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Introduction to Finance · Paolo Vitale LUISS University [email protected] Paolo Vitale Introduction...
Transcript of Introduction to Finance · Paolo Vitale LUISS University [email protected] Paolo Vitale Introduction...
Motivations and ObjectivesFinancial Assets
Financial MarketsIntermediaries and Financial Institutions
Introduction to FinanceFinancial Markets and Intermediaries
Paolo Vitale
LUISS University
Paolo Vitale Introduction to Finance
Motivations and ObjectivesFinancial Assets
Financial MarketsIntermediaries and Financial Institutions
Outline
Motivation and Objectives
Financial Assets
? The Role of Financial Assets
Financial Markets
? The Role of Financial Markets
? Separation of Ownership and Management
? Financial Markets Classification
Intermediaries and Financial Institutions
? Financial Agents
? The Role of Financial Intermediaries
? Investment Companies
Paolo Vitale Introduction to Finance
Motivations and ObjectivesFinancial Assets
Financial MarketsIntermediaries and Financial Institutions
Motivations and Objectives
In the next lectures we examine the following issues:
The role and general characteristics of financial assets;
The role and institutional aspects of financial markets;
The role and activity of financial agents.
Paolo Vitale Introduction to Finance
Motivations and ObjectivesFinancial Assets
Financial MarketsIntermediaries and Financial Institutions
The Role of Financial Assets
Financial Versus Real Assets
Differently from real assets, financial assets, such as bondsand stocks, do not have an intrinsic value.
Financial assets are intangible assets which provide holderswith a claim on real assets and the income such real assetsgenerate.
Financial assets are contracts between issuers (corporations,financial institutions, governmental agencies) and investors(households, mutual and pension funds), which transfer therights on part of the income generated by real assets from theformer to the latter.
Paolo Vitale Introduction to Finance
Motivations and ObjectivesFinancial Assets
Financial MarketsIntermediaries and Financial Institutions
The Role of Financial Assets
Bonds and Stocks
Fixed-income securities promise a given stream of income de-termined according to a specific formula.
Common stock or equity represents an ownership share of agiven corporation. The holders are not promised a particularpayment, but receive payments in form of dividends payout ofthe corporation’s earnings.
Derivative securities, such as futures, options and swaps, pro-vide the holders with payments which depend on the prices ofother assets.
Preferred stock, convertibles and warrants combine charac-teristics of bonds and equity.
Paolo Vitale Introduction to Finance
Motivations and ObjectivesFinancial Assets
Financial MarketsIntermediaries and Financial Institutions
The Role of Financial Assets
The Role of Financial Assets
Financial assets transfer resources from savers (households) toborrowers (firms and governments).
Financial assets transfer resources overtime and across statesof the world.
? Financial assets allow to store purchasing power and hencesmooth agents’ consumption overtime.
? Financial assets allow agents to allocate risk.
Financial assets change the nature of liabilities/investment.
These functions are facilitated by financial markets and inter-mediaries (commercial and investment banks, pension andmutual funds).
Paolo Vitale Introduction to Finance
Motivations and ObjectivesFinancial Assets
Financial MarketsIntermediaries and Financial Institutions
The Role of Financial Assets
Transfer Resources Over Time
Consider an individual who lives for two dates: now (t = 0) andlater (t = 1).
She is endowed with $100 now (t = 0) and $25 later (t = 1).
Her utility depends on a combination of her consumption now,C0, and later, C1, e.g.:
U(C0,C1) ≡ ln(C0) + ln(C1).
? She prefers a smoother consumption path over time.
In the presence of financial markets, she can borrow and lendat the interest rate r .
⇒ If (for simplicity) r = 0, the optimum is reached when she con-sumes equal amounts now and later.
Paolo Vitale Introduction to Finance
Motivations and ObjectivesFinancial Assets
Financial MarketsIntermediaries and Financial Institutions
The Role of Financial Assets
Consumption Over Time Without Financial Markets
6
-125
125
100
25
50
50
U
She consumes her endowment
C0
C1
ª
Figure 1: Consumption allocation without financial markets
1
Here a representation of the agent’s preferences and endow-ment over time.
Paolo Vitale Introduction to Finance
Motivations and ObjectivesFinancial Assets
Financial MarketsIntermediaries and Financial Institutions
The Role of Financial Assets
Consumption Over Time With Financial Markets
6
-125
125
100
25
She reaches the optimal allocation
U
C0
C1
62.5
62.5
U+
C0 + C1 = 125
ª
Figure 2: Consumption allocation with financial markets
1
Here a representation of the agent’s preferences and budgetconstraint with financial markets when r = 0.
