Economics 122

FINANCIAL ECONOMI CS (LECTURE 1)

M. DEBUQUE - G ONZ ALES
AY2014 -201 5

SOU RCE : BODIE, Z ., A . KA N E, A N D A . MA RCU S, 2009. INVES TMEN TS . 8TH

E D I T I O N . N Y: M C G R A W - H I L L / I R W I N ; L O , A N D R E W. 2 0 0 8 . F I N A N C E T H E O R Y
L E C T U R E S . M A S S A C H U S E T T S I N S T I T U T E O F T E C H N O L O G Y.
What  is  an  “asset”?
 Business entity
 Property, plant, and equipment
 Patents, R&D
 Stocks, bonds, options, etc.
 Knowledge, reputation, opportunities, etc.

From a business perspective, an asset is a sequence of cash

flows.
𝐴𝑠𝑠𝑒𝑡 ≡ 𝐶𝐹 , 𝐶𝐹 , 𝐶𝐹 , …
Real versus financial assets
Real assets
 They determine the productive capacity of an economy, and
ultimately material wealth of society
 They generate real income
Financial assets
 They do not directly contribute to the productive capacity of
the economy, but are means by which individuals in
developed economies hold claims on assets
 They simply define the allocation of income (or wealth)
among investors
Real versus financial assets
Securities are the financial assets of households
◦ Examples: bank accounts, corporate stock, bonds

However, they are the liabilities of the issuers of the

securities
Hence, aggregating over all balance sheets leaves only real
assets as the net wealth of the economy
Point to remember: Success or failure of a financial asset
ultimately depends on the performance of underlying real
assets
Table 1.1 Balance Sheet of U.S.
Households, 2007
Table 1.2 Domestic Net Worth
Taxonomy of financial assets
Fixed income and debt securities
◦ Offer fixed stream of income or determined by a formula, and unless
the borrower is declared bankrupt, these payments will be made
◦ Money market: short term, highly marketable, usually very liquid and
low risk (e.g., T-bills, commercial paper)
◦ Capital market: longer term, but riskiness varies (from safe Treasuries
to high-yield  or  “junk”  bonds);  diverse  provisions  re  payments  to  the  
investor and protection against bankruptcy of issuer
◦ Least closely tied to the financial condition of the issuer
Common stock, equity
◦ Performance of equities tied directly to the success of the firm and
its real assets
◦ For this reason, they tend to be riskier than debt securities
Taxonomy of financial assets
Derivatives
◦ Payoffs derive from the prices of other assets
◦ Used to hedge risks or transfer them to other parties (e.g., when an
importer or exporter tries to lock in the exchange rate)
◦ Can be used to take highly speculative positions, but commonly used
as risk management tools
Note: One can invest directly in real assets such as real estate or
commodities (e.g., precious metals like gold and agriculture)
Role of financial assets in
developed economies
1. Information role
 Facilitate deployment of capital resources to its most productive use
(however, uncertainty could result in failure of this role sometimes)
2. Consumption timing, smoothing
 Invest  (“store  wealth”)  in  financial  assets  in  high-earnings periods,
sell them during low-earnings periods to provide for consumption
needs
3. Risk allocation
 Financial markets and their diverse instruments allow risk (inherent
to all investments) to be carried by investors according to their
willingness to bear risk
 Investors can choose risk/return characteristics that best suit their
preferences, which also benefits firms since this leads to the best
possible price for the securities
Role of financial assets in
developed economies
4. Separation of ownership and management
 Financial  markets  allow  for  this  separation  by  helping  solve  “agency  
problems”  (e.g.,  if  managers,  hired  as  agents,  pursue  their  own  
interests)
 Several mechanisms have evolved to this end:
◦ Compensation plans
◦ Boards
◦ Market monitors (e.g., analysts) and large institutional investors
(e.g. pension funds)
◦ Threat of takeover
Corporate governance and
ethics
Despite these mechanisms, various scandals still emerged in
the early 2000s
◦ Accounting scandals – misstatement of accounts and hence of
financial status
◦ Auditor scandals – because of simultaneous consulting and auditing
functions (e.g., Arthur Andersen for Enron)
◦ Analyst scandals – misleading and overly optimistic reports in order
to generate investment banking business for firms

This suggests much to be improved still!

