Principles of Finance
Summer Semester 2009
Natalia Ivanova
[email protected]
Shota Migineishvili
[email protected]
Syllabus
Part 1 - Single-period random cash flows (Luenberger ch. 1, 6, 7.1-.7, 8.1-.4, 9.1-.5, A12, 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, 4.1-.4, 4.7-.9)
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
Literature
 First and Second Part:
Investment Science, David Luenberger, Oxford University
Press, 1998.
 Third Part:
Options, Futures, and Other Derivatives, John Hull, 6th
edition, Prentice Hall, 2005.
 Additional/alternative texts:
 Haugen, Robert A., Modern Investment Theory; Prentice Hall, 2001.
 Levy, Haim and Post, Thierry, Investments, Prentice Hall, 2005.
 Grinblatt, M., and Titman, S., Financial Markets and Corporate Strategy, 2nd
edition, 2002.
3
Introduction to financial markets
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
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 y1 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
Introduction to financial markets
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
Introduction to financial markets
Importance of capital markets
Indifference curves
1.
2.
3.
4.
5.
The individual, whose indifference curves are depicted in the
graph will be indifferent between consumption pairs (C0a,C1a)
and (C0b,C1b) represented by point A and B respectively.
At point D individual consumes more in both periods, hence his
utility is higher. In general curves located northeaster are
associated with higher utility.
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.
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.
Mathematically:
U (C , C )
0
MRS
C1
C0
1
C0
U (C0 , C1 )
C1
6.MRS is greater at point A than at point B, because of
convexity of indifference curves
7
Introduction to financial markets
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 (C0,C1) .
8
Introduction to financial markets
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 W0* W1* -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: MRSi=MRSj=-(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
Introduction to financial markets
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
Introduction to financial markets
Importance of capital markets
Market Places and Transaction Costs
1.
2.
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.
Than total costs society will incur is equal to N ( N 1) C 10C
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
11
Introduction to financial markets
Financial markets and the firm
Source: Admati (2002)
12
Introduction to financial markets
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
Introduction to financial markets
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
Introduction to financial markets
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
Introduction to financial markets
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
Introduction to financial markets
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
Global volume of financial assets
World GDP 2005: 44.4tr USD (worldbank)
Source: SIFMA (2007)
18
Single-period random cash flows: Stocks
Important stock markets
Market capitalization in billion USD
Source: FIBV
Exchange
NYSE
Nasdaq
Tokyo SE
London SE
Deutsche Börse
Swiss Exchange
Toronto SE
Vienna SE
Ljubljana SE
End 1990
End 1995
End 2000
End 2005
2692.6
310.8
2928.5
850
5654.8
1159.9
3545.3
1346.6
11534.6
3597.1
3157.2
2612.2
13310.6
3604
4572.9
3058.2
355.3
157.6
241.9
577.4
398.1
366.3
1270.2
792.3
770.1
1221.1
935.4
1482.2
26.3
-
32.5
0.3
29.9
3.1
126.3
7.9
19
Introduction to financial markets
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