FINANCIAL ECONOMICS I
INTRODUCTION TO FINANCIAL ECONOMICS
ASSETS
An investment is the current commitment of money
or other resources in the expectation of reaping
future benefits.
AERC, Financial Economics I
Types of assets
Real Assets
 Productive assets in the
economy
 Generate net income to the
economy
 Appear as assets in company
balance sheets
 Underlie the issuance of
financial assets
Examples: Land, buildings,
machinery, commodoties
Financial assets
 Claims on real assets
 Define the allocation of
income or wealth to investors
 Appear as liabilities in
company balance sheets
 Performance depends on the
performance of real assets
Examples: Fixed income
securities (money and capital
markets), Equities, Derivatives
2
FINANCIAL MARKETS AND THE ECONOMY
AERC, Financial Economics I
3
MARKETS ARE COMPETITIVE
Efficient markets
 New info is quickly reflected in security prices → prices
reflect market consensus of security values
 Implication: active management is not useful
Yet, security analysis keeps prices near fair values
By continuously looking for bargains, analysts’
actions ensure prices reflect available information
AERC, Financial Economics I
Risk-return trade-off
 If a security is priced below it’s fair value (as dictated
by its risk), arbitrage will force the price up and reduce
expected returns; and vice versa
 Risk is measured by volatility on a stand-alone basis.
But for a portfolio, there’s diversification effect
4
MAJOR PLAYERS
IN
THE FINANCIAL MARKETS

Firms: net borrowers – raise funds for investments

Households: net savers – purchase securities
Governments: net borrowers if budget deficit; net
savers (may retire outstanding debt) if budget surplus.
AERC, Financial Economics I

5
ASSET CLASSES AND FINANCIAL INSTRUMENTS
AERC, Financial Economics I
6
ASSET CLASSES AND FINANCIAL INSTRUMENTS
AERC, Financial Economics I
7
ASSET CLASSES AND FINANCIAL INSTRUMENTS
AERC, Financial Economics I
8
THE BOND MARKET – TREASURY BONDS
Long term debt securities issued by governments

Mostly issued to finance budget deficits

Coupon interest typically paid semi-annually

AERC, Financial Economics I

Yields computed through the bond pricing equation
as a semi-annual rate; then doubled to obtain
annual percentage rate (APR), or the bond
equivalent yield
9
THE BOND MARKET – MUNICIPAL BONDS
Issued
by local governments usually to fund capital expenditures;
interest payments typically exempt from income taxation
General
Munis
may also be secured/guaranteed by financial institutions of good
credit standing e.g., IFC or development banks
The
yield on munis should be evaluated on an after-tax basis:
Equivalent
after-tax yield, 𝑟 = 𝑟𝑀 /(1 − 𝑇)
AERC, Financial Economics I
obligation “munis” are backed by the full faith and credit of the
issuer; revenue munis are issued to finance a particular project and are
backed by revenues from that project’
𝑟
From
this equation, 𝑇 = 1 − 𝑀 , 𝑇 is the tax rate at which investors are
indifferent between tax exempt bonds and taxable bonds
The
𝑟
higher the ratio 𝑀, the lower is 𝑇 (hence the greater is the appeal of
tax-exempt bonds such as munis)
10
THE BOND MARKET – CORPORATE BONDS


Bonds are issued by firms to fund long-term investment
activities

Thus, liquidity premium inherently forms a part of bond yields

An issue of corporate bonds is usually covered by an indenture

Types of bonds
Zero
coupon bonds
Bearer
Term
AERC, Financial Economics I
Bonds trade in secondary markets, but bond markets are thin
relative to stock markets
bonds versus registered bonds
bonds, (bullet-/balloon-maturity) versus serial issues
Mortgage
Callable
bonds; collateral trust bonds; guaranteed bond; debentures
bonds; convertible bonds
11
MORTGAGE-BACKED SECURITIES (MBS)


Mortgage lenders originate loans and then sell
packages of such loans in secondary markets
The mortgage originator collects interest and principal
from loanees then passes them on to the mortgage
purchaser (pass-through)
AERC, Financial Economics I

