write one essay on finance topic about 600 words
stepheny
02FinancialMarketsandInstruments.pptxTopic 1 financial markets and instruments
Fundamentals of Finance
Fall 2017
Zhun Liu
Readings
Berk, DeMarzo and Harford, Chapter 1
The Financial Ecosystem
Financial Intermediaries (e.g. Banks)
Financial Markets:
CDs, Bonds, Stocks…
Agents with financing needs
Agents with investment needs
Deposits
Demand for
securities
Issuance of
securities
Lending
The Financial Ecosystem
Who are the agents with financing needs / Why they need financing?
Land, buildings, equipment, labour, working capital, consumption
Who are the agents with investment needs? / Why they need financing?
Banks, financial markets, venture capital, private equity
Types of financial intermediaries
Commercial Banks
Investment Banks
Full service consultant on issuance of new securities
Frequently take a position in new securities, at least temporarily
Mutual Funds
Pooling mechanism to overcome market frictions
Highly regulated
Hedge Funds
Similar to mutual funds, but restricted investor base
Less regulation
Venture Capital/Private Equity
Real versus financial assets
Real Assets
Assets used to produce goods and services
Necessary for economic production
Create real economic value
Positive net supply
Examples:
Tangible assets:
Factories, land, buildings, machinery, etc.
Commodities, materials, etc.
Intangible assets:
Human capital, patents, brand name, etc.
6
Real versus financial assets
Financial Assets
Claims to cash flows generated by real assets
Allows allocation and re-allocation of capital (value)/risk
Financing of projects – allocation of capital (value)
Hedging and diversification – allocation of risk
Consumption smoothing
Saving and borrowing – to maximize your utility
Zero net supply
Examples of Financial Instruments
Examples:
Primitive assets:
Direct claims to real assets
Equity (stocks)
Bonds (government/corporate)
Derivatives:
Claims to primitive financial assets
Options, futures, forwards, swaps, etc.
8
Types of Financial Markets
Primary and Secondary markets
Primary Market
where securities are issued/offered and sold for the first time
Typically through auction mechanism
To raise capital: cash flow from investors to issuing institution
9
Primary Markets
Examples:
Government securities: Treasure bills/bonds, Federal Agencies Debt, Municipal Bonds
Corporate securities (e.g. stock)
Initial public offering (IPO)
Seasoned equity offering (SEO)
Others (e.g. “rights issues”)
10
Markets: IPO activity
11
Types of Financial Markets
Primary and Secondary markets
Secondary Market
Previously issued securities are resold (traded)
On organized exchanges or OTC
Cash/securities are changed between investors
Investors usually trade through brokers
Examples:
Organized exchanges: NYSE, LSE…
Over-the-counter (OTC) markets: NASDAQ(?)
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Types of Financial Markets
Exchanges & Over-the-Counter Markets
Exchange
Location where sellers and buyers meet to conduct transactions
Equities: NYSE, NASDAQ(?), BATS
Over-the-Counter markets
De-centralized dealers conduct transactions over the phone or via computer.
Bonds, swaps, currencies
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I. Fixed Income Securities
Examples: borrowing instruments and bonds (treasury, municipal, corporate)
Now that we understand some of the important roles that financial assets play, let’s start by discussing the 4 broad categories of financial instruments.
Q: What is a bond?
Q: What are the cash-flows on a bond? A: a fixed amount of dollars.
[Notice the minus sign in front of the price. Why? It is a cash outflow. Also notice that Price is not equal to 40+40+…+1040 because of the time value of money adjustment!]
The cash-flows of a bond are two fold: principal repayment and semi-annual coupon payments (draw payoff graph)
As we will see in detail in classes 3 and 4, and later again in classes 17-19, to price a bond we need to sum up all the cash-flows (the coupon payments and the principal). However, to account for the fact that we rather have money now than money in the future, we discount future payments. This is a time value of money adjustment.
Now let’s talk in more detail about the kind of bonds
In the process I’ll also give you some idea about the relative importance of each of these securities.
3/48mins
I. Fixed Income Securities
Fixed cash-flows: coupons or interest payment
Valuation: Time value of money (TVM) adjustment
Example of payment structure: Cash Flow diagram for buying and holding a 10-year, 8%, semi-annual coupon bond with $1000 face value:
t=0
t=0.5
t=1.0
t=10.0
t=9.5
- Price
$40
$40
$40
$1,040
Now that we understand some of the important roles that financial assets play, let’s start by discussing the 4 broad categories of financial instruments.
