Foundations of Finance PDF

Key terms 08 February 2025 10:18 Lecture 1 Financial system - A system that channels funds from entities with surplus funds to units that have a shortage of funds Financial centre - Marketplace for buying and selling financial assets Financial markets - markets in which funds...

Key terms 08 February 2025 10:18 Lecture 1 Financial system - A system that channels funds from entities with surplus funds to units that have a shortage of funds Financial centre - Marketplace for buying and selling financial assets Financial markets - markets in which funds are moved from people with excess funds to units with investment opportunities (capital and money markets) Financial intermediaries - economic agents that specialise in the activities of buying and selling financial contracts and other securities Bubble - rapid substantial rise in equity prices that is not warranted by the economic fundamentals Emerging markets - market of a country that is experiencing rapid economic growth but whose income usually makes it a low/middle income economy Liquidity - ease at which an asset can be turned into cash without affecting the price Financial security - legal claim to a future cash flow Lecture 2 Foundations of Finance Page 1 Lecture 1 - Introduction to the Financial System 26 January 2025 22:26 backwood Footsy index FTSE Klarna Factors that fuelled growth of the financial services industry Globalisation ○ Tendency of financial institutions and customers to move beyond their domestic market to a global market + - Improved access to funds for borrows Loss of local knowledge Better investment opportunities for surplus Exposure to fraudulent practices funds Increased spillovers between markets (recession Expansion opportunities for financial institutions in one country can impact another) ○ Subprime mortgages - mortgages were made to people with low credit rating - higher interest rates to compensate for the risk - 2007 ○ Ponzi scheme - high rate of return which is financed by payments made by newly acquired investors eventually it collapses with large losses Technology ○ The adoption of new technology created more efficient financial service industry + - Increased speed (real-time trading) Security and reliability given privacy concerns Improved access to a broader range of services capital intensive while adequate returns are Reduced costs uncertain Backward compatibility (older versions of the software can't be used - only new software works) Deregulation ○ Reduction or elimination of regulations designed to increase competition and reduce prices facing consumers ○ Usually accompanied by privatisation + - Decrease in compliance costs Lower investor protection Improves the introduction of new innovative Competition across financial centres products ○ Federal deposit Insurance corporation (FDIC) - US corporation that insures deposits of up to 250,000, created to maintain public confidence in the banking system Financial innovation ○ Financial innovation - Design of new financial instruments or the packaging together of existing ones and delivering financial services ○ Market broadening innovation - improve liquidity of markets (securitisation) ○ Risk management innovation - redistribute financial risk exposure (trading portfolios such as index funds) ○ Arbitraging innovation: Exploiting opportunities in different markets using loopholes for regulatory or tax advantages ○ Pricing innovation: novel strategies to set or adjust prices to meet customers' needs (Funding circle or Klarna) ○ Marketing innovation: selling and distribution of financial products (investment apps; Tembo, Etoro) Climate change ○ Climate change refers to long-term shifts in temperatures and weather patterns.(Human factors- burning fossil fuels that generate greenhouse gas) ○ Sustainable Investment Strategies ▪ Green Investment Products including sovereign green gilts and green savings bonds issued by the UK Treasury to enable firms to support sustainability-linked projects. ▪ Corporations are required to disclose the Environmental, Social and Governance (ESG) impact of their activities in ESG reports. ▪ The Financial Conduct Authority legislation on ESG ratings for UK firms. ▪ Mobilising Green Investment (2023) Financial system, financial centres and emerging markets Financial system Financial system - A system that channels funds from entities with surplus funds to units that have a shortage of funds Competitive Financial centres are paramount for foreign exchange earners and provide substantial employment ○ On a global scale, New York, London and Tokyo are the foremost financial centres. ○ Europe- Paris and Frankfurt ○ Southeast Asia- Shanghai, Singapore, Hong Kong ○ Middle East- Qatar, Dubai ○ Africa- Casablanca, Johannesburg, Nairobi, Lagos Financial centres Financial centre - Marketplace for buying and selling financial assets Roles ○ Channel funds from surplus to deficit units Financial markets and Financial intermediaries Financial markets - markets in which funds are moved from people with excess funds to units with investment opportunities (capital and money markets) Financial intermediaries - economic