PRINCIPLES OF FINANCE
Lecturer: Truong Thi Thuy Trang
Email: truongthithuytrang.cs2@ftu.edu.vn
1
Course content
• Chapter 1: Overview of finance
• Chapter 2: Financial markets
• Chapter 3: Financial Institutions
• Chapter 4: Time value of money
• Chapter 5: Corporate finance
• Chapter 6: State budget
2
Books
• The Economics of Money, Banking, and Financial
Markets, Frederic S. Mishkin, 12th edition, 2019
• Financial Economics, Zvi Bodie, 2nd edition, 2000
• Cecchetti and Schoenholtz (2017), Money,
Banking, and Financial Markets, 5th edition,
McGraw-Hill
3
Course schedule
Lecture Content
Materials
Overview of finance
Mishkin, Chapter 1
Bodie, Chapter 1+2
2-3
Financial markets
Mishkin, Chapter 2
Bodie, Chapter 2
4-5
Financial Institutions
Mishkin, Chapter 2+8
Bodie, Chapter 2
6-9
Time value of Money
Bodie, Chapter 4,6,8,9
1
10
Application of Time value of money
11
Mid-term test
12 -14 Financial Statement Analysis
15
Bodie, Chapter 3
Berk, Chapter 2
Review
4
Course assessment
Assessment
Contribution
Attendance
10%
Mid-term exam
30%
Final exam (MCQs+ short questions)
60%
5
Class rules
• Be on time.
• Students need to use a phone/laptop with a microphone to
join the class.
• Students are required to turn on the camera during class.
• Student whose attendance score is less than 7 will be
prohibited from taking the final examination.
• +0.1 bonus point for every correct answer in class.
• If you want to send an email to your lecturer, please put
[ML…]… on the email subject.
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CHAPTER 1:
OVERVIEW OF FINANCE
Lecturer: Truong Thi Thuy Trang
Email: truongthithuytrang.cs2@ftu.edu.vn
7
Content
• Definition of Finance
• Why study Finance?
• Financial decisions
• Financial system
8
Definition of finance
• Finance is the study of how people allocate scare
resource over the time.
• The costs and benefits of financial decisions are
– spread out over the time
– usually not known with certainty in advance by either
the decision makers or anybody else.
9
Financial markets
• Financial markets are markets in which funds are
transferred from people and firms who have an
excess of available funds to people and firms who
have a need of funds
10
The Debt Market and Interest Rates
• A security (financial instrument) is a claim on the
issuer’s future income or assets.
• 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.
11
Figure 1. Interest Rates on Selected Bonds, 1950–2017
Source: Federal Reserve Bank of St. Louis, FRED database: https://fred.stlouisfed.org/series/TB3MS;
https://fred.stlouisfed.org/series/GS10; https://fred.stlouisfed.org/series/BAA
12
The Stock Market
• Common stock represents a share of ownership
in a corporation.
• A share of stock is a claim on the residual
earnings and assets of the corporation.
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Figure 2. Stock Prices as Measured by the Dow
Jones Industrial Average, 1950–2017
Source: Federal Reserve Bank of St. Louis, FRED database: https://fred.stlouisfed.org/series/DJIA
14
Financial Institutions and Banking
• Financial intermediaries: institutions that borrow
funds from people who have saved and in turn
make loans to people who need funds.
– Banks: accept deposits and make loans
– Other financial institutions: insurance companies,
finance companies, pension funds, mutual funds and
investment companies
15
The International Financial System
• Financial markets have become increasingly
integrated throughout the world.
• The international financial system has tremendous
impact on domestic economies:
– How a country’s choice of exchange rate policy affect
its monetary policy?
– How capital controls impact domestic financial systems
and therefore the performance of the economy?
– Which should be the role of international financial
institutions like the IMF?
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Why study finance?
• To manage your personal resources
• To deal with the world of business
• To pursue interesting and rewarding career
opportunities
• To make informed public choices as a citizen
• To expand your mind
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Financial decisions
1. Financial decisions of households
2. Financial decision of firms
3. Financial decision of government
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Financial decisions of households
• Households face 4 basic types of financial
decision:
– 1.
– 2.
– 3.
– 4.
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Financial decision of firms
• The branch of finance dealing with financial
decisions of firms is called business finance or
corporate finance.
– Capital budgeting process such as whether to build a
plant or produce a new product.
– Capital structure decision such as how much debt and
how much equity it should have in its capital structure.
– Working capital management, such as whether it
should extend credit to customer or demand cash on
delivery.
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Financial decision of government
• A government budget is a government document
presenting the government's proposed revenues and
spending for a financial year that is often passed by the
legislature (parliament, congress, and assembly).
• Government budgets are of three types:
– Balanced Budget: when government revenue and expenditure
are equal.
– Surplus Budget: when anticipated revenues exceed expenditure.
– Deficit Budget: when anticipated expenditure is greater than
revenues.
