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FINANCLIAL MARKETS
Topic 1: The Financial System
A-Functions of the Financial System
Merton and Bodie list 6 essential functions of a financial system:

1. Clearing and settling payments
Intermediaries, counterparty risk, transaction costs
2. Pooling resources
Securitization, subdividing shares, mutual funds
3. Transferring resources across time and space
Saving and borrowing, allocation of capital
4. Risk management
Hedging, diversification, insurance
5. Providing information
Prices as signals, implied volatility
6. Dealing with incentive problems
Asymmetric information, agency problems, executive compensation



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B. Financial Instruments
Several categories
Equity
Fixed income
Foreign exchange (currencies)
Commodities
Derivatives
Equity
Ownership interest in a corporation
Governed by shareholder agreement
Lower claims in bankruptcy than debt instruments
Liability of holder is limited to initial investment
Different classes of equity
Common stock no special rights
Preferred stock guaranteed dividend payment and may have additional preferences
Class x different voting or control rights
Fixed Income
Debt instrument with periodic fixed interest payment and principal payment
Length of the period usually determined in advance
Interest rate or method to determine interest rate fixed in advance

Money market
Treasury-Bills
Certificates of Deposit (CDs): time deposits with banks
Commercial paper: short-term debt from large companies

Bond market
Government notes and bonds
Corporate bonds
Asset-Backed Securities (ABS)
Pass-through securities: e.g., Mortgage-Backed Securities (MBS)
Collateralized Debt Obligations (CDO)
Foreign Exchange
Trading of currencies
Euro, dollar, yen, etc.
E.g., EURUSD (EUR/USD) is the price of a euro in US dollars (e.g., 1 EUR = 1.4 USD)
Carry trade
Borrow in currencies with low interest rates and invest in currencies with high interest rates
Yen carry trade
Dollar carry trade
Very liquid market
Commodities
Some physical resources
Metals
Agricultural products
Crude oil, natural gas, etc.
Physical delivery with storage and shipping costs
Trading on futures markets in standard units, often linked to historical delivery methods
E.g., corn contracts: 5,000 bushels
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Derivatives
An instrument whose price depends on another instrument
Option: For an up-front premium, the right to buy or sell an instrument at some point in the
future
Forward contract: Obligation to buy or sell an instrument in the future at a price agreed
when deal made
Futures contract: Same as forward, but standardized; position is marked-to-market daily
Swap: Agreement to swap cash flows (e.g., fixed-for-floating interest-rate swap)
Credit derivatives: Insurance against credit risk

C. Trading
Information traders and liquidity traders
Different trading mechanisms
Exchanges
Over-the-counter (OTC)
Electronic communication networks (ECNs) and crossing networks
Trading usually done via intermediaries
Brokers, dealers, market makers
In special markets via investment bankers
Sale of private companies, VC and PE, IPOs, etc.
Different types of orders Market order Limit order Stop order Short sale
Importance of margin
Clearing procedures

Costs
Broker's commission
Bid-ask spread
Market impact
Price manipulation
Cornering the market Hunt brothers and the silver bubble (1979-80)
Short squeeze Porsche and Volkswagen (Oct. 2008)
In this course we usually ignore trading costs, but in practice they are significant

D. What Is Finance?
Financial assets are claims on real assets, usually traded in financial markets
Finance studies financial assets
The management of money, investments, and credit
Some say that finance is buy low, sell high. Why should we expect that?
Time value of money: by just waiting you accumulate interest
Risk premium: if asset is risky, you should expect the price to increase in the future
to compensate you for the risk
In general, the following holds for any asset:
Expected Return = Risk-Free Rate + Risk Premium
The above discussion assumes that the price is right (markets are efficient)
If the price is not right, do an arbitrage
Buy the cheap asset
Sell the expensive asset
Another meaning for the phrase buy low, sell high

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Topic 2: Risk and Return
A. Return
Return is a measure of how well a security performs. It is the reward for
Not purchasing something else (time value of money)
Assuming the risk of the asset (risk premium)
Example: IBM stock over 6 months
Suppose
Today the price is P0=100
In 6 months the price becomes P1=105
During this period IBM pays 1 in dividends
How much has the IBM stock price (including dividends) appreciated during this period?
Solution: Compared to today, the price appreciated by

