„ Market Finance – Financial Theory“
Course at ESC Dijon
Chapter 1: Investments: Background and Issues
Chapter 2: Asset Classes and Financial Instruments
Chapter 3: Securities Markets
Chapter 4: The Market for Foreign Exchange
Chapter 5:The Efficient Market Hypothesis
Bibliography: Bodie, Z. / Kane, A. / Marcus, A. J. (2013): Essentials of Investments. 9th ed., New York.
Prof. Dr. Franke-Viebach
1
Chapter 1: Investments: Background and Issues
1.1 Real Assets versus Financial Assets
1.2 Financial Assets
1.3 Financial Markets and the Economy
1.4 The Investment Process
1.5 Markets Are Competitive
1.6 The Players
Bibliography: Bodie, Z. / Kane, A. / Marcus, A. J. (2013): Essentials of Investments. 9th ed., New York, chapter 1.
Prof. Dr. Franke-Viebach
2
Investment = current commitment of resources in the expectation of reaping future benefits
1.1 Real Assets versus Financial Assets
(1) Real Assets
= assets used to produce goods and services
→ they generate income and thus wealth (remember: wealth = PV of income)
examples: property, plants and equipment, human capital, etc.
(2) Financial assets
= claims on real assets or claims on real-asset income
→ they distribute income or wealth
examples: Toyota share, French government bond
Prof. Dr. Franke-Viebach
3
Exercise: Are the following assets real or financial?
a. Patents
b. Lease obligations
c. Customer goodwill
d. College education
e. U.S. treasury bill
Exercise: For each transaction, identify the real and/or financial assets that trade hands. Are
any financial assets created or destroyed in the transaction?
a. Toyota takes out a bank loan to finance the construction of a new factory.
b. Toyota pays off its loan.
c. Toyota uses $ 10 million of cash on hand to purchase additional inventory of spare auto parts.
Prof. Dr. Franke-Viebach
4
Exercise: Lanni Products is a start-up computer software development firm. It currently owns
computer equipment worth $30,000 and has cash on hand of $ 20,000 contributed by
Lanni‘s owners. For each of the following transactions, identify the real and/or financial
assets that trade hands. Are any financial assets created or destroyed in the
transactions?
a. Lanni takes out a bank loan. It receives $ 50,000 in cash and signs a note promising to pay
back the loan over three years.
b. Lanni uses the cash from the bank plus $ 20,000 of its own funds to finance the development
of new financial planning software.
c. Lanni sells the software product to Microsoft, which will market it to the public under the
Microsoft name. Lanni accepts payment in the form of 5,000 shares of Microsoft stock.
d. Lanni sells the shares of stock for $ 25 per share and uses part of the proceeds to pay off the
bank loan.
Prof. Dr. Franke-Viebach
5
(3) Saving – investment, financial and real
- saving = that part of disposable income which is not used for present consumption but laid back
(„saved“) for future consumption
- shift consumption to the future by a shift of purchasing power
- do so by a financial investment: buy a financial asset!
example: buy a Toyota share
- Toyota will then use the saver‘s purchasing power to make an investment in real assets
Remember: investment = current commitment of resources in the expectation of reaping future
benefits → hope to get back purchasing power in the future …!
Prof. Dr. Franke-Viebach
6
(4) Individual/sectoral wealth versus aggregate/ national wealth
(a) Household sector
- assets: real assets, financial assets
- liabilities
(b) National wealth (neglecting international relations)
- consists of real assets only
- reason: all financial assets (owner of the claim) are offset by a financial liability
(issuer of the claim)
→ when all balance sheets are aggregated, only real assets remain
(c ) Example: USA 2011
Prof. Dr. Franke-Viebach
7
Table 1.1
Balance
Sheet,
U.S.
Households,
2011
Assets
$ Billion % Total
Liabilities and Net Worth
$ Billion
% Total
Real assets
Real estate
Consumer durables
18,117
4,665
25.2%
6.5%
Mortgages
Consumer credit
10,215
2,404
14.2%
3.3%
Other
Total real assets
303
23,085
0.4%
32.1%
Bank and other loans
Security credit
Other
Total liabilities
384
316
556
13,875
0.5%
0.4%
0.8%
19.3%
8,038
1,298
13,419
8,792
6,585
5,050
4,129
1,536
48,847
71,932
11.2%
1.8%
18.7%
12.2%
9.2%
7.0%
5.7%
2.1%
67.9%
100.0%
Net worth
58,058
71,932
80.7%
100.0%
Financial assets
Deposits
Life insurance reserves
Pension reserves
Corporate equity
Equity in noncorp. business
Mutual fund shares
Debt securities
Other
Total financial assets
TOTAL
Note: Column sums may differ from total because of rounding error.
SOURCE: Flow of Funds Accounts of the United States, Board of Governors of the Federal Reserve System, June 2011.
Table 1.2
Domestic Net Worth, 2011
Assets
$ Billion
Commercial real estate
14,248
Residential real estate
18,117
Equipment and software
4,413
Inventories
1,974
Consumer durables
4,665
TOTAL
43,417
Note: Column sums may differ from total because of rounding error.
