Introduction to Financial Economics

1. 1 Introduction to Financial Economics Finance is the study of how people allocate scarce resources over time. Financial economics applies the techniques of economic analysis to understand the savings and investment decisions of individuals, the investment, financing and payout decisions of firms, the level and properties of interest rates and prices of financial derivatives and the economic role of financial intermediaries. To be covered: Financial Markets Utility theory given uncertainty Financial Instruments Bond pricing and term structure if interest rates

2. 2 Derivatives Portfolio theory The CAPM Financial Intermediation Asymmetric Information in Financial Markets Capital Structure Theory Financial Development and Growth

3. 3 The real economy and financial markets are not unrelated. We begin by distinguishing between real assets and financial assets. Real Assets Real assets: represent a society�s wealth. Real assets produce output consumed by economy. They determine the productive capacity of the economy. Examples include: land, buildings, machinery & equipment, knowledge.

4. 4 Financial Assets Financial assets are claims to the income generated by the real assets. They are just pieces of paper, or computer entries. They contribute to the productive capacity indirectly. Examples include: stocks, bonds, etc.

5. 5 Financial assets: Allow for the separation of ownership and management Facilitate the transfer of funds to enterprises with attractive investment opportunities. They are claims to the income generated by real assets. Their value depends on the value of the underlying real assets.

6. 6 The Relationship between Financial Assets and Real Assets Real assets produce goods and services. Financial assets determine the allocation of wealth among investors. Money firms receive when they issue securities (financial assets) is used to purchase real assets. The return on a financial asset comes from the income produced by a real asset. Financial assets are destroyed in the course of doing business (e.g. loan). Real assets are only destroyed by accident or through wearing out over time.

7. 7 Financial Markets and the Economy -Financial assets and the markets in which they are traded in do play an important role in the economy. -Financial assets allow us to make optimal use of the economy�s real assets. -These assets play 4 main roles: Consumption Timing Allocation of Risk Separation of Ownership and Management Transfer of funds from surplus units to deficit units.

8. 8 Consumption Timing Some individuals in the economy earn more than they want to spend. Others spend more than they earn Financial assets allow us to time our consumption. They make it possible for us to store our purchasing power. Invest in high earning periods and spend in low earning periods. Can allocate consumption to periods that provide greatest satisfaction. Individuals can separate decisions concerning current consumption from constraints imposed by current earnings.

9. 9 Allocation of Risk All real assets involve some risk. Cash flows are not certain but can be assigned probabilities depending on different scenarios. Investors with different risk profiles are catered for: risk averse, risk neutral, risk loving. Different financial assets cater for this e.g. equities and bonds. There is generally a positive relationship between risk and return. This allows firms to optimally price assets depending on the risk-return characteristics of investors. Facilitates process of building stock of real assets.

10. 10 Separation of Ownership and Management In today�s business environment characterized by large corporations owners do not necessarily manage firms. Financial markets allow this separation of ownership and management. Holders of equity are the owners, and appoint a management team to maximize their wealth. Agency problems: empire building, risk avoidance to protect jobs, excessive consumption of luxuries. Solutions: tie compensation to performance (stock options), outside monitors (security analysts).

11. 11 Risks associated with investing in financial assets Purchasing Power risk- this is the risk that is due to the uncertainty of the buying power of the cash flow you may receive from the financial assets. Default or credit risk � the issuer of the financial asset may fail to pay the lender i.e. the borrower may default on the obligation. Foreign exchange risk � for assets whose cash flow is not denominated in SA Rands there is the risk that the exchange rate will change adversely resulting in losses in SA Rands.

12. 12 Users of the Financial System The needs of the users of the financial system will determine what financial assets are available. 3 main groups of financial system users: The Household Sector The Business Sector The Government Sector

13. 13 The Household Sector The consumption timing function of financial assets is most relevant to households 2 factors have a significant effect on the financial needs of households: taxes and risk preferences. Taxes: high-tax bracket investors will seek tax-free securities. Financial services providers will endeavor to offer such assets. Risk preference: differences in risk preference leads to demand for a diverse set of investment alternatives. Also leads to demand for easy portfolio diversification.

14. 14 The Business Sector Businesses need to raise money to finance investment in real assets. 2 ways for businesses to raise money: -borrow from banks or households (issuing bonds) � this is referred to as debt. -issuing stocks (allowing new owners) � this is referred to as equity. - firms issue securities to get best possible prices, to minimize costs of issuing. To achieve this they use of investment banks. Low cost implies simplicity of securities. But households want variety. Intermediaries address this mismatch.

15. 15 The Government Sector Governments require money for investment, social services, salaries, etc. When revenue < expenditure governments need to borrow. The government cannot sell shares. It can: -print money (inflationary pressure) -issue treasury bills and other fixed income securities. These are highly liquid: quickly converted to cash with low transaction costs. Because of governments taxing power it is very credit worthy. Can therefore borrow at lowest interest rates.

16. 16 Financial Market A financial market is a market where financial assets are exchanged or traded. Examples include: Debt markets Equity markets Capital markets Money markets

17. 17 Role of Financial Markets Price discovery The interactions of buyers and sellers in a financial market determine the price of the traded asset. Liquidity A financial market offers liquidity. A buyer of an asset must be assured that if one needs to sell the asset in future one will manage to do so without any problems. The market facilitates this. Reduction of transaction costs A financial market helps in the reduction of transaction costs. The two costs associated with transacting are search costs and information costs. Search costs include such costs incurred as one advertises his intention to sell or purchase an asset as well as the value of time spent locating a counterparty to the impending transaction. Information costs are costs associated with assessing the investment merits of a financial asset, i.e. the likelihood of the cash flow expected to be generated.

18. 18 Classification of financial markets Financial markets can be classified by the type of financial claim such as debt markets or equity market. Examples would include stock exchanges where ordinary shares are traded. They can be classified by maturity of the claim � money market and capital markets. Money markets are markets where short-term instruments are traded. Capital markets deals with long-term debt instruments. They can also be classified as those dealing with newly issued instruments (primary markets) or those dealing with already existing assets (secondary markets). So an IPO would takes place in a primary market while a seasoned offering would occur in a secondary market.