agents that specialise in the activities of buying and selling financial contracts and other securities Bubble - rapid substantial rise in equity prices that is not warranted by the economic fundamentals Emerging markets Countries in southeast Asia and Latin America have received increased investors' attention in recent times They offer spectacular returns, but are volatile with heavy losses Problems: ○ Quality of accounting standards ○ Governance of companies ○ Information costs ○ Political risk Foreign exchange risk Foundations of Finance Page 2  ○ Foreign exchange risk Basic principles pervading all of finance 1. Concept of Money and its functions Financial claims/instruments a. Money - anything that is generally accepted in payment for goods or services Financial claim/instrument - claim to payment of sum of money at some future date or dates b. Medium of exchange - what we use to buy goods and services ○ Its issued by the borrower for which it’s a liability c. Store of value - way to transfer purchasing power from the present to the future ○ Lender holds the claim - which is an asset d. Unit of account - terms in which prices are quoted and debts are recorded 2. Money has time value Characteristics a. Present value ○ Risk b. Future value ▪ Some future outcomes and not known with certainty c. Real returns are only made when lenders charge rate of interest above inflation rate ▪ Price (market) risk - risk that the price will change 3. Information is the basis for decision making ▪ Default risk - risk of not being paid anything a. Good information can get you good returns ○ Liquidity b. Obtaining information can be costly ▪ Ease and speed at which an instrument can be turned into cash without loss c. Information asymmetry can lead to adverse outcomes ▪ Trading a large volume without moving the price 4. Theres always an expected return versus risk trade off ○ Real value certainty a. Risk averse investors - only take on increased risk if there is sufficient prospective return to ▪ Susceptibility to loss due to rise in general level of prices compensate ▪ The purchasing power of when the investment is made vs when its sold b. If Investments A and B have the same level of risk, the investment with the greater expected ○ Expected return return should be chosen. ▪ The higher the expected return the higher demand if risk stays the same c. Investors are exposed to a higher level of risk, expected return must increase to ○ Term to maturity compensate. ▪ Amount of time before the investment and profits can be withdrawn d. The higher the risk, the higher the returns ○ Currency denomination 5. Diversification ▪ Appreciation or depreciation on the relevant exchange rate a. Where risk is inevitable investors protect themselves by using varied portfolio ○ Divisibility b. Too much or too little of one type of investment can be determinantal at any time ▪ Degree to which an instrument can be subdivided into smaller units for transaction Class Activity purposes The spreading of investments provides a more diversified portfolio which will allow for less risk. That Types said the split of her investment should depend on her risk tolerance (willingness) as the emerging ○ Debt markets are more volatile (the prices can experience high changes during the open market), which ▪ Claim of debt means that she is more likely to lose her investment. That said they provide a higher return due to the ▪ Claim that is due to be repaid on a specified future date with interest being paid at increased volatility which could be what she aims to achieve. Depending on her goal and risk livingness regular intervals she should consider rebalancing her portfolio to being more index based rather than emerging markets ▪ Susceptible to a reduction in real value due to inflation to minimize the risk and ensuring stable and consistent growth. The time period she wants to look at will ▪ Repo also impact her decision as if she want to make money within a week she is much more likely to □ Sale and repurchase agreement generate high returns by investing in emerging markets. □ One party sells securities to another for cash with an agreement to repurchases these at an agreed future date and price ○ Equity ▪ Share representing ownership ▪ Most common are shares with the payment being the dividend ○ Liabilities ▪ 4 types of financial liabilities Type of Liability Amount of liability Timing of liability Type I Known Known Type II Known Uncertain Type III Uncertain Known Type IV Uncertain Uncertain Foundations of Finance Page 3  Lecture 2 - Financial Markets 04 February 2025 10:00 Financial intermediation - transfer of funds from economic agents with excess funds to those that need to acquire funds Direct finance Transfer of funds from surplus units to deficit units occurs via financial markets ○ This occurs due to trading of financial securities Surplus units receive returns in form of interest, profit or dividends The surplus unit bears all the risk of the investment Surplus agents ○ Have more money than they need so lend/invest some ○ Their expenditure is less than their income Deficit agents ○ Need money so borrow from surplus units ○ Their