Cntents Intrductin t Finance... 5 Definitins... 5 Finance... 5 Financial Markets... 5 Mney... 5 Mney vs. Barter Ecnmy... 5 Functins f Mney... 5 Evlutin f Mney... 6 Questins... 6 The Financial System... 7 Financial Agents... 7 Husehlds... 7 Firms... 8 Financial Markets... 10 Primary vs. Secndary markets... 10 Whlesale vs. Retail markets... 10 Mney markets vs. Capital markets... 10 Over-the-cunter vs. Exchange-traded markets... 10 Debt vs. Equity markets... 10 Intrductin t Financial Intermediaries... 11 Frms f Finance... 11 The Flw f Funds... 11 Internatinal Transfer f Funds... 12 Functins f the Financial System... 12 Questins... 14 Financial Intermediaries... 14 Characteristics f Financial Intermediaries... 14 Categrizatin by prducts and services... 15 Financial Intermediatin... 16 Cmmercial Banks... 17 Investment Banks... 19 Bank Accepted Bills... 21 Risk... 21 Regulatin... 22 Time Value f Mney... 24 Interest Rates... 25! 1
Simple Interest... 25 Cmpund Interest... 26 Ecnmic Determinants f Rates f Return... 26 Rate f returns n financial instruments... 27 Rate f return n Risky Assets... 27 Histrical Averages... 28 Inflatin and Interest Rates... 28 Questins... 29 The Mney Market... 30 Characteristics... 30 Functins... 30 Benefits f Mney Market... 30 Financial Instruments... 32 Pricing... 32 Calculating Dealer s spread... 34 Investment Risk... 34 Calculating Hlding perid return and Capital Gain... 34 Price Risk... 35 Mnetary Plicy... 35 What is the cash rate?... 35 Objectives f Mnetary Plicy... 35 Implementatin f Mnetary Plicy... 36 Open Market Operatins... 36 Transmissin f Mnetary Plicy t Ecnmy... 36 Questins... 37 Allcating Resurces ver Time... 37 Cmpunding... 38 Frequency f Cmpunding... 38 Discunting... 39 Investment Decisin Rules... 39 Decisin Rules as a Deficit Unit... 41 Multiple Cash Flws... 41 Annuities... 42 Perpetual Annuities... 42 Lan Amrtizatin... 43 Carry Trade... 43 Inflatin and Discunted Cash Flw Analysis... 43! 2
Taxes and Investment Decisins... 43 Questins nt dne... 44 Husehld Saving and Investment Decisins... 44 A Life Cycle Mdel f Saving... 44 Scial Security... 47 Deferring Taxes thrugh Vluntary Retirement Plans... 48 Shuld yu invest in a Prfessinal Degree?... 49 Shuld yu buy r rent?... 49 Questins nt dne... 51 Principle f Market Valuatin... 51 The relatin between an asset s Value and Price... 51 Value Maximisatin and Financial Decisins... 51 The Law f One Price and Arbitrage... 51 Arbitrage and the Prices f Financial Assets... 51 Interest Rates and the Law f One Price... 52 Triangular Arbitrage... 52 Valuatin Using Cmparables... 53 Tradable vs. Nn-tradable... 53 Valuatin Mdels... 53 Valuatin Shares f Stck... 53 Accunting Measures f Value... 54 The Efficient Market Hypthesis... 54 Different Frms f EMH... 55 Questins nt dne... 55 Valuatin f Knw Cash Flws: Bnds... 55 Characteristics f the Bnd Market... 55 Using PV Factrs t value knwn Cash Flws... 55 Pure Discunt Bnds/Zer Cupn Bnds... 56 Is there a single discunt rate?... 57 Cupn Bnds, Current Yield and Yield t Maturity... 57 Par Bnds... 57 Premium Bnds... 57 Discunt Bnds... 57 Current Yield... 58 Yield t Maturity... 58 Yields... 58 Yield fr the Same Maturity May Differ... 58! 3
! The Effect f the Cupn Rate... 58 The Effect f Default Risk and Taxes... 59 Other Effects n Bnd Yields... 59 Saw Tth Yield Curve... 59 Risk... 59 Questins nt dne... 60 Valuatin f unknwn cash flws: Shares... 60 Characteristics f Share Market... 60 Types f Shares... 60 Share Pricing... 60 Dividend Discunt Mdel... 60 Cnstant Grwth Mdel... 61 Share Issue... 61 Rights Issue... 61 Risk... 62 CAPM... 62 Expected Return... 62 Prblems with CAPM... 63! 4
! Intrductin t Finance Definitins Finance The study f hw peple allcate scarce resurces ver time Different as: Cst and benefits are spread ver time Cst and benefits are usually nt knwn in advance Financial Markets Set f markets and ther institutins used fr financial cntracting, exchange infrmatin and the exchange f assets and risk Mney A widely accepted medium f payment fr gds and services r the repayment f debt (e.g. currency, precius metals, savings depsits) Mney vs. Barter Ecnmy Barter is a methd by which gds and services are directly exchanged fr ther gds and services withut the use f a medium f exchange (e.g. wheat fr clthes) Prices in barter ecnmy =, where N is n. f gds in ecnmy Barter ecnmy is time cnsuming and difficult t undertake Mney vercmes inefficiency f barter ecnmy Functins f Mney Medium f exchange Methd f payment fr gds and services Minimises time spent exchanging gds and services Unit f Accunt Measure t establish cmparable prices between gds and services Decreases n. f prices in ecnmy Stre f Value Save the purchasing pwer frm time incme is received t the time it is spent Smth ut cnsumptin ver time! 5
