Financial Markets: Present vs Future Value

Session 1: Overview of Financial Markets

• The session aims to familiarize students with the terminology, characteristics, and mechanisms of financial markets and institutions.

Introductory Lecture Structure

• The lecture covers Financial mathematics
• Key Market concepts, financial institutions, technology and markets
• Financial markets and intermediaries
• Equity/Bond/Derivatives/Currency Markets
• Key valuation concepts - money/price/value
• Financial system infrastructure & stability

Discounting: Present Value (PV) vs. Future Value (FV)

• Having €100 now is preferable to €100 in a year due to the opportunity cost of potential interest earned.
• The future value of €100 today with 2% interest after one year is €102.
• The present value of €102 in one year, discounted at a 2% interest rate, is €100.
• The formula to calculate future value: FV = PV × (1 + i).
• The formula to calculate present Value: PV = FV / (1 + i).
• At a 2% interest rate over two years, €100 would become €104.04.
• With cash flow CF due in "n" years and the interest rate "i," the present value is PV = CF / (1 + i)^n.
• The present value of $250 to be paid in two years within an interest rate of 15% is $189.04.
• YTM is the constant interest rate that equals the present value of future cash flows to the value of the debt instrument today.
• For a simple loan, YTM (yield to maturity) is equal to the loan interest rate

Present Value (PV) of Multiple Cash Flows

• A perpetuity is a constant series of cash flows (C) occurring every period and continuing forever.
• PV of a perpetuity: PV = C / r, where r is the discount rate.
• A growing perpetuity is a series of cash flows (Ct) growing at a constant rate.
• PV of a growing perpetuity: PV = C / (r - g), where g is the growth rate.
• An annuity consists of constant cash occur every period for a fixed amount of periods.

Finance Explained

• Finance encompasses money, investment, borrowing, lending, budgeting, saving, and forecasting.
• Finance allocates limited resources, motivates productivity, supports useful enterprises, and manages risk.

Financial Institutions

• Entities that deal with monetary transactions like deposits, loans, investments, and currency exchange.
• Commercial Banks like BNP Paribas, Société Générale, Bank of America
• Ivestment Banks like J.P. Morgan, Goldman Sachs, Barclays
• Insurance Companies like AXA, MACIF, Allianz Life
• Brokerage Firms such as Fidelity, Vanguard
• Central Banks like ECB, and Fed

Financial Technology Defined

• Financial technology aims to improve financial service delivery through technology and innovation
• Areas include Artificial Intelligence, Big Data, and Software Robotics
• New asset classes like blockchain (cryptocurrencies)

Financial Markets

• They facilitate the trading of instruments (securities)
• A security is a tradable instrument with monetary value representing a claim on the issuer's future income or assets.
• The issuer could be a business, government, or municipality.

Trading Securities

• People invest to fulfill a need/desire (saving for retirement)
• Securities fall into four categories - Equity, Debt, Derivative, and Currencies.
• The market is called by its type - equity market, debt market, derivatives market, or forex market
• Equity securities include common and preferred stocks.
• Debt securities include bonds, treasury bills/notes, and bank notes.
• Derivative securities include forwards, futures, options, and swaps.
• Currencies include US Dollar, Euro, etc.

Bonds vs Stocks

• Bonds are not a share of ownership while stocks are
• Bonds are on a fixed maturity while stocks are not
• Bonds have contractual payments while stocks dont
• Bonds return on interest and stocks on dividends and price
• Bonds have highest seniority and stocks lowest

Importance of Financial Markets

• Financial markets channel funds from lenders to borrowers improving economic efficiency.
• Financial market activities affect individuals, firms, and the overall economy.
• Well-functioning financial markets are essential to high rates of economic growth.
• Lender-Savers are households, Businesses, governments and foreigners
• Borrower-Spenders are business firms, governments, households and foreigners

Functionality of Financial Markets

• Borrowers can borrow directly from lenders by selling financial instruments (direct finance).
• Borrowers can borrow indirectly from lenders through financial intermediaries (indirect finance).
• Firms may get a loan from a bank, or sell investors a bond
• Governments can issue bonds

Capital Allocation

• Financial markets must facilitate the efficient allocation of capital, allowing funds to move to productive investment opportunities.
• Well-being of consumers and ability to time purchases
• Financial markets must allocate capital to best use

Financial Intermediaries Importance

• Banks is plays the role of the middleman, they obtain funds from savers and then makes loans/investments with borrowers..
• Intermediation is more important than equity markets

Financial Intermediaries Benefits

• Financial intermediaries reduce transaction costs through expertise and economies of scale.
• Financial intermediaries provide liquiditiy services through checking accounts and converting interests to goods and services

Asymmetric Information

• Financial intermediaries reduce the impact which arises when one party lacks information affecting decision making
• Adverse selection happens before transaction
• Moral hazard occurs after the transaction

Risk Sharing

• Financial intermediaries reduce investor risk exposure through risk sharing, a process knows as asset transformation, because in a sense, risky assets are turned into safer assets for investors.

Exchanges vs. Over-The-Counter (OTC) Markets

• Security markets can be bough and sold via centralized exchanges or OTC, Over-The-Counter.

Equity Securities and Markets

• Represent shares of ownership, a claim to a portion of a business’s profits and assets.
• Returns include stock price increases dividend payments
• Two main types of equity - Common stocks and preferred stocks.

Primary vs. Secondary Markets

• New stocks are IPO, in the primary market.
• Previously issued stocks are traded in the secondary market following supply and demand.
• The price of a stock on the secondary market can fluctuate

Debt Securities and Markets

• Debt securities are created when one party lends money to another.
• The borrower repays the principal plus interest
• Debt markets include government bonds, corporate bonds, and municipal bonds
• Zero-coupon bonds