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Lecture notes 1 - Finance - Principles of Finance

Principles of Finance (Stockholms Universitet)

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• Finance Lecture 1
Incorporates many different fields such as economics,
psychology, mathematics etc

- 3 areas within finance

- = Capital markets and capital market theory
- =financial management
- = investment management

Information asymmetry
-People probably do not know you in the same manner,
everyone has different information
-Important concept, all the info and models and heavily
based on information asymmetry
-Different sets of information between those who want to invest and
those who need funds

Participants:
Lenders and borrowers
Financial markets
Financial intermediaries
Regulators

Difference between the real and financial assets

Real Assets:
Factories, machineries,
Used to produce goods/services
Tangible
e.g: real estate, consumer durables

Financial Assets:
Has nothing to do with factory or equipment
Has it’s on claims on these assets
Claims on real assets or generated by their income
Intangible
There are issuers and investors,
e.g: deposits, life insurance, debt securities,
mutual fund shares
Securities are typically divided into debts and equity,
a debt security represents money that is borrowed and must be repaid, with terms that define the
amount borrowed, interest rate and maturity/renewal date (stock and bonds)

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Why do we need them?

Mean of funds transfer:

Makes it so much easier to transfer funds from different asset
classes.
E.g: if you are a farmer you can buy as many potatoes as you want
by issuing these financial assets

Distribution of risk:
e.g. Issuing debt for some sort of project
and it needs financing, you are an individual investor that must
think about the risk (by yourself the risk is much greater)
If you pool all investors together you get an equal
portion of the investment, each investor gets a smaller fund

Classification of Financial Assets

FIXED INCOME OR DEBT

Payments fixed (predetermined)

Money market instruments:

short-term, highly liquid, no risk

Capital market instruments:

long-term, different levels of risk

COMMON STOCK OR EQUITY

If profits grow, and the income is stable,
the only problem you can expect is some sort or
return such as dividends

Payments are not fixed but depend on firm performance

DERIVATIVE SECURITIES

Preferred stock:
Owner of the company but you don't have the voting right
Instead the company guarantees you money
You will be paid before everyone else
Much more preferred

Common stock:
Pre determined, fixed

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Financial System:

1: Lenders and borrowers

Everybody

2: Financial Markets
Orgs that help pool all the funds
Places where we all meet

3: Financial Intermediaries
an institution, such as a bank, building society, or unit-trust company, that holds funds from
lenders in order to make loans to borrowers.

Not only banks, but

-depository institutions
-Non-deposit financial companies
-regulated

Role of Financial Intermediaries

Maturity intermediation
If you don't have any intermediaries involved
and buy bonds directly from a company,
it would probably mean you would have to keep the
security, and you are stuck with this bond
You can buy and sell basically of now

Diversification
-Mutual funds, lots of security….

Cost Reduction
- Information processing costs, contractual costs,
- if you want to sell bonds, and you don't have financial intermediary involved
- you will have to sign a contract, the costs are very high
Financial intermediary is very helpful in this case

Financial Markets

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Money Market: treasury bills, certificate deposits, ropes (type of asset, that is between banks to
banks when they don’t need it, but have the opportunity to sell it back )
Short-term, liquid low risk, often have large denominations

Repo: Repurchase agreement, promising to buy it back from you

Short-term: Urgent liquidity, low risk

Capital Market:
Stocks and bonds
Longer-term, riskier

PRIMARY MARKET:
Initially public offering, issuing stocks for the first time
would operate in this market
All the perceives goes to the company

SECONDARY MARKET:
Resale of already existing issued securities
Trading: the company (issuer) is not involved anymore

3 MAJOR PROBLEMS OF Financial Market

1: Price
- find a price that satisfies both the issuer and the buyer

2: Liquidity
- fm helps you find buyers and sellers, so you don’t have to wait (when selling and purchasing
bonds)

3: Transaction costs reduction

Get a lower price on the security
and reduces the reduction costs (don’t have to go around 10000 stockholder, you can pay for only
one stock transaction)

REGULATORS

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3 major goals of regulation:

Disclosure regulations
- Required to at least share some sort of information
- Information asymmetry, so investors will see the information

Financial activity regulations

- Inside trading (have to be reported to a state run institution)
- To control that there is no inside information in this transaction
Regulations of Financial Institutions
- monitoring, capital requirements
- determines amounts and structures, and how many reserves you should make
- gives the amount of risk involved within in a category
- too low reserves indicates something is wrong,

Financial Markets are efficient and competitive

It is hard to tweak the market

Risk-return trade off:

The basic rule of the whole FM, higher risk involved there
will be an additional benefit, associated with a high rate of return

Market Efficiency:
Market hypothesis: everything that happened in the market before
is taken into the price of the security

Weak form of market efficiency:

all historic information about the assets is already reflected in
the asset’s price

Semi-strong:
Price reflects all publicly available information

Strong:
Strong availability of information, high information asymmetry

Everything that you calculate will be the same, because everybody

has the same information

Financial Market indicators

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Price-weighted average: A stock index in which each stock influences the index in proportion to
its price per share. The value of the index is generated by adding the prices of each of the stock in
the index and dividing them but the total number of stocks. Stocks with a higher price will be given
more weight and therefore, will have a great er influence over the performance of the index.

e.g a popular price-weighted stock is the Dow Jones Industrial Average

Market value-weighted :
Stock that has the largest amount of shares

Worldwide Stock Markets

Most is happening in the US.
Most efficient and developed market

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