Evlutin f Mney Cmmdity Mney mney by precius metals r valuable cmmdities Fiat Mney paper currency established by gvt. as legal tender Checks instructin t transfer mney between peple s accunts Electrnic Payment allw payment f bills via internet withut mailing checks E-mney mney existing in electrnic frm (e.g. debit card) Questins 1. Since we studied the evlutin f the payment system, d yu think we are heading twards a cashless sciety? (nt fully)! Scieties based n alternative frms f payments (credit card, debit cards and smart cards) will becme mre cmmn, hwever pilt prjects f intrducing smart cards t cnvert cnsumers t the use f e-mney have nt been a great success. Althugh e- mney might be mre cnvenient and may be mre efficient than a payments system based n paper, several factrs wrk against the disappearance f the paper system. First, it is very expensive t set up the cmputer, card reader, and telecmmunicatins netwrks necessary t make electrnic mney the dminant frm f payment. Secnd, electrnic means f payment raise security and privacy cncerns (hackers accessing bank details). A further cncern is that the use f electrnic means f payment leaves an electrnic trail that cntains a large amunt f persnal data n buying habits. There are wrries that gvernments, emplyers might be able t access this data, thereby encraching n ur privacy. 2. One cmpnent f mney is currency in circulatin. Assume there are 721.0 billin Eurs in circulatin, wh d yu think will hld all these Eurs? If this amunt was t be averaged ver every Eurpean citizen, each persn in Eurpe wuld hld mre than 2200 Eur in cash. Hlding currency means incurring a large pprtunity cst. Peple wh hld mst f the cash are: businesses (makes transactins less traceable fr tax purpses) criminals (n recrd r evidence), freigners (uncertainty abut their wn currency). Half f the Eurs (and USD fr that matters) are held abrad.! 6
Financial Decisins f Husehlds Cnsumptin and Saving hw much f current wealth shuld be spent n cnsumptin and hw much shuld be saved? Investment what frm shuld mney saved be invested? (e.g. term depsit vs. shares) Financing when and hw shuld husehlds brrw (use thers mney) t implement cnsumptin and investment plans? (e.g. buy r rent a huse) Risk Management hw, why and n what terms shuld husehlds reduce r increase risk? (e.g. insurance against fire and theft) Firms Entities whse primary functin is t prduce gds and services Branch f finance fr financial decisins f firms is business/ crprate finance Financial Psitin: Surplus Unit: Prfit - Dividends = Retained Earnings (Saving) = Saving - Investment = (+) Deficit Unit: Saving - Investment = (-) Firms require capital as bth: Physical Capital buildings, machinery etc. Financial Capital stcks, bnds Financial Decisins f Firms Strategic Planning what business firm wants t be in (invlves evaluatin f csts and benefits spread ver time) Capital Budgeting Prcess plan fr acquiring lng-lived assets and persnnel training Investment Prject identifying ideas, evaluating, deciding apprpriate prject, implementing prject Capital Structure finances f entire firm, determine a feasible financing plan then issuing ptimal financing mix. Determines wh gets what share f future cash flw and cntrl f cmpany (sharehlders elect bard members, bnds (cvenants) restrict activities f management) Wrking Capital Management management f day t day cash flws, e.g. ensure cash flw deficits are financed and cash flw surpluses are efficiently invested Chices are dependent upn: Technlgy Industry Regulatins Market Structures Tax Systems! 8
Separatin f Ownership and Management Owner shuld delegate respnsibility t prfessinal managers as: Superir Ability pr managers have better technical knwledge, mre experience, mre suitable persnality Pling f Resurces t achieve an efficient scale f business requires many wners, all f which cannt actively manage the business Diversificatin f Risk wners hld stakes acrss many firms, thus ne wner cannt successfully manage many firms f which they wn a stake in Efficient Infrmatin gathering pr managers gather inf mre efficiently thrugh day t day actin with cmpany Learning Curve when wner sells stake in business, the manager cntinues in place t wrk fr new wners Allws frequent changes in wners by share transfer withut affecting the peratins f the firm Changes in wnership shuld be mre frequent than changes in cmpsitin f management Hwever, separatin f wnership can cause; Cnflict f Interest manager may neglect their bligatins t the sharehlders due t incmplete inf surrunding manager Principle Agent prblem principle hires agent t act in principle s interest, yet agent acts in wn interest The Gal f Management T maximise the wealth f current stckhlders Desn t require the managers t knw the risk preferences r pinins f the sharehlders Market Disciplines: Takevers Imprtant mechanism fr aligning the incentives f managers with thse f sharehlders E.g. Management has chsen an investment plan leading t a market value less than the max. value btainable (mismanaged). A bidder successfully buys enugh shares in firm, replaces the managers with nes wh will perate it ptimally, bidder sells the shares at new market prices, immediate prfit! 9