So the return of IBM for the period is 6% Annual figure: 6%2 = 12%
We have just computed the net return of IBM. The net return of an asset during the period
from t and t+1 is denoted by rt+1 where Pt is the price at t, Pt+1is the price at t+1, and
Dt+1are the cash payments to investors during this period

Sometimes we work with the gross return Rt+1

Gross return Rt+1is the dollar amount obtained at t+1 from 1 dollar invested in the asset at t
We often separate net returns into two components

Dt+1/ Ptis the Income Yield:cash payouts received by the investor
Dividends for stocks
Coupon payments for bonds
(Pt+1Pt) / Ptis the Capital Gain/Loss: the change in security price
Example:In the IBM example above
Income (dividend) yield: Dt+1 / Pt= 1 / 100 = 1%
Capital gain: (Pt+1Pt) / Pt= (105 100) / 100 = 5%
Net return (non-annualized): 1% + 5% = 6%
Multi-period Returns and Compounding
Notations
Rt+1= the gross return from tto t+1
Rt+2= gross return from t+1 to t+2
Rt+2(2) = gross return from tto t+2
rt+2(2) = Rt+2(2)-1 net return from tto t+2
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Start with $1 at time t, which yields Rt+1at t+1
$1 at time t+1 yields Rt+2at time t+2
Therefore, investing Rt+1at t+1 yields Rt+1x Rt+2at t+2
In conclusion, $1 at t yields Rt+1x Rt+2at t+2
This means that
This implies the familiar compounding formula


Example: Suppose you run a fund that earns 10% in year 1 and 20% in year 2. What is the 2-
year (net) return?
Solution: Use the compounding formula:

What is the average annual return in the example above? We want a rate r such that

r is called the geometric average of 10% and 20%
Because of compounding, r is different from (10% + 20%) / 2 = 15%, which is the
arithmetic average
The geometric average is always less than the arithmetic average. Is it better to use geometric
or arithmetic average?
Theoretically, geometric averages are more consistent
We use arithmetic averages in empirical work
Sometimes one can get significant differences
Example: 5 years of returns on Dell up to the end of 2006

Kevin Rollins (Dell CEO, fired in Feb. 2007) would have probably preferred the arithmetic
average
At the start of the period these variables are usually not known. We sometimes indicate this
by a tilde over them, e.g.,
Nevertheless, at twe can compute the expected return:

At t+1 we can actually compute the realized return:

The two numbers may be very different! Recall Dells realized returns

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At t= January 2005, was Dells expected return negative?

B. Risk
Risk indicates unexpected variation
The most common measure is =standard deviation
It measures deviation from the mean
Some assets are very risky
E.g., U.S. stocks have annual ~= 20%
Thus, on average, 1 year out of a 20-year period the
stock market should go up or down by more than 2 = 40%
In reality, more often than that

Example: You are an equity analyst and you analyze two stocks, Johnson & Johnson (JNJ)
and Halliburton (HAL). You believe there are 3 possible scenarios concerning the U.S.
economy: Good, Average and Bad

Each of these states is equally likely, with probability 1/3
Under the 3 scenarios, JNJ and HAL have the following expected returns:
Compute the expected return (E), standard deviation (), and correlation () for JNJ and
HAL
Solution: Think of the returns of JNJ and HAL (rJNJ, rHAL) as random variables, whose
outcomes depend on the state of the economy

Statistics Refresher
In general, suppose we have some states with probabilities p1, p2,, pn. We are also given
two (discrete) random variables X and Y with outcomes (X1, X2,..., Xn) and (Y1,Y2,..., Yn)
We have the following formulas:


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To compute the correlation between JNJ and HAL, start by computing the covariance:

Risk Aversion
Consider a gamble where you will either receive $40,000 if a coin lands heads and lose
$20,000 if it lands tails

