• Key financial concepts

    This page brings together a number of posts that I call key financial concepts. Each is explained simply for non-experts, mostly without any diagrams or equations. They are intended to be helpful to students or anybody just curious about finance. More posts to come soon. Net present value and cost benefit analysis What do we…

  • Key finance concepts: Net present value and cost benefit analysis 

    A key question in corporate finance is, how should companies decide when to invest the funds at their disposal? The best answer provided by financial economics is to use the net present value (NPV) rule. Here I want to show that NPV is a specific case of the wider principle of cost-benefit analysis (CBA), which…

  • Key finance concepts: the benefits of diversification

    The two foundational concepts in financial economics are: i) risk and return tend to go together, which we explore here; and ii) diversification is a good thing. * The old European proverb, don’t put all your eggs in one basket, captures the benefits of diversification: if you’re collecting your eggs from the chickens in the morning, or if you’re carrying them to market,…

  • Key finance concepts: What do we mean by risk and return? 

    There are two basic, common-sense principles at the heart of finance theory. The first is that risk and return tend to go together, in other words, if somebody offers you an investment which promises to be both low risk and high return there’s probably something wrong with it. And the second principle is the benefit of diversification, which is captured in the old European proverb, don’t put all your eggs…

  • Key finance concepts: The cost of equity

    The cost of equity is the return that equity investors need to be paid, or to expect to be paid, as compensation for bearing equity risk. That’s the the systemic, undiversifiable risk risk you have to bear if you hold a well-diversified equity portfolio,. It’s a key input to the capital asset pricing model (CAPM). * We call it the cost of equity,…

  • Key finance concepts: The risk-free rate of interest

    A key concept in the theory of finance is the risk-free rate of interest, a rate that an investor can achieve at zero risk of a loss. It is the minimum return to compare with the higher expected returns on risky assets, such as equities. It plays a key role in the capital asset pricing…

  • Debt-fuelled bubbles are the dangerous ones

    Bubbles are an enduring feature of financial and commodity markets. But it is when they are driven by debt that their bursting becomes dangerous * The best book I’ve read on financial bubbles is William Quinn and John D. Turner’s “Boom and Bust: A Global History of Financial Bubbles“. It covers the famous ones like…

  • A nuclear three-body problem

    China’s growing nuclear weapon capability risks overturning the relative stability of nuclear deterrence based on only two adversaries * Chinese author Liu Cixin’s novel The Three-Body Problem was an international best seller, and was later turned into a really interesting, though somewhat controversial Netflix TV version (for the record, I liked it). The Chinese title…

  • Learning from the California gold rush

    Selling shovels instead of trying to find gold is an old piece of wisdom about booms and bubbles * It’s a cliché about booms and bubbles that you can probably more dependably make money from selling shovels than actually finding gold. I’ve used this line myself, but only recently, when doing research for a new…

  • Key finance concepts: real versus financial assets

    Real assets are the assets that companies seek to acquire, to build and to invest in. Financial assets are the resources that they raise to allow that to happen. The distinction underpins what we call corporate finance – the financing of corporations. * When economists talk about the real economy, what they mean is the flow of goods and services…