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INTRODUCTION
TO FINANCIAL MATHEMATICS

School of Economics and Management

Contents

1. Why study financial mathematics?

2. Course objectives

3. Contents in brief

4. Financial market and fundamental concepts

2
Why study financial mathematics?
What is financial mathematics?
Financial mathematics is a branch of mathematics that focuses on
analyzing data, solving problems and modeling financial markets.

Learning financial mathematics often includes understanding financial

formulas, functions, systems of equations, fractions, modeling and
other math skills.

It’s useful in many industries and roles, and there are many potential
applications in financial mathematics including:

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Why study financial mathematics?
What is financial mathematics?
It’s useful in many industries and roles, and there are many potential
applications in financial mathematics including:
•Economics: Micro and macro economics
Microconomics is the study of how businesses or consumers produce
and consume goods and services, including the supply and demand of
goods.
•Statistics: Statistics is the study of data, including data analysis.
•Probability: Probability is the likelihood of an event occurring in
mathematic terms like percentages.

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OVERVIEW

• Chapter 1: Introduction
• Chapter 2: Review of Basic Mathematics
• Chapter 3: Simple Interest and Applications
• Chapter 4: Compound Interest
• Chapter 5: Annuities
• Chapter 6: Other types of Annuities
• Chapter 7: Amortization of Loans and Mortgages
• Chapter 8: Bonds and Sinking Funds
• Chapter 9: Business Investment Decisions
TEXTBOOK AND REFERENCES

● Textbook:
▪ Mathematics of Business and Finance, 4th Edition – Larry Daisley,
Thambyrajah Kugathasan and Diane Huysmans
● References:
▪ Mathematics for Economics and Business, 9th Edition – Ian Jacques,
Pearson
▪ Mathematics with Business Applications – McGraw-Hill Education
▪ Business Mathematics, 13th Edition - Gary Clendenen and Stanley A.
Salzman, Pearson
EVALUATION

● Mid-term mark:
▪ Attendance (10%)
▪ Homework exercises (10%)
▪ Mid-term exam (20%)

● Final mark:
▪ Final exam (60%)
Financial market

Definition: markets in which funds are transferred from people who

have an excess of available funds to people who have a shortage.

The roles of financial market:

- promote greater economic efficiency
- direct effects on personal wealth
- effects on the behavior of businesses and consumers, and the
cyclical performance of the economy.

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Financial market
Debt markets and interest rates
A security (also called a financial instrument) is a claim on the issuer’s
future income or assets (any financial claim or piece of property that is
subject to ownership)
A bond is a debt security that promises to make payments periodically
for a specified period of time
An interest rate is the cost of borrowing or the price paid for the rental
of funds (usually expressed as a percentage of the rental of $100 per
year). There are many interest rates in the economy—mortgage interest
rates, car loan rates, and interest rates on many different types of bonds

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Financial market
Debt markets and interest rates
Interest rates are important on a number of levels:

On a personal level, high interest rates could deter you from buying a
house or a car because the cost of financing it would be high. Conversely,
high interest rates could encourage you to save because you can earn
more interest income by putting aside some of your earnings as savings.

On a more general level, interest rates have an impact on the overall

health of the economy because they affect not only consumers’
willingness to spend or save but also businesses’ investment decisions.
High interest rates, for example, might cause a corporation to postpone
building a new plant that would provide more jobs

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Financial market
The Stock Market
A common stock (typically just called a stock) represents a share of
ownership in a corporation. It is a security that is a claim on the earnings and
assets of the corporation
Issuing stock and selling it to the public is a way for corporations to raise
funds to finance their activities.
The stock market, in which claims on the earnings of corporations (shares of
stock) are traded, is the most widely followed financial market in almost every
country that has one; that’s why it is often called simply “the market.”

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Financial market
The Foreign Exchange Market
For funds to be transferred from one country to another, they have to be
converted from the currency in the country of origin (say, dollars) into the
currency of the country they are going to (say, euros).

The foreign exchange market is where this conversion takes place, so it is

instrumental in moving funds between countries. It is also important because
it is where the foreign exchange rate, the price of one country’s currency in
terms of another’s, is determined.

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Structure of the Financial System
Debt and Equity Markets
A firm or an individual can obtain funds in a financial market in two ways.
- debt instrument: a bond or a mortgage (long-term, short-term and
intermediate-term)
- E.g. If you wanted to make a loan to IBM or General Motors, for example,
you would not go directly to the president of the company and offer a loan.
Instead, you would lend to such companies indirectly through financial
intermediaries, institutions such as commercial banks, savings and loan
associations, mutual savings banks, credit unions, insurance companies,
mutual funds, pension funds, and finance companies that borrow funds from
people who have saved and in turn make loans to others
- The second method of raising funds is by issuing equities, such as common
stock, which are claims to share in the net income (income after expenses and
taxes) and the assets of a business.

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Structure of the Financial System

Debt and Equity Markets

A firm or an individual can obtain funds in a financial market in two ways.