Corporate governance reforms
In the US, the Sarbanes-Oxley Act passed in 2002:
◦ Requires corporations to have more independent directors who are
not managers or affiliated with managers
◦ Requires each CFO to personally vouch for accounting statements
◦ Creation of oversight board to oversee auditing of public companies
◦ Prohibits auditors from providing various other services to clients.
Corporate governance reforms
In the Philippines, reforms made under the Securities
Regulatory Code of 2000:
◦ Strengthens enforcement powers of SEC
◦ Protects minority investors through mandatory tender requirement
(if 3rd party to buy in excess of 15%, or 30% if within a year)
◦ Tighter rules on insider trading and market manipulation
◦ Delegation of some regulatory powers to PSE which was
demutualized (i.e., turned into a stock corporation)
◦ Stronger corporate governance in terms of greater disclosure, more
independent  boards  (at  least  two  independent  directors,  ‘fit  and  
proper’  rule  for  directors,  shift  to  international  accounting  standards,  
and greater role for external auditors)
The Main Cast
Firms
◦ Net borrowers (raise capital now to pay for real investment, where
income generated provides the returns to investors)

Households
◦ Net savers (buy the securities issued by firms that need funds to
finance plant, equipment, etc.)

Governments
◦ Borrower or lender depending on budget balance (i.e. need funds to
cover deficits)
Financial intermediaries
Financial intermediaries
 They stand between the security issuer (the firm) and the ultimate
owner of the security (the individual investor)
 They evolved to bring lenders and borrowers together
 They include banks, investment companies (e.g., mutual funds),
insurance companies, credit unions
 Basic mechanism: Intermediaries issue their own securities to raise
funds to purchase the securities of other corporations
◦ Ex. A bank raises funds by borrowing (or taking deposits) and lending that
money to other borrowers and gaining from the spread
 Flow Model of the Economy

Source: Lo, Andrew. 2008. Finance theory lectures. Massachusetts Institute of Technology.
 Cash Flows between the Firm
and the Financial Markets
Firm issues securities to raise cash
(the financing decision)

Firm invests in assets

(capital budgeting)

Source: Ross, S., R. Westerfield, and B. Jordan. 2011. Corporate Finance: Core Principles and Applications.
Financial intermediaries
 Profit opportunities of intermediaries trace to economies
of scale advantages
 They differ from other businesses in that both their assets
and liabilities are primarily financial (simply move funds
from one sector to another, their primary social function
being the channelling of household savings to businesses)
Financial intermediaries
 Summary of advantages offered by financial
intermediaries (FIs) in their intermediary role:
◦ By pooling resources of many small investors, FIs can lend large
amounts to large borrowers
◦ By lending to many borrowers, FIs achieve significant diversification
(e.g., can accept loans that individually might be too risky)
◦ FIs build expertise through the volume of business they do and can
use economies of scale and scope to assess and monitor risk
Financial Intermediaries
Investment companies
 They pool and manage money of many investors, and also arise out
of economies of scale
 Basic problem of most household portfolios: too small to spread
across a wide variety of securities (buying shares of many different
firms expensive in terms of brokerage fees and research cost)
 Mutual funds, the common name for open-end (stand ready to
redeem or issue shares at NAV) investment companies, have the
advantage of large-scale trading and portfolio management
◦ Participating investors are assigned a prorated share of the total funds
according to the size of their investment (pay a management fee to the
mutual fund operator)
◦ Sold in the retail market
 Other investment companies can design portfolios specifically for
large investors with particular goals
Financial Market Players
Analytic services
 These include newsletters, databases, and brokerage house research
services made available to investors
 Economies of scale again explain their proliferation (i.e., they all
engage in research to be sold to a large client base, while investors
with small portfolios may find it costly to personally gather the
desired info)
 Profit opportunity present since a firm can perform such a service for
many clients and charge for it
Financial Market Players
Investment banks
 Corporations usually do not market their own securities but hire
agents (investment bankers) to represent them to the investing
public (again since scale economies create such niches for specialized
services)
 Investment bankers specialize in activities such as security issuance
(stocks and bonds), not a very frequent activity of a firm, and hence
can offer their services at a cost below that of maintaining an in-
house security issuance division (they are called underwriters in this
role)
 Main functions:
◦ Advising the issuing corporation on the prices it can charge for the
securities issued, the appropriate interest rates, etc.
◦ Ultimately marketing the security in the primary market where
new issues are offered to the public (later, these investors can
trade paper among themselves in the secondary market)