Intro to Financial Markets and Present Value

Session 1 Overview: Financial Markets

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

Introductory Lecture Key Topics

• Financial mathematics
• Finance concepts, financial institutions, technology, markets
• Financial markets and intermediaries
• Equity, bond, derivatives, and currency markets
• Valuation concept: Money, price, and value
• Financial system, its infrastructure, and stability

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

• Opportunity cost is positive when receiving €100 today is preferable to receiving it in the future.
• Future Value (FV) of €100 is €102 with a 2% interest rate.
• Present Value (PV) of €102 is €100, given a 2% interest rate.
• The formula for Future Value: FV = PV × (1 + i).
• The formula for Present Value: PV = FV / (1 + i).
• For money paid back in two years with a 2% interest: €102 * 1.02 = €100 * (1.02)^2 = €104.04
• Formula for cash flow CF due in n years with interest rate i: PV = CF / (1 + i)^n
• The present value of $250 to be paid in two years at 15% interest is $189.04 which is calculated as: $250 / (1.15)^2
• Yield to maturity is a constant interest rate that makes future cash flow's present value equal to the debt instrument's value today.
• For a simple loan, yield to maturity equals the loan interest rate.

Present Value of More Than One Cash Flow

• A perpetuity is a constant series of cash flows, C, occurring every unit period and continuing indefinitely.
• The formula for present value for perpetuity PV = C / r.
• A growing perpetuity is a series of cash flows, Ct, occurring every unit period which continues forever. The cash flow grows at a constant rate, g, every unit period (year) after.
• The present value formula for growing perpetuity is PV = C / (r-g) with C equaling the cash flow
• An annuity features a series of constant cash flows, C, occurring every period for a fixed number of unit periods
• An annuity matures on the period of the last cash flow
• Present value for an annuity formula calculates at PV = C/r * (1- 1/(1+r)^T)
• Growing annuity: series of period cash flows, Ct, which occur for a fixed number of periods It grows at a constant rate g, every period after.
• With given period T, when the last cash flow occurs and the annuity is said to have a maturity of T periods Present value fomular calculates as PV= C/(r-g) * (1-((1+g)/(1+r))^T)

Finance Defined

• Finance covers money, investing, borrowing, lending, budgeting, saving, and forecasting.
• Finance is a pillar of human society, involving the allocation of limited resources across space and time.
• Finance includes motivating productivity, supporting enterprises, and managing risk and uncertainty.

Financial Institutions

• Financial institutions handle financial and monetary transactions like deposits, loans, investments, and currency exchange.
• Examples include Commercial Banks like BNP Paribas, Investment Banks like J.P. Morgan, Insurance Companies like AXA, Brokerage Firms like Fidelity and Central Banks

Financial Technology Overview

• Financial technology aims to innovate and compete with traditional financial service delivery methods.
• Key technologies include Artificial Intelligence, Big Data, Software Robotics, and new asset classes like blockchain/cryptocurrencies.

Understanding Financial Markets

• Trading of financial instruments namely securities occurs in financial markets.
• A security is a tradable instrument holding monetary value, representing a claim on the issuer's future income or assets.
• A security is a tradable financial instrument that is a claim on the issuer's future income or assets, and the issuer could be a company, a government, a municipality, etc
• Securities broadly include equity securities, debt securities, derivative securities, and currencies.
• Financial Market types are equity markets, debt markets, derivatives markets, and Foreign Exchange Markets (Forex).

Bonds vs Stocks

• Bonds aren't a share of ownership with fixed maturity, include return as interest, and are the highest seniority
• Stocks are a share of ownership with no maturity that return as dividend+increase of price and are the lowest seniority.
• Stocks entail more risk, so must have higher return

The Importance of Financial Markets

• Financial markets channel funds from lenders to borrowers, promoting economic efficiency.
• They impact personal wealth, business firms, and the overall economy.
• They are key factors in fostering high economic growth.

Lender-Savers vs Borrower-Spenders

• Channels excess funds from Lender-Savers to Borrower-Spenders.
• Lender-Savers include households, business firms, government and foreigners
• Borrower-Spenders include business firms, government, households and foreigners
• Direct finance involves borrowing directly via financial instruments; indirect finance goes through intermediaries.

How Financial Markets Function

• General Motors can get a loan bank, use a selling investors bond, or a debt a security to manufacture electric cars
• A government facing a deficit can issue bonds to reimburse previous debts.
• Financial markets more capital from those who lack production to those who have opportunity

Financial Intermediaries: Why Are They Important?