- The second method of raising funds is by issuing equities, such as common
stock, which are claims to share in the net income (income after expenses and
taxes) and the assets of a business.
- Equities often make periodic payments (dividends) to their holders and are
considered long-term securities because they have no maturity date.
- The main disadvantage of owning a corporation’s equities rather than its
debt is that an equity holder is a residual claimant; that is, the corporation
must pay all its debt holders before it pays its equity holders.

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Structure of the Financial System

Primary and Secondary Markets

- A primary market is a financial market in which new issues of a security,
such as a bond or a stock, are sold to initial buyers by the corporation or
government agency borrowing the funds.
- A secondary market is a financial market in which securities that have been
previously issued can be resold.
- Securities brokers and dealers are crucial to a well-functioning secondary
market. Brokers are agents of investors who match buyers with sellers of
securities; dealers link buyers and sellers by buying and selling securities at
stated prices.

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Structure of the Financial System
Exchanges and Over-the-Counter Markets
Secondary markets can be organized in two ways.
- One method is to organize exchanges, where buyers and sellers of securities
(or their agents or brokers) meet in one central location to conduct trades. The
New York and American Stock Exchanges for stocks and the Chicago Board of
Trade for commodities (wheat, corn, silver, and other raw materials) are
examples of organized exchanges.
- The other method of organizing a secondary market is to have an over-
thecounter (OTC) market, in which dealers at different locations who have an
inventory of securities stand ready to buy and sell securities “over the counter”
to anyone who comes to them and is willing to accept their prices. Because
overthe-counter dealers are in computer contact and know the prices set by
one another, the OTC market is very competitive and not very different from a
market with an organized exchange.

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Structure of the Financial System

Exchanges and Over-the-Counter Markets

- Many common stocks are traded over the counter, although a majority
of the largest corporations have their shares traded at organized stock
exchanges.
- The U.S. government bond market, with a larger trading volume than the
New York Stock Exchange, by contrast, is set up as an over-the-counter
market. Forty or so dealers establish a “market” in these securities by
standing ready to buy and sell U.S. government bonds. Other over-the-
counter markets include those that trade other types of financial
instruments such as negotiable certificates of deposit, federal funds,
banker’s acceptances, and foreign exchange

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Structure of the Financial System
Money and Capital Markets
Another way of distinguishing between markets is on the basis of the maturity
of the securities traded in each market.

- The money market is a financial market in which only short-term debt

instruments (generally those with original maturity of less than one year) are
traded;
- The capital market is the market in which longer term debt (generally with
original maturity of one year or greater) and equity instruments are traded.

Money market securities are usually more widely traded than longer-term
securities and so tend to be more liquid.

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Function of financial markets

- Financial markets perform the essential economic function of channeling

funds from households, firms, and governments that have saved surplus
funds by spending less than their income to those that have a shortage of
funds because they wish to spend more than their income.

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Function of financial markets

Flows of funds through the financial system

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Function of financial markets
- In direct finance (the route at the bottom of the Figure), borrowers borrow
funds directly from lenders in financial markets by selling them securities
(also called financial instruments), which are claims on the borrower’s future
income or assets.

- Securities are assets for the person who buys them, but they are liabilities
(IOUs or debts) for the individual or firm that sells (issues) them.

- For example, if General Motors needs to borrow funds to pay for a new
factory to manufacture electric cars, it might borrow the funds from savers by
selling them a bond, a debt security that promises to make payments
periodically for a specified period of time, or a stock, a security that entitles
the owner to a share of the company’s profits and assets

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Function of Financial Markets
✓ Why is this channeling of funds from savers to spenders so important to
the economy? The answer is that the people who save are frequently not
the same people who have profitable investment opportunities available
to them, the entrepreneurs.
✓ Without financial markets, it is hard to transfer funds from a person who
has no investment opportunities to one who has them. Financial markets
are thus essential to promoting economic efficiency
✓ The existence of financial markets is beneficial even if someone borrows
for a purpose other than increasing production in a business.
✓ Well-functioning financial markets also directly improve the well-being of
consumers by allowing them to time their purchases better. They provide
funds to young people to buy what they need and can eventually afford
without forcing them to wait until they have saved up the entire purchase
price. Financial markets that are operating efficiently improve the
economic welfare of everyone in the society
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Function of financial intermediaries: indirect finance

✓ As shown in the Figure , funds also can move from lenders to borrowers
by a second route called indirect finance because it involves a financial
intermediary that stands between the lender-savers and the borrower-
spenders and helps transfer funds from one to the other.
✓ A financial intermediary does this by borrowing funds from the lender-
savers and then using these funds to make loans to borrowers-penders.
✓ The process of indirect finance using financial intermediaries, called
financial intermediation, is the primary route for moving funds from
lenders to borrowers. Indeed, although the media focus much of their
attention on securities markets, particularly the stock market, financial
intermediaries are a far more important source of financing for
corporations than securities markets are.

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Types of Financial Intermediaries

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Stocks Vs Bonds

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