Paolo Vitale Introduction to Finance
Motivations and ObjectivesFinancial Assets
Financial MarketsIntermediaries and Financial Institutions
The Role of Financial Assets
Transfer Resources Across Time
At the optimum she is indifferent between $1 later and $1now.
This is coherent with what the market says:
? The interest rate is r = 0.
Claim
At the margin, agents agree on the time value of money, which isthe market interest rate: Their marginal rate of substitutions areequal to the relative price of current and future consumption,
MRS ≡ UC0/UC1 = (1 + r).
Paolo Vitale Introduction to Finance
Motivations and ObjectivesFinancial Assets
Financial MarketsIntermediaries and Financial Institutions
The Role of Financial Assets
Transfer Resources Across Different States
Consider an individual who lives one period.
The economy can be in state a or b with equal odds.
She is endowed with $100 in state a and $25 in state b.
Her (expected) utility depends on the combination of herconsumption in the two states of the world, Ca and Cb, e.g.:
U(Ca,Cb) ≡ 12 ln(Ca) + 1
2 ln(Cb).
She would like to smooth consumption over states:
? When insurance is free, she can trade $1 of consumption instate a with $1 of consumption in state b.
? Then, she will consume an equal amount in both states.
Paolo Vitale Introduction to Finance
Motivations and ObjectivesFinancial Assets
Financial MarketsIntermediaries and Financial Institutions
The Role of Financial Assets
Consumption Across States Without Financial Markets
6
-125
125
100
25
50
50
U
She consumes her endowment
Ca
Cb
ª
Figure 3: Consumption allocation without financial markets
1
Here a representation of the agent’s preferences and endow-ment across states.
Paolo Vitale Introduction to Finance
Motivations and ObjectivesFinancial Assets
Financial MarketsIntermediaries and Financial Institutions
The Role of Financial Assets
Consumption Across States With Financial Markets
6
-125
125
100
25
She reaches the optimal allocation
U
Ca
Cb
62.5
62.5
U+
Ca + Cb = 125
ª
Figure 4: Consumption allocation with financial markets
1
Here a representation of the agent’s preferences and budgetconstraint with financial markets when pa = pb.
Paolo Vitale Introduction to Finance
Motivations and ObjectivesFinancial Assets
Financial MarketsIntermediaries and Financial Institutions
The Role of Financial Assets
Transfer Resources Across Different States
At the optimum, she is indifferent between $1 in state a and$1 in state b.
This is coherent with what the market says:
? Same price for state-a (pa) and state-b (pb) contingent-claims.
Claim
At the margin, agents agree on the relative value of money in dif-ferent states, ie. the market price of different state contingentclaims.
Paolo Vitale Introduction to Finance
Motivations and ObjectivesFinancial Assets
Financial MarketsIntermediaries and Financial Institutions
The Role of Financial MarketsSeparation of Ownership and ManagementFinancial Markets Classification
Functions of Financial Markets
Financial markets allow agents to allocate resources
? over time
? and across different states of the economy.
Financial markets play a price discovery role, in that equili-brium prices for assets are found via the trading process.
Financial markets provide liquidity, as they allow agents totrade assets quickly and with limited execution risk.
Financial markets reduce transaction costs, for agents can buyand sell assets with a small impact on transaction prices.
Paolo Vitale Introduction to Finance
Motivations and ObjectivesFinancial Assets
Financial MarketsIntermediaries and Financial Institutions
The Role of Financial MarketsSeparation of Ownership and ManagementFinancial Markets Classification
Perfect Financial Markets
These functions are best served, when
Financial markets are “perfect”, as:
? A rich set of securities is traded (markets are complete).
? Traders are price-taker (markets are competitive).
? There are no transaction costs, short-sell constraints, capitalcontrols (markets are frictionless).
Access to financial markets is free.
Paolo Vitale Introduction to Finance
Motivations and ObjectivesFinancial Assets
Financial MarketsIntermediaries and Financial Institutions
The Role of Financial MarketsSeparation of Ownership and ManagementFinancial Markets Classification
Separation of Ownership and Management
For most firms ownership and management are distinct.
Management does not have to know the specifics of thestockholders preferences towards timing and riskiness.
Anyhow, well functioning financial markets allow any investorto choose investments with any desired
? time pattern (preferences over time),
? riskiness of cash flows (preferences over risk).
Claim (Fisher’s Separation Principle)
Management must concentrate on maximizing the firm’s value.
Paolo Vitale Introduction to Finance
Motivations and ObjectivesFinancial Assets
Financial MarketsIntermediaries and Financial Institutions
The Role of Financial MarketsSeparation of Ownership and ManagementFinancial Markets Classification
Investment Decisions with Financial Markets
Consider an individual with wealth W0 in period 0.
