Lecture 1: An introduction to financial markets

BEAM047A Fundamentals of Financial

Management
Lecture 1: An introduction to financial markets

Panagiotis Couzo↵

Autumn Term, 2017/18

Lecture 1: An introduction to financial markets

About myself

I Dr Panagiotis (Panos) Couzo↵

I Lecturer in Finance at the University of Exeter Business School
(2016 - )
I Previously, LSE Fellow in Finance (2013 - 2016)
I PhD in Accounting and Finance from Lancaster University
Management School
I Contact email address: P.Couzo↵@exeter.ac.uk
I Office hours: Mondays 14:00-15:00 & Tuesdays 11:00-12:00
Lecture 1: An introduction to financial markets

Module Overview (Syllabus plan)

I Introduction
I Fixed income securities
I Equities
I Risk and return
I The Capital Asset Pricing Model
I Market Efficiency
I Capital budgeting
I Cash flow estimation
I Cost of capital
I Financial policy
I Capital structure
I Payout policy
I Valuation methods
Lecture 1: An introduction to financial markets

How to succeed & ground rules

I “Lecturing is that mysterious process by means of which the
contents of the notebook of the professor are transferred through
the instrument of the [. . . ] pen to the notebook of the student
without passing through the brain of either.” (Edwin Slosson)
Not in my lectures!!
I Self-study: “I hear and I forget. I see and I remember. I do and I
understand” (Confucius)
I Seminars: The perfect time to be wrong!!

I Attendance is mandatory and exercises have to be (seriously)

attempted before the seminars.
I Be not afraid of mistakes...
I Be respectful of others!
Lecture 1: An introduction to financial markets

Assessment

I You will be assessed twice for this module:

I Mid-term exam (30mins): 20% of final mark; on Thursday of week 7
(November 9), venue to be confirmed.
I Final exam (1h 30mins): 80% of final mark; after the end of the
course (in January exam period)
I Should a resit exam be required, a 1h 30mins examination
accounting for 100% of the final mark
Lecture 1: An introduction to financial markets

Readings

I Recommended textbooks:
I Berk and DeMarzo, 2014. Corporate Finance, 3rd (global) edition,
Harlow, Essex: Pearson Education Limited
I For further reading, there is a large number of textbooks on the
subject areas of this module which can be found in the library and
through any good bookseller. Keywords to look for:
I Financial management
I Finance
I Asset markets
Lecture 1: An introduction to financial markets

Online sources

I Module ELE
I Lecture slides
I Seminar problem sets and suggested solutions
I Additional material
I Library
I E-library for textbooks and academic journal articles
I News media (newspapers, periodicals, etc.)
Lecture 1: An introduction to financial markets

Outline

Introduction

Financial system

Assets and contracts

Financial institutions and institutional investors

Lecture 1: An introduction to financial markets
Introduction

Outline

Introduction

Financial system

Assets and contracts

Financial institutions and institutional investors

Lecture 1: An introduction to financial markets
Introduction

What is finance?

I Finance can be loosely defined as the science of money

management.
I In our science, it is a colloquial (informal) term used instead of the
more formal financial economics.
I Financial economics is the branch of economics concerned with “the
allocation and deployment of economic resources, both spatially and
across time, in an uncertain environment” (Nobel Prize lecture by
Robert C. Merton, 1997).
I It is generally understood as the study of the financial side of the
economy (prices, interest rates, financial markets, etc.), as opposed
to the real economy, i.e. the actual production of goods and services.
Lecture 1: An introduction to financial markets
Introduction

What is finance? (cont’d)

I Financial economics can be further broken down into two main areas
of focus:
I Asset pricing: broadly, it concerns the valuation of assets and
reflects the perspective of providers of funds (investors) on financial
transactions
I Corporate finance: it deals with decisions made by corporations
about their capital structure (the choice among sources of funding)
and capital budgeting allocation (how these funds are used) in their
e↵ort to maximize firm value. In a way, it reflects the perspective of
users of capital on financial transactions.
Lecture 1: An introduction to financial markets
Introduction

So, what is financial management?