21
Figure 3. Vietnam: Budget balance between
2009 to 2021 in relation to GDP
22
Figure 4. Vietnam: National debt from
2014 to 2024
23
Figure 5. Vietnam: Inflation rate
from 1984 to 2021*
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Financial System
• Financial system is defined as the set of markets
and other institutions used for financial contracting
and exchange of assets and risks.
• The financial system includes markets, stocks,
bonds and other financial instruments, financial
intermediaries and the regulatory bodies that
govern all of these institutions.
25
Financial System
• People use the financial system for 6 main
purposes:
1. to save money for the future;
2. to borrow money for current use;
3. to raise equity capital;
4. to manage risks;
5. to exchange assets for immediate and future
deliveries; and
6. to trade on information.
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Functions of the financial system
• The main functions of the financial system are to
facilitate:
1. the achievement of the purposes for which people use
the financial system;
2. the discovery of the rates of return that equate
aggregate savings with aggregate borrowings; and
3. the allocation of capital to the best uses.
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Six Parts of the Financial System
1.
Money
To pay for purchases and store wealth.
2.
Financial Instruments
To transfer resources from savers to investors and to transfer risk to
those best equipped to bear it.
3.
Financial Markets
4.
Financial Institutions
To buy and sell financial instruments.
To provide access to financial markets, collect information & provide
services.
5.
Regulatory Agencies
To provide oversight for financial system.
6.
Central Banks
To monitor financial Institutions and stabilize the economy.
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Money
• Money (or the “money supply”): anything that is
generally accepted as payment for goods or
services or in the repayment of debts.
– Functions of money: Medium of Exchange, Unit of
Account, Store of Value
• Money is at the heart of the payments system.
• Money (a stock concept) is different from:
– Wealth: the total collection of pieces of property that
serve to store value
– Income: flow of earnings per unit of time (a flow
concept)
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Financial Instruments
• The written legal obligation of one party to transfer
something of value, usually money, to another
party at some future date, under certain
conditions.
30
Financial Instruments
• Financial instruments act as a means of payment (like
money).
– Employees take stock options as payment for working.
• Financial instruments act as stores of value (like money).
– Financial instruments generate increases in wealth that are larger
than from holding money.
– Financial instruments can be used to transfer purchasing power
into the future.
• Financial instruments allow for the transfer of risk (unlike
money).
– Examples: Insurance contracts, future contracts.
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Examples of financial instruments
• The basic types of financial assets are debt,
equity and derivatives.
– Debt instruments are issued by anyone who borrows
money: corporate bonds, government bonds, residential and
commercial mortgages and consumer loans.
– Equity represents the shareholders' stake in the company
– Derivative instruments are those where their value and
payoffs are “derived” from the behaviors of the underlying.
Underlying instruments are used by saver/lenders to
transfer resources directly to investors/borrowers.
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Features of Financial Instruments
• These contracts are very complex. This
complexity is costly, and people do not want to
bear these costs.
• Standardization of financial instruments
overcomes potential costs of complexity. Most
mortgages feature a standard application with
standardized terms.
33
Features of Financial Instruments
• Financial instruments also communicate
information, summarizing certain details about
the issuer.
• Financial instruments are designed to handle the
problem of asymmetric information.
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Financial Markets
• Financial markets are places where financial
instruments are bought and sold.
• These markets are the economy’s central nervous
system.
• These markets enable both firms an individuals to
find financing for their activities.
• These markets promote economic efficiency.
• They ensure resources are available to
who put them to their best use.
• They keep transactions costs low.
those
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Financial Markets
36
Financial Institutions
• Firms that provide access to the financial
markets, both to savers who wish to purchase
financial instruments directly and to borrowers
who want to issue them.
• Also known as financial intermediaries.
– Examples: commercial banks, investment banks,
insurance companies, securities firms, and pension
funds.