She can invest her wealth in a financial asset which pays in-terest rate r to transfer purchasing power to period 1.
Her preferences over current, C0, and future consumption, C1,are represented by utility function U(C0,C1).
Her budget set is
C1 = (1 + r) (W0 − C0).
The optimum investment is reached when the marginal rate ofsubstitution between current and future consumption is equal tothe corresponding relative price,
MRS ≡ UC0/UC1 = (1 + r).
Paolo Vitale Introduction to Finance
Motivations and ObjectivesFinancial Assets
Financial MarketsIntermediaries and Financial Institutions
The Role of Financial MarketsSeparation of Ownership and ManagementFinancial Markets Classification
Investment Decisions with Financial Markets (cont.ed)
.................
...........................................E
U
U
W1
C0
C1
C∗1
C∗0
−(1 + r) C1 = W1 − (1 + r)C0
W0
Figure 5: Financial Markets and Utility Maximization
1
The optimality condition is identified by point E, where
MRS = (1 + r).
Paolo Vitale Introduction to Finance
Motivations and ObjectivesFinancial Assets
Financial MarketsIntermediaries and Financial Institutions
The Role of Financial MarketsSeparation of Ownership and ManagementFinancial Markets Classification
Investment Decisions with Production Opportunities
In a Robinson economy there are no financial markets butproduction opportunities.
A production opportunity set (the PP on next page’s Figure)is obtained by choosing
? first the production projects with the highest rates of return
? and then adding those with smaller rates of return.
The optimum investment is reached when the marginal rate ofsubstitution is equal to the marginal rate of transformation,
MRS ≡ UC0/UC1 = MRT .
Paolo Vitale Introduction to Finance
Motivations and ObjectivesFinancial Assets
Financial MarketsIntermediaries and Financial Institutions
The Role of Financial MarketsSeparation of Ownership and ManagementFinancial Markets Classification
Investment Decisions with Production Opportunities
.............................
E
U
U
MRS=MRT
A
C1
W0 C0
P
P
Figure 6: Production Opportunities and Utility Maximization
1
The optimality condition is identified by point E, where
MRS = MRT .
Paolo Vitale Introduction to Finance
Motivations and ObjectivesFinancial Assets
Financial MarketsIntermediaries and Financial Institutions
The Role of Financial MarketsSeparation of Ownership and ManagementFinancial Markets Classification
Fisher’s Separation Principle
When financial markets and production opportunities coexist theagent invests in all production projects which yield rates of returnexceeding the interest rate, r . From the Figure on next page wesee that:
Investing JW0 in production projects, she obtains OG in pe-riod 1, with net present value (NPV) W0K0.
If she wants to invest more, she will find it more convenient tobuy financial assets, since further projects have negative NPV.
If she desires to consume more than 0J in period 0 she willundertake all projects with positive NPV and then borrow atthe interest rate r .
Paolo Vitale Introduction to Finance
Motivations and ObjectivesFinancial Assets
Financial MarketsIntermediaries and Financial Institutions
The Role of Financial MarketsSeparation of Ownership and ManagementFinancial Markets Classification
Fisher’s Separation Principle (cont.ed)
....................................................................
U
U
P
J0 ︸ ︷︷ ︸NPVW0
W1
K1
K0C0
G
C1
E
Figure 7: Production Opportunities and Financial Markets
1
The optimality condition is identified by point E, where
MRS = (1 + r),
on the new budget constraint K0K1.
Paolo Vitale Introduction to Finance
Motivations and ObjectivesFinancial Assets
Financial MarketsIntermediaries and Financial Institutions
The Role of Financial MarketsSeparation of Ownership and ManagementFinancial Markets Classification
Fisher’s Separation Principle (cont.ed)
Her budget set shifts from W0W1 to K0K1. Analytically,
C1 = (1 + r) (W0 − C0) + W1K1.
The optimum investment is reached when the marginal rate ofsubstitution is equal to the relative price of present and futureconsumption:
MRS = (1 + r).
Conclusion: Corporate managers must maximize company valueswhatever the preferences of their shareholders, whichcan maximize their utilities by borrowing and lending.
Paolo Vitale Introduction to Finance
Motivations and ObjectivesFinancial Assets
Financial MarketsIntermediaries and Financial Institutions
The Role of Financial MarketsSeparation of Ownership and ManagementFinancial Markets Classification
Financial Markets Classification
Financial markets are classified with respect to:
the timing of delivery into spot markets and forward markets;
the type of securities traded into bonds, equities and deriva-tives markets;
the type of issue into primary and secondary markets;
the type of structure into over-the-counter, dealer and auctionmarkets.
