Principles of Finance Summer Semester 2009

Transcription

1 Principles of Finance Summer Semester 2009 Natalia Ivanova Shota Migineishvili

2 Syllabus Part 1 - Single-period random cash flows (Luenberger ch. 1, 6, , , , A1-2, B1-3) Stocks (incl. empirical features of returns) Mean-variance portfolio theory Utility theory Capital Asset Pricing Model (incl. performance measurement) Factor models (incl. Arbitrage Pricing Theory ) Part 2 - Multi-period deterministic cash flows (Luenberger ch. 3, , ) Fixed income securities (incl. credit and market risk) Floating rate notes Midterm Part 3 - Derivative securities (Hull parts from ch. 1-3, 5, 7-11, 13, 15, 17) Forwards Futures Options Swaps 2

3 Literature First and Second Part: Investment Science, David Luenberger, Oxford University Press, Third Part: Options, Futures, and Other Derivatives, John Hull, 6th edition, Prentice Hall, Additional/alternative texts: Haugen, Robert A., Modern Investment Theory; Prentice Hall, Levy, Haim and Post, Thierry, Investments, Prentice Hall, Grinblatt, M., and Titman, S., Financial Markets and Corporate Strategy, 2 nd edition,

4 Overview Importance of financial markets Financial markets and the firm Players in financial markets Products traded on financial markets Classification of financial markets Pricing 4

5 Importance of capital markets Question: Do capital markets benefit the society? To answer this question we should compare welfare of the society in situations with and without capital markets. No capital market Additional Assumptions: - No uncertainty - No transaction costs, no taxes - One period context - One individual-robinson Crusoe - Individual is endowed with beginning of the period and tend of the period income: y 0 and y 1 Euros. - Individual possesses inter-temporal utility function over the consumption pair. Individual prefers beginning of the period consumption to end of the period consumption. - Holding end of the period consumption constant utility function U satisfies, U >0, U <0. - Individual faces a production opportunity set, inhabiting decreasing but positive marginal rate of return. 5

6 Importance of capital markets Inter-temporal Utility function in the three dimensional space More convenient way graphically to represent utility of individuals is to draw so called indifference curves i.e. set of curves in two dimensional space, showing bundle of consumption between which individual is indifferent. 6

7 Importance of capital markets Indifference curves 1. The individual, whose indifference curves are depicted in the graph will be indifferent between consumption pairs (C 0a,C 1a ) and (C 0b,C 1b ) represented by point A and B respectively. 2. At point D individual consumes more in both periods, hence his utility is higher. In general curves located northeaster are associated with higher utility. 3. Slope of the straight line tangent to the indifference curve measures the trade-off rate between beginning and end of the period consumption at the point of tangency. 4. This trade-off rate is called Marginal Rate of Inter-temporal Substitution (MRS) and represents internal price of today's one unit of consumption in terms of tomorrows consumption. In other words it is measure of time preference. 5. Mathematically: U ( C0, C1) C1 C0 MRS C U ( C 0 0, C1) C 1 6.MRS is greater at point A than at point B, because of convexity of indifference curves 7

8 Importance of capital markets Equilibrium in the Robinson Crusoe Economy 1.AX curve represents individual s production opportunity frontier. 2. At initial point the individual compares MRS with marginal rate of transformation (MRT). If the latter is more than the former he will invest. 3. The individual will continue to invest till MRS=MRT. 4. Equilibrium consumption bundle is represented by the point B (C 0,C 1 ). 8

9 Importance of capital markets Equilibrium with Capital Markets 1. Now let s make modification in our initial assumptions and assume that there exist a capital market. 2. In our context this means that there exist risk-free investment possibility in securities, with risk-free rate of return r. 3. Capital market is represented on our graph with the straight line W 0* W 1 * -called capital market line (CML). The slope of the line is equal to (1+r). 4. Now individual compares MRT with 1+r and invests till MRT=1+r (point D). 5. Than he, if relatively impatient, will borrow money in the capital market and increase consumption today (point B). 6. Or if lenient, he will lend money at the capital market to other individuals to increase his future consumption (point A). Equilibrium condition: MRS i =MRS j =-(1+r)=MRT Irving Fisher, Theory of Interest (1930): Through the alterations in the income streams provided by loans or sales, the marginal degrees of impatience for all individuals in the market are brought into equality with each other and with the market rate of interest. 9

10 Importance of capital markets 1. As we see from the graph both individuals attain higher utility levels, meaning that capital markets increase welfare of the society. 2. Capital markets allow the efficient transfer of funds between borrowers and lenders. In particular : 3. Individuals who have insufficient wealth to take advantage of all their investment opportunities, that yield higher than market rate of return can borrow at the capital market and invest more than they would without capital markets. 4. On the other hand lenient individuals, with sufficient wealth but scarce investment opportunities will be able to lend funds at the financial market. 5. This process increases welfare of both lenders and borrowers. 6. Interesting implication of the above given analysis is so called Fisher separation theorem: Given perfect and complete capital markets, the production decisions are governed by an objective market criterion, without regard to individual s subjective preferences between inter-temporal consumption decision. 7. This means that optimal rule for the firm s investment decision is to invest till marginal rate of return equals marginal opportunity cost of that investment. At the same time investment decision can be delegated to managers. 10