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Types of Financial Intermediaries
Table 1. Primary Assets and Liabilities of Financial
Intermediaries
Type of Intermediary
Primary Liabilities
(Sources of Funds)
Primary Assets (Uses of Funds)
Depository institutions (banks)
Blank
Blank
Commercial banks
Deposits
Business and consumer loans,
mortgages, U.S. government
securities, and municipal bonds
Savings and loan associations
Deposits
Mortgages
Mutual savings banks
Deposits
Mortgages
Credit unions
Deposits
Consumer loans
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Types of Financial Intermediaries
[Table 1 Continued]
Primary Liabilities
(Sources of Funds)
Primary Assets (Uses of Funds)
Contractual savings
institutions
Blank
Blank
Life insurance companies
Premiums from policies
Corporate bonds and mortgages
Fire and casualty insurance
companies
Premiums from policies
Municipal bonds, corporate bonds
and stock, and U.S. government
securities
Pension funds, government
retirement funds
Employer and employee
contributions
Corporate bonds and stock
Type of Intermediary
39
Types of Financial Intermediaries
[Table 1. Continued]
Type of Intermediary
Primary Liabilities
(Sources of Funds)
Primary Assets (Uses of Funds)
Investment intermediaries
Blank
Blank
Finance companies
Commercial paper, stocks,
bonds
Consumer and business loans
Mutual funds
Shares
Stocks, bonds
Money market mutual funds
Shares
Money market instruments
Hedge funds
Partnership participation
Stocks, bonds, loans, foreign
currencies, and many other assets
40
Types of Financial Intermediaries
Table 2. Primary Financial Intermediaries and Value
of Their Assets
Value of Assets ($ billions, end of year)
Type of Intermediary
Depository institutions (banks)
Commercial banks, savings and loans,
and mutual savings banks
1990
Blank
2000
Blank
2010
Blank
2016
Blank
4,744
7,687
12,821
16,834
217
441
876
1,238
Contractual savings institutions
Blank
Blank
Blank
Blank
Life insurance companies
1,367
3,136
5,168
6,764
533
866
1,361
1,908
1,619
4,423
6,614
9,099
820
2,290
4,779
6,103
Credit unions
Fire and casualty insurance companies
Pension funds (private)
State and local government retirement
funds
41
Types of Financial Intermediaries
[Table 2. Continued]
Value of Assets ($ billions, end of year)
Type of Intermediary
Investment intermediaries
1990
Blank
2000
Blank
2010
Blank
2016
Blank
Finance companies
612
1,140
1,589
1,385
Mutual funds
608
4,435
7,873
13,616
Money market mutual funds
493
1,812
2,755
2,728
Source: Federal Reserve Flow of Funds Accounts; https://www.federalreserve.gov/releases/z1/current/data.htm,
Tables L110, L114, L115, L116, L118, L120, L121, L122, L127.
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Government regulatory agencies
• Government regulatory agencies provide wideranging financial regulation – rules and
supervision.
43
Regulation of the Financial System
• To increase the information available to investors:
– Reduce adverse selection and moral hazard problems
– Reduce insider trading (SEC)
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Regulation of the Financial System
• To
ensure
the
intermediaries:
soundness
of
financial
– Restrictions on entry (chartering process).
– Disclosure of information.
– Restrictions on assets and activities (control holding of
risky assets).
– Deposit Insurance (avoid bank runs).
– Limits on competition (mostly in the past):
§ Branching
§ Restrictions on interest rates
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Regulation of the Financial System
Table 5. Principal Regulatory Agencies of the U.S.
Financial System
Regulatory Agency
Subject of Regulation
Nature of Regulations
Securities and Exchange
Commission (SEC)
Organized exchanges and
financial markets
Requires disclosure of information;
restricts insider trading
Commodities Futures Trading
Commission (CFTC)
Futures market exchanges
Regulates procedures for trading
in futures markets
Office of the Comptroller of the
Currency
Federally-chartered commercial
banks and thrift institutions
Charters and examines the books
of federally chartered commercial
banks and thrift institutions;
imposes restrictions on assets they
can hold
National Credit Union
Administration (NCUA)
Federally-chartered credit unions
Charters and examines the books
of federally chartered credit unions
and imposes restrictions on assets
they
can hold
46
Regulation of the Financial System
[Table 5. Continued]
Regulatory Agency
Subject of Regulation
Nature of Regulations
State banking and insurance
commissions
State-chartered depository
institutions and insurance
companies
Charter and examine the books of statechartered banks and insurance companies,
impose restrictions on assets they
can hold, and impose restrictions on
branching
Federal Deposit Insurance
Corporation (FDIC)
Commercial banks, mutual
savings banks, savings
and loan associations
Provides insurance of up to $250,000 for
each depositor at a bank, examines the
books of insured banks, and imposes
restrictions on assets they can hold
Federal Reserve System
All depository institutions
Examines the books of commercial banks
and systemically important financial
institutions; sets reserve requirements for
all banks
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Central banks
• Central banks began as large private banks to
finance wars.
• Central banks control the availability of money and
credit to ensure low inflation, high growth and
stability of financial system.
48
Figure 6. Flows of Funds Through the
Financial System
49
Direct finance
• Borrowers borrow funds directly from lenders in
financial markets by selling them securities
50
Indirect Finance
• Lower transaction costs (time and money spent in
carrying out financial transactions)
– Economies of scale
– Liquidity services
• Reduce the exposure of investors to risk
– Risk sharing (asset transformation)
– Diversification
51
Indirect Finance
• Deal with asymmetric information problems:
– Adverse Selection (before the transaction): try to
avoid selecting the risky borrower by gathering
information about them
– Moral Hazard (after the transaction): ensure borrower
will not engage in activities that will prevent him/her to
repay the loan.
§ Sign a contract with restrictive covenants.
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Five rules of finance
• Money has time value
• Risk Requires Compensation
• Information Is The Basic for Decisions
• Markets Determine Prices and Allocate Resources
• Stability Improves Welfare
53