I Financial management refers to the efficient and e↵ective

management of money in a way that accomplishes the objectives of
a corporation, or more generally an organisation.
I Capital budgeting decision: What long-term investments or
projects should the business take on?
I Capital structure: How should the firm pay for its assets? Should it
use debt or equity?
I Working capital management: How should the firm manage its
day-to-day finances?
I In other words, it’s corporate finance for managers!
Lecture 1: An introduction to financial markets
Financial system

Outline

Introduction

Financial system

Assets and contracts

Financial institutions and institutional investors

Lecture 1: An introduction to financial markets
Financial system

The financial system (uses and purposes)

I The financial system consists of markets and intermediaries that help

transfer assets (real or financial) and risks across entities, time, and
space.
I The financial system is used for six main reasons:
1. Save money for future use
2. Borrow money for current use
3. Raise capital
4. Manage risks
5. Exchange assets (for immediate or future deliveries)
6. Trade on information
Lecture 1: An introduction to financial markets
Financial system

The financial system (role) and financial markets

I The role of the financial system can be summarised by three main

functions:
1. Facilitate the six purposes listed above
2. Determine the rates of return that equate savings and borrowings
3. Enable the allocation of capital to its best use

I What is a financial market?

I Similar to physical asset markets where real goods and services are
exchanged, financial asset markets are markets for financial goods
and services.
I Broadly speaking, this is where financial transactions take place.
Lecture 1: An introduction to financial markets
Financial system

Types of financial markets

I Financial markets can be classified

I based on maturity (time until expiration)
I The money market is the market in which short-term securities
(usually with a maturity of less than one year) are traded
I The capital market is the market for longer term securities
(maturities of more than one year)
I based on the timing of the transaction
I In the spot market, trades take place (almost) immediately at the
currently quoted market price
I In the futures market, transactions that will take place at some time
in the future are contracted today; the time of the actual transaction
and the price to be paid are among the things that are agreed upon
Lecture 1: An introduction to financial markets
Financial system

Types of financial markets (cont’d)

I Financial markets can be classified (cont’d)

I based on the seller of the security
I The primary market is the market in which corporations raise capital
by issuing new securities (IPOs, SEOs, private placements)
I These securities are then traded among investors in the secondary
market
I based on the rigidity of regulation
I In a private market (or over-the-counter market), transactions are
negotiated directly between the two parties
I In a public market, buyers and sellers trade standardised securities
through an exchange
I based on the level of perceived “sophistication”
I Traditional investment markets include all publicly traded debts and
equities
I Alternative investment markets include hedge funds, private equities,
commodities, etc. which are often harder to value and harder to trade
Lecture 1: An introduction to financial markets
Financial system

When is a financial system functioning well?

I Well-functioning financial systems are characterized by:

I the existence of well-developed markets where instruments that help
people solve their financial problems are traded (markets are
complete);
I liquid markets in which the costs of trading/transacting are low
(markets are operationally efficient);
I timely financial disclosures by issuers of securities that allow market
participants to estimate fundamental values (supports next point);
I prices that reflect all available information and fluctuate primarily
due to changes in fundamental values and not demands for liquidity
by uninformed traders (markets are informationally efficient).
I A well-functioning financial system promotes real investments, and
eventually generates growth.
Lecture 1: An introduction to financial markets
Financial system

The role of market regulation

I Market regulation facilitates the functioning of the financial system

by promoting fair and orderly markets.
I It aims to protect less sophisticated investors from the complexity of
financial markets.
I The objectives of regulation are to:
I control fraud;
I control agency problems;
I promote fairness;
I set mutually beneficial standards;
I prevent undercapitalised financial firms from exploiting investors
through excessively risky investments;
I ensure that long-term liabilities of financial firms are funded.
Lecture 1: An introduction to financial markets
Assets and contracts

Outline

Introduction

Financial system

Assets and contracts

Financial institutions and institutional investors

Lecture 1: An introduction to financial markets
Assets and contracts

What is traded in financial markets?

I Assets and contracts that are traded in financial markets:

I Securities
I Fixed-income securities, equities, pooled investment vehicles
I Currencies
I Contracts (derivatives)
I Forwards, futures, swaps, options
I Commodities
I Real assets
Lecture 1: An introduction to financial markets
Assets and contracts

Fixed income securities

I Fixed income securities o↵er a contractual claim, or stream of
claims, against the issuer. They are essentially promises to (re)pay
(borrowed) money.
I Fixed income securities are issued by domestic and foreign
governments, public authorities and public corporations.
I The issuer of a fixed income security may default, in which case the
holder of the security will receive less than the promised claim, and
possibly nothing.
I The likelihood of default for corporate fixed income securities varies
widely and is reflected in credit ratings.
I Default may result in bankruptcy for the issuer, as was the case for
Lehman Brothers.
I The biggest bankruptcy case in US history was filed on September
15, 2008 after a default on $120bn of debt (Lehman had at the time
assets worth $639bn, but also debt amounting to $768bn).
Lecture 1: An introduction to financial markets
Assets and contracts