SOURCE: Flow of Funds Accounts of the United States, Board of Governors
of the Federal Reserve System, June 2011.
Exercise: In a wave of pessimism, housing prices fall by 10% across the entire economy.
a. Has the stock of real assets of the economy changed?
b. Are individuals less wealthy?
c. Can you reconcile your answers to a. and b.?
Prof. Dr. Franke-Viebach
10
1.2 Financial Assets
(1) Debt securities
(a) General feature:
pay a stream of income that is determined according to a specified formula
(b) Classification by maturity
- money-market debt securities: short-term
examples:
- capital-market debt securities: long-term
examples:
- in any case: a limited lifetime → the holder is entitled to get his money (the „face value“
of the debt security) back at maturity: this is part of his
claim because the holder is a creditor!
Prof. Dr. Franke-Viebach
11
(2) Equity (common stock)
- represents an ownership share in a company
→ the holder is an owner, not a creditor! This has several implications:
(i) he can not claim his money back from the issuer
(ii) in the case of bankruptcy of the company, creditors are served first
- equity entitles to dividend payments if (a) the company can pay and (b) wants to pay
→ riskier than debt securities
- equity confers a voting right (choice of board of directors, strategy of the company, …)
Prof. Dr. Franke-Viebach
12
(3) Derivatives
- payments from a derivative security (so-called payoffs) are determined by the
prices of other assets (so-called underlying assets)
- example: price and thereby the payoff of an option on Toyota stock depend on the
price of the Toyota share
(4) Foreign currency
(5) Addendum: real assets
- commodities
- real estate
Prof. Dr. Franke-Viebach
13
1.3 Financial Markets and the Economy
Financial assets help us to make the most of a country‘s real assets
(1) The Informational Role of Prices
Example: stock prices reflect investors’ collective assessment of a firm’s current performance
and future prospects
good performance/prospects
↓
high share price
Prof. Dr. Franke-Viebach
14
(2) Consumption timing
- remember: saving = shift of consumption to the future by a shift of purchasing power
how: by temporarily investing part of income into financial assets (or directly into real assets)
- likewise: we can dissave, i. e. „pull“ future consumption to the present
how: by selling an asset
(i) this can be an existing („old“) asset
(ii) it can also be a new one, i. e. we take a credit
- all in all, we will typically watch a life-cycle of dissaving and saving
Prof. Dr. Franke-Viebach
15
(3) Allocation of risks
- prices of financial assets can not be foreseen with certainty
example: share price depends on an assessment of future dividends; these may be
higher or lower
- different assets have different risks
example: as bond income is contractually fixed, bonds have a lower risk than stocks
- rule: higher risk is associated with higher return (see below: risk-return trade-off)
- investors will chose assets (i. e. a combination of risk and return) according to their
so-called risk attitude
Prof. Dr. Franke-Viebach
16
(4) Separation of ownership and management
- owner-operated company: limited in size because of lack of capital
- solution: create large companies by selling shares, i. e. by assembling many owners and their
capital
- problem: not all owners can participate in management → elect a board of directors → the
directors than hire the managers → result: owners ≠ managers
- benefit: stability of business despite instability of ownership
- problem: can the many shareholders agree on on the company‘s objectives?
usually yes because they all have one goal in common: their wealth → they all want a high
share price
Prof. Dr. Franke-Viebach
17
- „principal-agent“ problem: managers may be attempted not to pursue shareholder value …!
- solutions:
(i) incentive-compatible remuneration contracts
(ii) board of directos can fire bad management
(iii) outside observers monitor the management and make their successes/failures public
(v) threat of takeover by another company that fires the management
Exercise: Discuss the advantages of the following forms of management compensation in terms of
mitigating agency problems, that is, potential conflicts of interest between managers and
shareholders.
a. Fixed salary
b. Stock in the firm that must be held for five years
c. Salary linked to the firm‘s profits
Prof. Dr. Franke-Viebach
18
(5) Corporate governance and corporate ethic
(a) Problems in companies
- misleading/wrong financial status or income status
- example: many during 2000 – 2002 “dot-com bubble”
(b) Overly optimistic research reports by stock market analysts
background:
- many analysts belonged to investment banks
- they were paid according to the business their reports generated for
their investment banks
Prof. Dr. Franke-Viebach
19
(c) Auditors
- often, they were also business consultants → lenient in their auditing work in order
to get a consultancy mandate
- example: Arthur Anderson’s role in the Enron bankruptcy 2003
(d) Reaction of USA: Sarbanes-Oxley Act (2002) → tightens rules of corporate governance
• Requires more independent directors on company boards
• Requires CFO to personally verify the financial statements
• Created new oversight board for the accounting/audit industry
• Charged board with maintaining a culture of high ethical standards
• Auditors no longer allowed to provide other services to same company
(e) Conclusion: financial markets deal with the future
↓
they require trust to function
↓
reputation and straightforward incentive structures are essential
Prof. Dr. Franke-Viebach
20
1.4 The Investment Process
(1) Portfolio (French: portefeuille) = collection of assets
- created by investment, i. e. by purchase of assets
- changed by sales and puchases of assets → structure or size change
(2) Portfolio selection: “top-down” approach
(a) Step 1: asset allocation = decision on percentage shares of broad asset categories
(b) Step 2: security selection = choice of particular securities within each asset class
(3) Portfolio selection: “bottom-up” approach
- invest in the most attractive single securities!