Paolo Vitale Introduction to Finance
Motivations and ObjectivesFinancial Assets
Financial MarketsIntermediaries and Financial Institutions
Financial AgentsThe Role of Financial IntermediariesInvestment Companies
Financial Agents
Firms are net borrowers, which raise capital to invest in pro-duction opportunities. Their real assets yield income whichprovides returns to owners of the firms’ securities.
Governments are usually net borrowers, which raise funds viagovernment securities issues to cover their budgets deficits.
Households are net savers, which purchase the securitiesissued by firms, governments and other financial institutions.
Financial institutions, such as commercial and investmentbanks, mutual and pension funds, stand in between issuers ofsecurities and their ultimate owners.
Paolo Vitale Introduction to Finance
Motivations and ObjectivesFinancial Assets
Financial MarketsIntermediaries and Financial Institutions
Financial AgentsThe Role of Financial IntermediariesInvestment Companies
The Services of Financial Institutions
Financial intermediation: as they transform existing securitiesin others with different characteristics.
Securities trading: as they purchase and sell financial assets
? on their own account (proprietary trading)
? or on behalf of their clients (brokerage service).
Securities underwriting: as they advise corporations on theterms of a securities issue and help selling it to investors.
Private banking: as they advise clients on their financialinvestments.
Portfolio management: as they manage portfolios of assets onbehalf of households and institutional investors.
Paolo Vitale Introduction to Finance
Motivations and ObjectivesFinancial Assets
Financial MarketsIntermediaries and Financial Institutions
Financial AgentsThe Role of Financial IntermediariesInvestment Companies
The Role of Financial Intermediaries
Intermediaries transform financial assets with respect to theirmaturities and payments:
? This helps investors to reduce
− their risk-exposure,
− the cost of writing and enforcing contracts,
− the cost of collecting and processing information.
Intermediaries manage the payment system.
Paolo Vitale Introduction to Finance
Motivations and ObjectivesFinancial Assets
Financial MarketsIntermediaries and Financial Institutions
Financial AgentsThe Role of Financial IntermediariesInvestment Companies
Investment Companies
Investment companies are intermediaries which
collect funds from individual investors and
pool and invest these funds into a wide range of real and fi-nancial assets.
Investment companies perform several functions, such as
? diversify risk and fractionize investment,
? reduce transaction costs,
? collect and process information.
Paolo Vitale Introduction to Finance
Motivations and ObjectivesFinancial Assets
Financial MarketsIntermediaries and Financial Institutions
Financial AgentsThe Role of Financial IntermediariesInvestment Companies
Unit Investment Trusts
Investment companies comprise
? Unit investment trusts and
? Managed investment companies.
Unit investment trusts are pools of money invested into aportfolio of assets which is fixed for the life of the fund.
? A trustee buys a portfolio of securities deposited into a trust.
? Shares, or “units”, are sold to the public at a premium to theirnet asset value (NAV), ie. to the cost of the underlying assets.
? Investors can liquidate their holdings by selling the units backto the trustee at the NAV.
Paolo Vitale Introduction to Finance
Motivations and ObjectivesFinancial Assets
Financial MarketsIntermediaries and Financial Institutions
Financial AgentsThe Role of Financial IntermediariesInvestment Companies
Managed Investment Companies
Managed investment companies comprise
? Closed-end funds and
? Open-end funds or mutual funds.
Management companies are hired to manage their portfolios.
Open-end funds are ready to redeem or issue shares at NAV.
Closed-end funds do not redeem or issue new shares: investorscan liquidate their shares by selling them to other investors.
Shares of closed-end funds can be traded a prices differentfrom NAV on organized exchanges.
Paolo Vitale Introduction to Finance
Motivations and ObjectivesFinancial Assets
Financial MarketsIntermediaries and Financial Institutions
Financial AgentsThe Role of Financial IntermediariesInvestment Companies
Mutual Funds
Mutual funds are classified according to their investmentpolicies into money-market, equity, bond and index funds.
Index funds replicate the performance of a broad marketindex, by mimicking the portfolio of securities in the index.
Mutual funds impose a complex fee structure, inclusive of
? front-end load (entry) and back-end load (exit) commissions
? annual operating expenses and performance fees.
Paolo Vitale Introduction to Finance
Motivations and ObjectivesFinancial Assets
Financial MarketsIntermediaries and Financial Institutions
Financial AgentsThe Role of Financial IntermediariesInvestment Companies
Hedge Funds
Hedge funds are a particular class of closed-end funds which
are open to wealthy and institutional investors,
differently from mutual funds are not regulated,
pursue aggressive investment strategies, relying on
− short sales, derivatives and leverage.
Paolo Vitale Introduction to Finance