11 Importance of capital markets Market Places and Transaction Costs 1. Assume there are 5 individuals in the economy and assume that individuals should visit each other to exchange funds. Assume cost of trip is equal to C. 2. Than total costs society will incur is equal to N( N 2 3. Suppose now there is a market place where all individuals can gather. In this case total cost of the society is equal to 5 C. 4. This simple example shows how marketplaces reduce transaction costs, this is referred as operational efficiency of capital markets. 5. Existence of capital markets enables individuals to share risk 1) C 10C 11

12 Financial markets and the firm Source: Admati (2002) 12

13 Players in financial markets Borrowers: need funds Lenders / investors: wish to invest funds Hedgers: want to reduce risk Speculators: are willing to take risk Arbitrageurs-People who engage in arbitrage. They lock in profits by exploiting market inefficiencies Type A arbitrage If an investment produces immediate positive reward, with no future obligation. Type B arbitrage- If an investment has non-positive costs but positive probability of yielding a positive payoff, and no probability of yielding negative payoff in the future. Financial Intermediaries (FI) 13

14 Players in financial markets: Financial Intermediaries (FI) Banks: match borrowers and lenders / investors Ex-post information asymmetry between potential lenders and a risk neutral entrepreneur and costly monitoring FI (commercial banks) are optimal (least costly alternative) given a high number of lenders (see Diamond (1984)). Other FI: Investment banks: help companies to obtain funding directly from lenders, managing M&A Brokers: match investors wishing to trade with each other Market makers: commit to quote prices at which they are willing to buy or sell from or to investors Insurance companies Mutual funds-closed-end,open-end,uit. Hedge Funds 14

15 Products traded on financial markets Bonds / fixed income securities (deterministic contractual CF stream): classification e.g. according to issuer (government bonds and corporate bonds), or default risk (investment grade, junk bonds, etc.) Shares (random CFs): common stock are securities which entitles their holders to some share in the companies profit. In particular their holders receive dividends. In addition, holders of common stock are able to influence the corporation through voting on establishing corporate objectives and policy, stock splits, and electing the company's board of directors. Preferred stock usually carries no voting rights, but bear superior priority over common stock in the payment of dividends and upon liquidation. Currencies / foreign exchange (FX) 15

16 Products traded on financial markets Derivatives: forwards, futures, swaps and options Forwards-are contracts initiated at one time, performance in accordance with the terms of the contract occurs subsequent time. Price at which exchange occurs is set at the time of the initial contracting. Futures-are type of forward contract with highly standardized and closely specified contract terms. - Futures always trade on organized markets. Performance is guaranteed by clearing house. They require that traders post sum of money on the margin accounts. Swaps are agreements to exchange one cash flow stream for another. There exist interest rate, currency swaps and commodity swaps. Options-there exist two types of options: calls and puts. - Calls-are contracts which give a right (not an obligation) to their holders to buy a specified commodity for a specified price at a specified date (European call) or at any time before its expiration (American call). - Puts-are contracts which give a right to their holders to sell a specified commodity for a specified price at a specified date (European put) or at any time before its expiration (American put). 16

17 Classification of financial markets according to traded products: stock market, bond market, derivatives market, FX market, commodities market according to the maturity of investments Spot market: trade date equals delivery date Future market: trade date before delivery date Money market: short-term borrowing (/ - debt financing) and investing Capital market: long-term borrowing (/ - debt financing) and investing according to issuance vs. trading of securities Primary market: initial public offerings (IPOs) Secondary market: trading of existing securities according to the trading system Organized exchanges: centralized auction-type markets Over-the-counter (OTC) market: network of security dealers who make markets by taking positions in individual securities on their own account 17

18 Global volume of financial assets World GDP 2005: 44.4tr USD (worldbank) Source: SIFMA (2007) 18

19 Single-period random cash flows: Stocks Important stock markets Market capitalization in billion USD Source: FIBV Exchange End 1990 End 1995 End 2000 End 2005 NYSE Nasdaq Tokyo SE London SE Deutsche Börse Swiss Exchange Toronto SE Vienna SE Ljubljana SE

20 Pricing Supply and demand price and quantity in an equilibrium (supply = demand) What determines the price at which investors are willing to trade? Expectations about future cash flows Timing of these cash flows Riskiness of these cash flows Present value of future CFs The usual assumptions Investors prefer more to less Investors are risk averse Investors prefer early consumption to late consumption Investors are rational 20