Fixed income securities (cont’d)

I Short term fixed income securities are traded in the money market
and are known as money market instruments:
I Bills, certificates of deposit, commercial papers, repurchase
agreements
I Money market instruments involve a single payment at maturity,
known as the principal or face value, and are sold at a discount.
I Longer term fixed income securities are traded in the capital market:
I notes (if maturity is within 10 years) or
I bonds (if maturity is more than 10 years).
I A bond typically o↵ers a series of regular smaller claims, known as
coupons, followed by a larger terminal payment.
Lecture 1: An introduction to financial markets
Assets and contracts

Equities

I In contrast to fixed income securities, equities (or shares, or

stocks) represent a residual claim on the issuer. They represent
ownership rights in companies.
I Stockholders own the business and have the right to receive
dividends.
I Although stockholders have only a residual claim over a company’s
earnings (i.e. they get paid only after all contractual claimants have
been paid), the size of the claim is unlimited.
I If the company does better than expected, then it is the company’s
stockholders that mainly benefit.
Lecture 1: An introduction to financial markets
Assets and contracts

Equities (cont’d)

I Common shareholders, the holders of common shares, select the

managers who run the corporations through the board of directors
that they elect.
I Preferred stock (or preference shares) is equity that promises a
dividend payment, but does not typically have voting rights.
I However, unlike bonds, failure to pay the dividends of a preferred
stock does not result in bankruptcy, but instead the unpaid
dividends accumulate.
Lecture 1: An introduction to financial markets
Assets and contracts

Derivatives

I Derivatives (or contingent claims) are securities whose value

depends on the value of some other underlying asset, either physical
(e.g. wheat, corn, tomatoes) or financial (e.g. equities, bonds,
currencies, interest rates).
I Derivatives are mainly used for hedging or speculation purposes.
I Some fixed income securities incorporate derivative features, such as
convertible bonds, callable and putable bonds.
Lecture 1: An introduction to financial markets
Assets and contracts

Types of derivatives

I Derivatives include
I Forward contracts: agreement to buy or sell the underlying security
at some future date, and are usually tailor-made arrangements
between private individuals or institutions
I Futures contracts: same as forward, but is traded through
standardised contracts on a regulated exchange. They operate using
a system of marking to market, whereby any profit and loss
accruing to the contract is settled on a daily basis
I Options: they give the right – but, importantly, not the obligation –
to buy or sell the underlying asset/security at or up to some future
date
I Swaps: agreement to swap cash flows between two obligations
Lecture 1: An introduction to financial markets
Financial institutions and institutional investors

Outline

Introduction

Financial system

Assets and contracts

Financial institutions and institutional investors

Lecture 1: An introduction to financial markets
Financial institutions and institutional investors

What is the financial institution?

I A financial institution is an establishment that conducts financial

transactions and provides financial services for its clients and
members.
I Their role of financial intermediary in modern economy is vital:
I The transfer of capital from investors and savers (holders of funds)
to companies and borrowers (users of funds) is usually conducted via
a financial institution.
Lecture 1: An introduction to financial markets
Financial institutions and institutional investors

Types of financial institutions

I In developed financial markets, there are many types of financial

institutions with separate specific roles. Among others,
I Commercial banks facilitate the flow of funds from savers to
borrowers and vice versa
I Investment banks act as an intermediary between issuers of
securities (companies) and the investing public
I Insurance companies pool the risk of a large number of clients by
collecting premiums and paying for claims that may arise
I Pension funds are funded from individuals, companies, and
governments and provide retirement income
I All of the above are also institutional investors, entities pooling
large amounts of money that are used to purchase financial
securities. They are major players in financial markets
Lecture 1: An introduction to financial markets
Financial institutions and institutional investors

Types of financial institutions

I Further, less regulated, types of financial institutions comprise

I Mutual funds are organisations that pool investor funds which are
then used to purchase targeted asset classes and securities
I Hedge funds are like mutual funds, but vary more in their
investment strategies. They are less regulated than mutual funds and
are accessible only to qualified investors and institutions
I Private equity companies pool funds from limited partners
(investors) that are subsequently invested in securities of companies
that are not publicly traded on a stock exchange