MBS are either ownership claims on, or obligations
secured by, a pool of mortgages (securitization)
Conforming
mortgages (borrowers must meet certain
standards of credit worthiness) vs.
Sub-prime
borrowers)
mortgages (made to financially weaker
12
EQUITY SECURITIES – COMMON STOCK
Common
stock represents equity (ownership) interest in a company
Returns
Key
features: residual claim (lowest priority on assets, earnings);
limited liability
Voting
rights: stockholders vote on certain key matters (e.g.,
election of board of directors, approval of amendments to articles of
association)
Each
AERC, Financial Economics I
to common stockholders are in the form of cash dividends
and capital change
share is usually allocated one vote; majority voting commonly
used
→ Proxies → proxy fights (corporate governance)
13
EQUITY SECURITIES – PREFERRED STOCK
 Promises its holder a fixedamount ofdividendeach year,in perpetuity
 Conveys no voting power to its holder
 not a contractual obligation
 typically cumulative
 nottax deductible,unlike interest on debt.
AERC, Financial Economics I
 Preferredstock dividendpayment is
 USA:However, forinstitutional investors, upto 70% ofpreferreddividend
received(from domestic issuers) may be excludedfrom reportedearnings
 Preferredstock may be redeemableorconvertible
14
DERIVATIVES – OPTIONS
a contract in which one party (option writer) grants another (option holder) the
right, but not obligation, to buy or sell a specified asset at a specific price
(exercise/striking price) on or before a specified time (option expiration)
European options can be exercised only at the expiration date
American options can be exercised at any time up to the expiration date
call (put) options give the holders the right to buy (sell) a specified number of
units of the underlying asset
AERC, Financial Economics I
option holder/buyer pays option premium/price for the right
exercise dates and striking prices are standardized by Options exchanges
no certificates of ownership; rather, transactions handled as book keeping entries
15
DERIVATIVES – FUTURES
commitments entered into currently by contracting parties with respect to a
specific commodity or financial instrument to be traded and at a specified price
(or rate), but which are deferred for execution to a later but fixed date
a futures contract protects each party from future price (or rate) fluctuations
futures contracts are traded in auction markets organized by futures exchanges
the clearinghouse of the futures exchange guarantees the performance
the existence of secondary markets makes it possible for traders to close their
positions prior to the predetermined delivery date by executing reverse trades
AERC, Financial Economics I
futures contracts are standardized with respect to: (1) the amount and type of
asset to be delivered (2) the delivery date (3) place and process of delivery.
the trader taking the long (short) position commits to purchasing (delivering) the
instrument or commodity on the delivery date.
exchanges also often place restrictions on trading: limits, margin requirements
16
SECURITY TRADING
AERC, Financial Economics I
PRINCIPLES OF
17
STOCKBROKERS AND ADVISORS




Types of brokers
 Deep discount brokers
 Provide

AERC, Financial Economics I

To trade in security markets, one needs brokerage
services
Step I: open an account with the broker
Step II: instruct the broker on trade preference
Broker executes the trade and charges a commission
Broker also maintains the account
account maintenance and order execution services
Full-service brokers
 All
above plus: security market research and investment advisory;
sometimes specialize (e.g., retail investors only)
18
STOCKBROKERS AND ADVISORS
Types of Accounts

Margin accounts
 Broker lends investor money (subject to limits) to
trade
 Interest is paid on the debt equal to call money rate
(what the broker pays for the money) plus spread
 Trading on 60% margin means investor puts 60%
equity in the asset and borrows the rest from broker
AERC, Financial Economics I

Cash accounts
 Securities can be purchased only to the extent that
cash is available in the account
19
STOCKBROKERS AND ADVISORS
Initial and Maintenance Margins

Maintenance margin – minimum margin always
required after purchase (percent of total trade)
If
margin falls below maintenance margin, investor
receives margin call

AERC, Financial Economics I

Initial margin – minimum equity (as percentage of total
trade) required by broker to enable investor trade on
margin
Margining allows investors to lever their returns above
what would be available otherwise
20
STOCKBROKERS AND ADVISORS
Hypothecation and Street name registration



Re-hypothecation – broker pledges the same
securities as collateral to his/her lender
Street name registration
Securities on margin account are held in the street
name – broker is their “owner of record”
these circumstances, actual trader (investor)
is called “beneficial owner”
AERC, Financial Economics I
Hypothecation – the act of holding securities purchased
on margin by broker as collateral
Under
21
TYPES OF ACCOUNTS
Long position – investor holds/buys security

Short position – investor sells security

Short sale – selling security that one does not own
How do short sales work?
 Investor borrows securities from broker and sells them

Later: buys them back and returns them to broker (i.e.,
covering short position)

Broker borrows the securities from traders’ margin accounts

Investor
Initial and maintenance margins apply

Pays dividend should dividends be paid on short-sold stock
AERC, Financial Economics I

22