Lecture 0 Foundations of Finance1Lecture 0: OverviewI. ReadingA. BKM Chapter 1. B. Skim BKM Chapters 2 and 4.II. Asset ClassesA. Real Assets1. natural resources.2. physical capital.3. human capital.B. Financial Assets (referred to as securities)1. Money (as a medium of exchange)a. is held to allow the completion of transactions.2. Debta. a claim to a predetermined payment stream secured on a set of realor financial assets.b. maturity is time from issue to expiration.3. Equitya. residual claim to a set of real or financial assets (usually of acorporation) usually coupled with corporate control.4. Derivativesa. payoff is dependant on the value of some other (usually financial)asset.Lecture 0 Foundations of Finance2C. Illustration: Debt vs Equity.1. Suppose XYZ Co’s assets pay off a random amount CF in 1 year’s timeand XYZ has issued debt with a promised payment of $100 in 1 year’stime, and equity. CF <100 60 80 100 >100 120 140 160 180Debt CF 60 80 100 100 100 100 100 100 min{CF,100}Equity 0 0 0 0 CF-100 20 40 60 80 max{0,CF-100}Firm CF 60 80 100 CF 120 140 160 180 CF2. If CF is uncertain, XYZ’s equity is riskier than XYZ’s debt. D. Example: IBM Corporation.1. Real Assets: plant used to build Thinkpads.2. Claims on the Real Assets:a. Equity: IBM stock.b. Debt: IBM bonds.c. IBM stock is much more volatile than IBM bonds.3. Derivatives: Claims on IBM stock.a. A call option on IBM stock gives the holder the right (but not theobligation) to buy the stock at a given exercise price.Lecture 0 Foundations of Finance3Lecture 0 Foundations of Finance4Example: A firm may want to expand by going public; i.e., by issuing equity to the public inreturn for cash. Since the public knows that the firm is going to use cash to expand, aninvestor will only subscribe to the IPO if she thinks expansion is a value enhancing strategy.Example: An MBA student has low income now but high future income. A student loanallows the student to smooth her consumption through time relative to her income throughtime.III. Financial System: refers to the collection of institutions by which financial assets arecreated and traded.A. Purposes (which allow the financial system to create wealth)1. transfer capital from savers (investors) to capital users (usuallycorporations).2. discipline investment decisions by firms.3. allow investors to smooth consumption intertemporally.4. facilitate the reduction of riskbearing by repackaging risks.5. disseminate information.B. Institutions1. Government2. Financial Markets: institutions which trade financial assets.3. Financial Intermediaries: entities which operate within or outside financialmarkets to facilitate the trading of financial assets.Lecture 0 Foundations of Finance5Example: An IPO is an initial public offering of equity by a privately-held firm. The $-valueof this market has been steadily growing in the last few years.IV. Financial MarketsA. Primary vs Secondary Markets1. Primary Market: new issues of a security are sold to initial buyers.2. Secondary Market: previously issued securities are traded in a secondarymarket.Lecture 0 Foundations of Finance6Examples: 1) NYSE (stocks); 2) Chicago Board of Trade (futures).Examples: 1) government bonds are traded over the counter through primary and secondarydealers; 2) the National Association of Securities Dealers Automated Quotation System(NASDAQ) is an example of a trading network for stocks.B. Exchange vs Over-the-Counter Market1. Exchange: Buyers and sellers of securities meet in one central location toconduct trades.2. Over-the Counter Market: Dealers at different locations stand ready to buyand sell securities "over the counter" to anyone that accepts their prices.C. Money vs Capital Markets1. Money: short term debt instruments (<1 year maturity).2. Capital: long term debt instruments (>1 year maturity) and equity..Lecture 0 Foundations of Finance7V. Financial IntermediariesA. Services Provided1. reduce search costs associated with finding saving or investmentopportunities.2. generate information needed by investors.3. provide risk and portfolio management services.4. issue financial assets that repackage risks.5. take advantage of the economies of scale associated with buying andselling financial assets.B. Types1. Depository Institutionsa. Commercial Banks.b. Savings and Loan Associations, Mutual Savings Banks.c. Credit Unions.2. Contractual Savings Institutionsa. Life Insurance Companies.b. Fire and Casualty Insurance Companies.c. Pension Funds.3. Investment Intermediariesa. Brokers.b. Mutual Funds.c. Money Market Mutual Funds.d. Finance Companies.Lecture 0 Foundations of Finance8C. Growth of Mutual Funds. A mutual fund is a firm that manages a pool of moneythat has been placed with the fund by other people. Money placed with the fund isinvested in certain specified types of assets. People buy shares in the fund andtheir value changes over time with changes in the value of the fund’s assets. 1. Over the last 20 years, there has been tremendous growth in:a. number of funds.b. types of funds.c. dollars invested in funds.2. Index Funds: Particularly high growth has occurred for a type of mutualfund known as an index fund. a. An index fund is a mutual fund whose investment goal is to trackthe return on a particular stock index (for example, the S&P 500index). b. A stock index is a portfolio of stocks formed according to apredetermined rule. For example, the S&P 500 index is a portfolioof 500 stocks chosen so that the index mirrors the U.S. stockmarket. A stock is chosen (according to the S&P Corporation) forinclusion in the index if its performance is representative of theperformance of its industry. The S&P 500 index invests more in alarge stock contained in the index than a small stock: it is a value-weighted index.Lecture 0 Foundations of Finance9Examples: 1) CAPM is a asset pricing model; 2) Black-Scholes model values call options; 3)Cox Ingersoll Ross model values fixed income assets.VI. Issues addressed by Finance TheoryA. Financial decision-making by corporations. How do corporations decide whetherto undertake an investment project? (Corporate Finance)B. Financial decision-making by individuals. How do individuals invest theirsavings?C. Valuation of assets both real and financial. Why do expected returns vary acrossassets?Lecture 0 Foundations of Finance10TB - 1 mth Treasury BillsGB - Long-term U.S. Government BondsCB - Corporate BondsS&P - S&P 500 IndexSF - Small Firm EquityLecture 0