Q: What is a bond?
Q: What are the cash-flows on a bond? A: a fixed amount of dollars.
[Notice the minus sign in front of the price. Why? It is a cash outflow. Also notice that Price is not equal to 40+40+…+1040 because of the time value of money adjustment!]
The cash-flows of a bond are two fold: principal repayment and semi-annual coupon payments (draw payoff graph)
As we will see in detail in classes 3 and 4, and later again in classes 17-19, to price a bond we need to sum up all the cash-flows (the coupon payments and the principal). However, to account for the fact that we rather have money now than money in the future, we discount future payments. This is a time value of money adjustment.
Now let’s talk in more detail about the kind of bonds
In the process I’ll also give you some idea about the relative importance of each of these securities.
3/48mins
I. Fixed Income Securities
as of Q4 2013, US market
Source: Securities Industry and Financial Markets Association (SIFMA)
Picture from Wikipedia
II. Equity
Equity
Voting rights: ‘Ownership in a firm’
Cash flow rights:
receive company’s profit as dividends
Future cash-flows (dividends) are uncertain
Limited liability: (residual claim) Stockholder gets (claims) whatever is left after all debts are paid
Maturity is indefinite
Involves risk, variable liquidity
Two main classes of equities
Common Stock: voting rights (‘junior’).
Preferred Stock: non-voting (‘senior’); hybrid.
Q: What is a stock (= equity)?
Q: What are the cash-flows on a stock? A: the dividends.
Q: What are dividends? A: that part of the profits that are not reinvested in the company but turned over to the stock holders. For example, If you own a stock of General Electric, you have a contract with GE that entitles you to a part of its profits. You own a small piece of the machines it uses to build cars and make a profit. A stock is a claim to the profits of GE.
The difference with bonds is that the cash-flows are risky. So the price of a stock will be the sum of the dividends, but we need to do 2 adjustments. The first one is the time-value of money adjustment. The second one is a risk-adjustment.
We said that stocks are claims on the companies profits. Those are paid in the form of dividends. Stocks are different from bonds in that the cash flows are uncertain. If the company makes losses in a given year the dividend will be zero. The 2nd difference is that they have an infinite maturity. As long as the company doesn’t go broke, you keep receiving the dividend every year.
3mins/63mins
II. Equity
First ever share: Dutch East India
Important Financial Assets
III. Derivatives
Definition: ‘securities whose cash flows depends on values of other assets’
Underlying assets: asset, stocks, index, interest rate
Examples: Options, Futures, Swaps, Bonds with option-feature (convertible or callable bonds)
IV. Composite assets - Mutual Funds and ETFs
V. Asset-Backed Securities
Q: What are the cash-flows on a derivative? A: a contingent $ amount: $ if X happens.
The most important forms of derivatives are options, futures and swaps.
There are also other option-like securities such as convertible bonds or callable bonds.
Q: Anybody know what a convertible bond is? A: It is a bond with an option attached that gives the holder the right at expiration to exchange his bond for stocks at a pre-specified price per share.
Now consider two GM bonds, one with the convertibility option and one without the option, so the convertible and a standard bond.
Q: Which one would you pay most for?
A: the convertible. The price of an asset with an option feature is adjusted for that option feature. This is the option-adjustment.
2mins/72mins
Mutual Funds Markets
Financial intermediaries that pool funds from investors and buy assets
Advantages:
Record keeping and administration
Diversification and divisibility
Professional management and analysis
Lower analyzing/information costs
Lower transactions costs
Competition from Exchange-Traded Funds
Q: What is a mutual fund?
A: it is a financial intermediary that collects money from many small investors like you and me and uses that money to invest in a diversified portfolio of stocks and bonds.
Of course, you could buy and sell stocks on your e-trade account yourself and create a well-diversified portfolio.
However, buying and selling stocks all the time maybe expensive ($7 per trade).
If you participate in a mutual fund, these transaction costs are split over many investors.
In addition, these people are professionals who follow the market closely.
It would cost you a lot of time and effort to do that yourself.
2/76mins
One advantage of mutual funds
Cumulative Value of $100 Invested in 1926
22
Firm Statistics in the U.S.
Source: www.bizstats.com