Compare this with getting $10,000 for sure
Most people would prefer the sure $10,000: they are risk averse
Both choices offer an expected reward of $10,000, but one of them is risky, which we
dislike
If the sure thing reward was only $5,000, you might choose the lottery instead
The difference between the expected value and the sure thing reward is the risk premium

C. Estimation of Risk and Return
How do we estimate expected returns or standard deviations in practice?
We can use the past history of prices. Suppose r1, r2, ..., rT are the past returns over T
months

Return: how large an asset's payoffs are
Risk: how uncertain the asset payoffs are
Fundamental trade-off between risk and reward (expected return)
The higher the risk, the higher the reward Why is this true?
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If an asset has high risk, risk-averse investors stay away from it (flight to safety). The
assets price goes down, which implies that the expected return goes up
For the same reason, in a recession expected returns should be higher than in an economic
expansion!

U.S. evidence U.K. evidence
















The Equity Premium (Puzzle)
If you had invested 100 in U.K. equities in 1900, you would have had 2.3 million at the
end of 2010
Stocks have earned a higher average return than bills and bonds. The difference is called the
equity premium

Equity premium = E(rStocks) E(rBills)
The historical equity premium over the last half century is close to 6%, which is substantially
higher than before
Breakdown of the recent increase in the equity premium
Real bond returns have fallen sharply in the 20th century
By contrast, real stock returns have been relatively stable
Equity Premium Puzzle
Economists have trouble justifying a premium as big as 6%: this would mean that
investors are too risk averse!

D. Case: The Historical Dataon T-Bills, Bonds and Stocks
So far we have been using nominal returns
If we are concerned about real purchasing power and inflation, we must use real returns
E.g., if the annual inflation rate is 4%, an investor will be able to buy as much with $1 next
year than with $1/(1+.04) = $0.96 today
In general, if is the inflation rate then by definition

This can be approximated by



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Case: The Historical Data on T-Bills, Bonds and Stocks Real returns for the U.S. (1802-
2006)

Stocks Nominal and real returns
Some numbers for nominal returns


Some numbers for real returns


Longer horizons
Let's look at the risk of stocks and bonds over longer horizons, using different measures of
risk
If we measure risk by standard deviation (annualized), the estimates depend on the
investment horizon:

So over the long run stocks are both less risky, and (as we have seen before) have higher
average returns than bonds! How is this possible?
Due to mean-reversion in stock returns: after a good year, it is a bit more likely that stock
market will do poorly, and vice-versa; good years cancel out bad years








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Stocks Min. and max. real holding period returns


Question: Given the superior performance of stocks over the long run, why does anyone
hold bonds?
In the short run stocks are much riskier than bonds
Many investors only have a short investment horizon
Flight to safety during recessions
Maybe the high stock returns after 1929 were just luck

Topic 3: Time Value of Money and Net Present Value
A. Time Value of Money
Most investment decisions involve trade-offs over time
Within a project, trade-off between
Investment now
Payoff later
Across projects
Investment 1, which involves a stream of payoffs
Investment 2, with a different stream of payoffs
How do we quantitatively compare cash flows that occur at different times?
We need a way to compare future cash flows with present cash flows) Time
Value of Money
Suppose you are asked if you are interested to
Invest $1 today, and
Receive $1 one year from now
Typically you should NOT do it
Having $1 today is worth more than receiving the same $1 in the future
You need to be compensated for waiting
Instead, if you receive $1.05 one year from now, you might be interested
You are compensated with a return of 5%
It depends whether the $1.05 payoff is safe or risky
If its safe, you may be satisfied with 5%
If its risky, you may need a higher expected return, say 7%

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B. Future Value and Present Value
Suppose you invest $1 today and you have a safe return of 5%. How much do you receive in
one year from now? $1.05
If at the end of the 1styear you invest the principal together with the interest for another
year, again at 5%, how much do you receive at the end of the 2ndyear?
$1.05 1.05 = $1.1025 or $1 (1.05)^2
If you continued one more year you would receive
$1.1025 1.05 = $1.157625 or $1 (1.05)^3
More generally, the Future Value of a cash flow of C dollars in T years, invested at a rate of
return r is:

Let us now flip the story: how much is $1 to be received in 3 years worth to us today?
Answer: It is worth the amount we should invest today so as to receive $1 in 3 years
The Present Value of $1 to be received in 3 years equals:

If the interest rate is 5%, the PV of $1 to be received in 3 years from now is $0.864
In general, the Present Value of C dollars to be received in T years, when the interest rate is
r, is:

Example: You have to choose between receiving
(A) $10M in 5 years, or (B) $15M in 15 years. Which is better if r= 5%?
Solution: Compute the respective present values

We find that opportunity A is worth more than B

C. Net Present Value
Example: Consider a firm thinking of acquiring a new computer system that will enhance
productivity for five years to come. This computer system project:
Requires an initial investment of $1M today, but
Yields in return the following cash inflows as a result from the enhanced productivity:
Year1 $100,000
Years 2, 3, 4 $300,000
Year5 $100,000

Solution: To assess the computer system project, we calculate the Net Present Value
(NPV), which is the sum of the PV of future cash inflows minus the initial investment
The discount rate, r, is the expected return on an equivalent in terms of timing and risk
investment opportunity
Lets say r= 5%
It is also called the (opportunity) cost of capital
The NPV should be the same as the market value

The net present value is negative: NPV < 0
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The PV of the future cash inflows ($951,662) is less than the initial investment ($1M)
So the market value is also negative
The computer system project is therefore not worthwhile
It is not worthwhile to forego the equivalent investment opportunity
More generally, consider a project involving a series of (net) cash flows C0 , C1 , C2 , ,
CT occurring in 0 , 1 , 2 , , T years
The NPV of this project is
If the NPV is positive, the project is worthwhile, and if the NPV is negative, it is not
Taking positive NPV projects increases the value of a firm by the amount of the NPV
Taking negative NPV projects decreases the value of a firm by the amount of the NPV

The Net Present Value Rule also tells us whether to undertake a single project, or several
independent projects, or several mutually exclusive projects:

For a single project:
Undertake the project if NPV > 0
Reject the project if NPV < 0

For many independent projects:
Undertake all projects with NPV > 0
Reject all projects with NPV < 0

For mutually exclusive projects:
Undertake the project with the highest positive NPV

A perpetuity is a constant stream of cash flows, C, that occur every unit period (say year)
and continues forever
Examples
Long-term coupon bonds
Consol bonds (UK)
Preferred stock
Some specific projects (e.g., rental agreements)
The price (PV) of a perpetuity is

Example: Suppose you own a plot of land. You have an agreement to rent out the property
(which is otherwise worthless) each year for $1,000
The city offers to buy the land from you for $17,000
Should you accept the offer?
Assume the interest rate remains at 5% per annum forever
Solution: The value of continuing the rental agreement is obtained applying the perpetuity
formula

The city is only offering $17,000. Hence, you should not accept
What if the interest rate goes up to 7% per annum in two years from now, and stays there
forever?
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The value of renting the property out to the town becomes

Here, given that the city is offering $17,000, you should accept
A growing perpetuity is a stream of cash flows that grow at a constant rate g (say per year)
forever
The price of a growing perpetuity is given by
This formula only works for g< r. The case g r is not economically meaningful
If C is the dividend of a company, this is called the Gordon growth formula
Example: Suppose your contract with the town specifies that the rent you can charge for the
land is allowed to grow by 2% each year in order to cover rising costs. What is the value of
your land?
Assume the interest rate is again r= 5% forever
Solution: Applying the growing perpetuity formula, we obtain that the plot of land is now
worth

An annuity is a constant stream of cash flows, C, that occur every year, with maturity T
years
PV can be computed as the PV of a perpetuity issued now, minus the PV of another
perpetuity being issued in Ty ears from now

Example: Suppose your daughter will enter college next year, and you would like to put
enough money into the bank to afford her $10,000 tuition for each of the next 4 years
You therefore essentially would like to buy a security that pays her $10,000 every year, for 4
years
Solution: The fair price you will have to pay the bank today for this annuity is (assume r=
5%)