• Financial intermediation is how funds move Lenders to Borrowers in financial market'
• Intermediaries obtain funds from savers, then makes loans/investments with borrowers.
• They are a key force behind transactions costs and asymmetry of information

Problems and Limitations

• Absence of financial transactions has limitations such as high transactions costs, and information asymmetry.
• Intermediaries reduce transactions costs, provide liquidity services, and solve liquidity services

Asymmetric Information & Financial Intermediaries

• Financial intermediaries reduce impacts of asymmetric information in which one party lacks key information about another
• Asymmetric factors include adverse selection and moral hazard, which can both affect decision making

Adverse Selection & Moral Hazard

• Adverse selection happens prior to transaction establishment
• It consists of bad (adverse) borrowing outcomes, and unhealthy people wanting insurance for current and known problems
• Moral hazard happens post-transition establishment
• In the insurance sector, people engage in risky activity because the person will not payback borrowed money

Risk Sharing

• Financial intermediaries reduce risk by process of risk sharing and create/sell low-risk assets by selling lower risks
• Through asset transformation risky, assets become lower risks

Exchanges vs Over The Counter (OTC)

• The security market allows financial securities to be bought and sold between parties, based on demand and supply.
• Major types of security markets include centralized exchanges and broker-dealer networks for an offer the counter or over the counter

Equity Securities and Markets

• Equity securities are shares of ownership with returns from stocks increasing in stock value or dividends being rewarded
• They can be structured as common stocks or preferred stocks

Primary vs Secondary Markets

• New stocks are released with an underwriting bank, and buyers via initial public offerings in the primary market to raise funds
• Investors engage in the secondary market following the first public stock release
• All securities follow the primary and secondary patterns with secondary market patterns determine the value and success of equity

Debt Securities and Markets

• In order to acquire principal and an interest of time, borrower sellers are required to repay in financial assets and in debt
• Government vs corporate vs municipal bonds along with zero-coupon bonds, are types of debt.

Comparison of Geographical Areas

 Stock market is more dominant across the EU then Bond markets
 In the USA, the comparison ratio is balanced with bonds playing as the majority and the stock market operating as the secondary.
 Historical reasons, culture, religion, protection of investors, enterprise governance, and disclosure of information, factor into stock market and bond success

Derivatives and Markets

• Value is based of underlying assets and some or more secure These are financial instruments whose values are based off of the underlying asset
• Markets are leveraged to both speculate or head to risks
• Contracts fall into forwards which are private agreements and options, which provide owners the right to buy or sell underlying assets

Foreign Exchange (Forex) Markets

• Sets international currency change rates
• Since it is electronically conducted over the counter
• Since it is electronically conducted, the largest worldwide with 6.6 trillion changing rates which affect imports

Money & Monetary vs Value & Price

• Money is a medium of exchange that is a measure of value
• Price is what we pay or the markets values
• But value is our belief of something's worth intrinsically

Money and Medium

• Necessary for exchange rate medium, but only has value because the financial system supports it.
• It is not backed by silver or gold
• Central banks determine the value of an economy

Federal Reserve System vs European Central Bank (ECB)

• These are central banks are important in financial systems
• The following video will provide context: https://www.youtube.com/watch?v=TAlcFwGIQBg&ab_channel=EuropeanCentralBank

The Financial System Infrastructure

• Consists of institutions, financial markets, and financial infrastructure of payment transfer The clearinghouse functions as a transfer of funds between banks and securities

Video on the topic

• The following video can provide you with more information: https://www.youtube.com/watch?v=hc9ntZmB0i8&ab_channel=EuropeanCentralBank

The Financial System Ingredients

• There must be enforced property rights, the institutional framework is to be trusted, and be transparent
• Lack of trust can disrupt markets

France and AMF

• Regulated by the Autorité des Marchés Financiers (AMF), ensuring investor safety and orderly markets. The ACPR supervises banking and insurance sectors The “police of the banks”, in which enities impose sanctions
• France and ACPR

Supervisory Functions

• Single supervisory mechanism SSM with ECB provides for all banking to ensures safety, soundness and, integration stability
• The following video can provide more context on the single supervisor mechanism (SSM):https://www.youtube.com/watch?v=xC_2N0Y20qQ

Financial Stability

• Is how the market can absorbs financial and real economic shock and transfers funds from savers to investors
• Professional risks are managed and transferred
• Lack of this can lead to financial crisis such as the 2007 and 2008 crisis and/or the pandemic