expenditure is more than their income Functions and classification of financial markets Why do we need financial markets Markets which facilitate the movement of funds between people with excess to units with investment opportunities Functions of Financial Markets 1. Pricing function Foundations of Finance Page 4  1. Pricing function a. Financial markets provide both buyers and sellers with a fair valuation of the asset they are buying/selling 2. Discipline function a. Fear of adverse market reaction compels corporates and governments to pursue prudent financial policies Classification of Financial Markets Financial markets can be classified according to their characteristic features 1. Whether the assets traded are newly issued or already issued New Assets - Primary Market Seasoned Assets - Secondary Market Sale is UNDERWRITTEN by a financial institution and The Issuer (Company A) does not receive DISTRIBUTED (usually to institutional investors) proceeds from the sale but rather the Issuer (Private company A) receives proceeds from the sale shareholders in Company A. a. Even though the issuer (company) does not get any proceeds from the sales in the secondary market, this market is vital for the issuers, for two reasons: i. prices on the secondary market, determined by the market makers, are an estimate of a company’s value ii. the liquidity provided by secondary markets decreases the cost of capital of the issuers 2. Types of assets traded Debt Markets Equity Markets A security reflecting the amount of money An asset reflecting ownership interest, issued by borrowed by one party from another public corporations to potential investors Debt Instruments: Equity Instruments Bonds (government, corporate), Treasury ○ Ordinary shares (Common stock) bills, Commercial paper, Debentures ○ Preference Shares (Preferred stock) 3. Maturity of the asset traded Money Markets Capital Markets Money markets cater to short-term funding Capital Markets are the markets where long- requirements of financial institutions e.g. banks, term financial securities with maturity longer mutual funds etc. than a year are issued and traded The instruments traded in this market have a The instruments traded are equity (shares) and maturity period of less than one year, typically bonds (debt) debt securities (e.g. Treasury bills) 4. The means of settlement Cash/Spot Market Forward Market This is a market where settlement occurs This is a market where the price is agreed upon today immediately. The price is agreed on today, but settlement (payment and delivery) occurs at a and the delivery of goods is completed today. future date agreed between two parties. Foundations of Finance Page 5  and the delivery of goods is completed today. future date agreed between two parties. Purchasing commodities like corn, wheat, Entering into a forward contract in the oil industry to cocoa and coffee purchase a specific number of barrels 5. The obligation to exchange Futures Market Options Market This is a market where the asset price and date of The buyer has the RIGHT, but not the purchase in the future are predetermined and agreed obligation, to buy the asset on the date and upon in a standardised contract on the exchange. at the price agreed in the past. At this date, the buyer is obliged to complete the purchase consistent with the terms of the agreement 6. The organisational structure of the market a. Regulated market - trading is organised by the exchange (NYSE etc) b. Over the Counter (OTC) Market - buyers and sellers simply trade between themselves, and the products offered are specifically designed to meet clients' requirements c. Tailor-made products based on the client's needs are traded in these markets 7. The method of sale/pricing a. Over the Counter (OTC) market: Products are tailor-made products and pricing is determined directly between buyers and sellers b. Pit trading: occurs INSIDE the exchange (open outcry). Example: the London International Financial Futures Exchange (LIFFE) and Chicago Mercantile Exchange (CME) c. System of Market Makers: market makers quote bid (buy)-ask (sell) prices and buy or sell securities. Example: the London Stock Exchange Financial Market Participants Broker - acts as an intermediary on behalf of investors wishing to conduct a trade ○ Legal agent of the investors ○ Obtain commission for their service Market makers - act as dealers in financial securities ○ Quote both a price at which he is willing to buy (bid price) and higher price at which he is willing to sell (ask price) Motivation for trading - they do it for themselves Arbitrageurs - exploit pricing anomalies to make riskless guaranteed profits If security A trades at a higher price on market 1 than market 2, arbitrageurs will buy the asset in market 2 at a cheap price and immediately sell it in market 1 at higher price. Prices then adjust until the anomaly is eliminated. Hedgers - seek to buy or sell to reduce/eliminate existing risk ○ Try to minimise the risk of the held assets (if negative information breaks they sell) Speculators - undertake long or short positions in markets in hope of making a profit Foundations of Finance Page 6