D. Internal Rate of Return
IRR is the discounting rate that makes the NPV equal zero
IRR is also called the Yield to Maturity (used for securities)
IRR used for capital expenditures, Venture Capital and Private Equity
IRR is calculated using the same formula as the NPV, except that the rate r is unknown

where V0 is the initial investment in the project
The IRR is the rate r for which the initial investment is equal to the present value of the
future cash flows from the investment
It can be found using a math solver, or just trial and error
NPV and IRR can give opposing views of a project
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Investment A has the lower NPV and higher IRR compared to Investment B
A is more profitable than B in the sense of return on initial investment
But the overall dollar amount (in PV terms) is less for A than for B
In general, NPV is preferred to IRR


Investment A has the lower NPV and higher IRR compared to Investment B
A is more profitable than B in the sense of return on initial investment
But the overall dollar amount (in PV terms) is less for A than for B
In general, NPV is preferred to IRR

E. Interest Rates and Compounding
The rate of interest is what is quoted in the market
Quoted on a per annum basis
Quoted with a compounding frequency
Quoted for a particular maturity date
Also called Annual Percentage Rate (APR)
The rate of return from today (t) to next period (t+1) is what you actually care about

Also called the Effective Annual Rate (EAR)
Interest rates are quoted on a per year basis
The return is 5% per year, compounded annually
The return is 5% per year, compounded monthly
Here, 5% is the APR
However, this does not mean that interest is paid only once a year. Many securities pay
interest more frequently:
Semi-annually (e.g., corporate bonds)
This is simple interest, not compounded interest
Monthly (e.g., some savings accounts)
Daily
Continuously
If compounding frequency is less than a year, divide the APR by the number of periods in a
year
E.g., if the rate is 5% per year, compounded monthly, the rate per month is 5%/12 =
0.42%
Example: Suppose you invest $1,000 and the return is 5% per year. How much will you get
back in 6 years if the return is compounded annually, semi-annually, quarterly, monthly,
daily, or continuously?
Annually: $1 000 x (1 + 0.05)
6
= $1,340.10
Semi-annually:$1 uuu x (1 +
0.05
2
)
26
= $1,344.89
Quarterly: $1 uuu x (1 +
0.05
2
)
46
= $1,347.35
Monthly:$1 uuu x (1 +
0.05
2
)
126
= $1,349.02
Daily: $1 uuu x (1 +
0.05
2
)
3656
= $1,349.83
Continuously: $1 uuu x c
00.56
= $1,349.86
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The formula is:

where m is the number of periods in a year, T is the number of years, and r is the APR. Thus,

Example: Suppose your credit card company charges a monthly interest rate of 2%. APR is
reported as 12 2% = 24%
The EAR however is higher because of compounding. In this example (m= 12), the effective
rate is:

In the case of daily compounding (m= 365), an APR of 24% would translate into an EAR of:

When compounding continuously (m= ):

Multiplying your investment and the Rule of 72
Sometimes we want to put things in perspective: if the return is 8%, how long does it take to
double our money?
We want to set T so that FVT(C) equals 2 times C. knowing that FV(C) = C * (1 + r)
T
, we
calculate:
1 * (1 + r)
T
= 2 * 1 T * ln(1 + r) = ln(2) T = 9.006 years.
So it takes T= 9.006 years to double the initial investment
The Rule of 72 is a pretty close approximation


Mortgage Payments
Example: Suppose you wish to buy a house worth $500,000with a mortgage from a bank.
You want to do the following:
Make an immediate payment of $100,000
Borrow the difference with a fixed rate loan, making constant monthly payments over 30
years
The bank offers to lend at an APR of 8.5%
How is the fixed monthly payment C computed?
How is C divided into interest and principal payments?
Solution: You are basically liable an annuity with monthly cash flows C, and you know the
fair value is $400,000
Use the annuity formula: $400 000 -
C
r
* (1-
1
(1+r)^T
)

= C * 130.0536 C = $3,075.65 (The amount to pay each month)