock market rally tomorrow. Unfortunately, however investing is not that simple. What if the Federal Reserve does not cut the interest rate, or the cut is less than what investors expected? In either case, the market will be disappointed, and prices will fall as a result. In general, investors do not completely agree on future forecasts. For example, some investors predict a cut in interest rates while some do not; hence, each investor pursues a different investment strategy. What is safe to assume is that no one has perfect foresight. Rather, investors can only estimate the probability of future events.

    Even if one knows with certainly that some event will occur, no one knows for certain how the stock market will react to the event. Even though the stock market typically rallies when interest rates fall, there is no guarantee that a rally will occur in response to such as interest rate change. For example, from July 1991 through April 1992, the Japanese interest rate was cut from 6% to 3.75%, yet the Japanese stock market fell approximately 20%. Thus, even if investors know for sure that interest rates will be cut in the future, they should not put all their money in the stock market. There is always a risk that the stock market will not react favorably to an interest rate cut.

    Suppose an investor believes that for General Motors (GM), there is a 50% chance that cash dividends and earnings will increase and a 50% chance that they will decrease. For AT&T the same investor predicts a 75% chance of an increase in earnings and dividends and a 25% chance of a decrease. If investors were certain about the future events, they would buy only one stocks – the one with the highest increase in value. However, the future of both stocks is subject to uncertainly. The GM stock could go up and AT&T could go down, despite the odds. To minimize the chance of a loss, the investor may decide to diversify and buy a quantity of both GM and AT&T stocks. Experts recommend that investors diversify by holding several different assets. Analysts further tell investors to study the many investment opportunities outside the United States. These markets may provide an opportunity for substantial risk reduction.

    In reality, information on future earnings, dividends, interest rates, inflation, and productivity is not known with certainty. Thus, the best policy is to invest in a group of securities known as a portfolio, a strategy that reduces the overall risk exposure. Indeed, a large part of this book is devoted to portfolio analysis and how to construct portfolios when perfect knowledge regarding future prices is not available.

    Some of the information will be familiar to readers from work in other classes – particularly corporate finance. This chapter begins by comparing corporate finance and investments and examines careers in the field. The chapter also looks at the types of investments available and the way investors can organize their investment strategies.