Elective – Semester I

Money, Financial Institutions and

Markets
Lecture 1
Finance - Basics
 Finance - Basics
• Finance is the application of Economic
Principles to decision-making that involves the
allocation of money under conditions of
uncertainty
• We about money and its return in future
• Investors allocate funds among financial assets
in order to accomplish their objectives
• Firms and govts raise funds by issuing claims
against themselves and use them for various
operations
 Finance - Basics
• The financial system provides the platform
to transfer funds from those who have
funds to those who need them
• The foundations of finance drawn from
economics, hence called financial
economics
 Aspects of financial economics
1. It is analytical using statistics, probability,
and mathematics to solve the problems
2. It is based on economic principles
3. It uses accounting information
4. It studies how to raise money and to
invest it productively
5. Its perspective is global
 Major topics in finance
• Capital market and capital market theory
• Financial management
• Investment management
 Capital market and its theory
• It studies three aspects
• (a) the financial system,
• (b) the structure of interest rates,
• (c ) the pricing of risky assets
Components of financial system
• The financial markets
• The financial intermediaries
• The financial market regulators
 Major issues of finance
• Pricing efficiency of financial markets
• The role and investment behaviour of the
players in the financial markets
• The best way to design and regulate the
financial markets
• The measurement of risk
• The theory of asset pricing
 Pricing efficiency of financial
markets
• Knowledge of pricing efficiency of financial
market is essential to design active or passive
strategy
• An investor always tries to ‘beat the market’ if
she knows that the market is inefficient is
discovering the true price of the financial asset,
the corresponding strategy is called active
strategy
• An investor thinks that the market is efficient in
pricing, then her strategy is to go with the market
and it is called passive strategy
 What is meant by ‘beating the
market’?
• Beating the market means generating a
return on investment higher than the
normal return of the risk and transactions
costs.
• To beat the market the investor has to be
able value the financial asset against risk
and in alternate scenarios of the market
 Valuation of a financial asset
• The value of any financial asset is the
present value of the expected cash flows.
• Valuation of a financial asset involves (a)
estimating the expected cash flows, (b)
determination of the appropriate interest
rate for discounting the cash flow, (c )
calculating the present value of the
expected cash flows
 Financial Management
• Financial management variously called as
business finance and corporate finance, deals
with financial decision-making within a business
entity
• Financial managers are concerned with how to
raise money at low cost with desired time profile
and to invest the money to get highest return
that corresponds to the expectations of the
investors
 Financial Management -2
• Whether profits should be retained or
distributed to the investors?
• Whether new investments should be
financed through retained profits or loans
or new equities?
 Financial Plan
• Financial plan is a framework to achieve
the goal of maximizing the owners’ wealth
• Implementing the financial plan requires
both long-term and short-term financial
planning that brings together forecasts of
the company’s sales with financing and
investment decision-making
 Capital structure
• The capital structure of a company is the
mixture of debt and equity that
management elects to raise the money to
finance the assets of the company.
• There are theories to describe the optimal
capital structure of a company
 Capital Budgeting and other
activities of FM
• Capital budgeting about long-term investment
that a company plans to make
• It is about expansion or new investments
• FM also takes decisions about the current
assets
• Current assets are those assets that could
reasonably be converted into cash within one
operating period such as ready cash available,
marketable securities, accounts receivable, and
inventories
 Other activities of FM
• FM also manages risk
• She has to decide which risk to accept,
which risk to neutralize and which risk to
transfer
• This involves identification, assessment,
mitigation and transference of risks
 Investment management
• Other words commonly used are portfolio
management, asset management, wealth
management, and money management
• Setting objectives in line with expectations
of the investors
• Taking into consideration the objectives,
regulatory and legal contraints, investment
policy is created
 Investment management
• Develop an investment strategy in line with
the investment policy
• Select a portfolio of financial assets
• Evaluate the performance of the portfolio