- benefit: pulls your attention to promising investments
- danger: you may end up with a very high proportion of single sectors or even singe securities
Prof. Dr. Franke-Viebach
21
1.5 Markets are Competitive
(1) Origin of competitiveness
- competition among investors for the best assets
o individual investors, institutional investors
o instrument of competition: purchase price
- competition among suppliers of financial assets
o companies, governments, banks
o instrument of competition: sales price
Prof. Dr. Franke-Viebach
22
(2) The risk-return trade-off
- background: returns are not known with certainty
- example: assets A and B
o A has an expected return of 5 % and a risk of 3 %
o B has an expected return of 9 % and a risk of 8 %
o why does B have a higher return than A?
- empirical evidence USA 1926 - 2011
o Stock portfolio loses money 1 of 4 years on average
o Bonds: have lower average rates of return (under 6%);
have not lost more than 13% of their value in any one year
Prof. Dr. Franke-Viebach
23
(3) Diversification
- returns of various assets are not perfectly positively correlated:
o perfect positive correlation means: if the return of A goes up (down), that of B always goes
up (down), too
o positive, but not perfect positive correlation means: if the return of A goes up (down), that
of B usually also goes up (down), but not always and not always to the same extend
o negative, but not perfect negative correlation means: if the return of A goes up (down),
that of B usually also goes down (up), but not always and not always to the same extend
- if returns are not perfectly positively correlated, the investor can reduce the total risk of his
portfolio by diversification, i. e. by investing his funds in various assets
Exercise: The average rate of return on investments in large stocks has outpaced that on
investments in Treasury bills by about 7% points since 1926. Why, then, does anyone
invest in Treasury bills?
Prof. Dr. Franke-Viebach
24
(4) Efficient markets
(a) Hypothesis: prices/returns of financial assets quickly and correctly reflect available information
(b) Reason:
- there is an incentive to collect information about the relevant aspects of an asset
- analysts who collect and compute information faster and better than others, can be the first to
discover that an asset is traded at a false price
→ they can make a bargain, e. g., buy an asset that is too cheap, at today’s low price
- their actions will then drive the price up to the appropriate level
→ the price/return will finally reflect the new information correctly
(c) Reality: markets are
- … only nearly efficient
- … sometimes not efficient at all
(d) Implication: active portfolio management may pay
(passive PF management: holding a highly diversified portfolio without spending time/money to permanent security analysis)
Prof. Dr. Franke-Viebach
25
1.6 Market Participants
1.6.1 Original givers and takers of money
(1) “Original”
 financial business is not their business
 financial business: giving and taking money; other financial services
(2) Original givers of money
 they are “surplus units” in the period under consideration, i. e. they have a “financial
surplus”: income > expenditure
 they “give” this surplus of funds to the market, i. e. they are lenders in this period
→ they look for an investment
 typical givers: private households
Prof. Dr. Franke-Viebach
26
(3) Original takers of money
 they are “deficit units” in the period under consideration, i. e. they have a “financial
deficit”: income > expenditure
 they “take” these missing funds from the market, i. e. they are borrowers in this period
→ they look for finance
 typical takers: companies, governments
(4) Direct finance: market-based system
 when original lenders and original borrowers make contracts directly with each other,
we call this “direct” finance
 a system where such direct relations prevail, is called a “market-based” system
Prof. Dr. Franke-Viebach
27
1.6.2 Financial Intermediaries (FIs)
(1) Background: FI provide convenience for original lenders and borrowers
(2) General feature of FIs
 their primary business consists in taking (borrowing) and giving (lending, investing)
money → they offer services to both original lenders and original borrowers:
o to lenders, they offer an investment opportunity
o to borrowers, they offer a financing opportunity
 implication: compared to non-financial companies, their assets are overwhelmingly
financial
→ compare the next two slides
Prof. Dr. Franke-Viebach
28
Balance Sheet of Commercial Banks, 2011
Assets
$ Billion
% Total
Real assets
Equipment and premises
Other real estate
Total real assets
Liabilities and Net Worth
$ Billion % Total
Liabilities
110.4
46.6
157.0
0.9%
0.4%
1.3%
Deposits
Debt and other borrowed funds
Federal funds and repurchase agreements
Other
Total liabilities
8,674.6
1,291.8
499.1
308.4
71.4%
10.6%
4.1%
2.5%
10,773.9
88.6%
1,383.4
11.4%
12,157.3
100.0%
Financial assets
Cash
Investment securities
Loans and leases
Other financial assets
Total financial assets
1,066.3
2,406.1
6,279.1
1,153.9
10,905.4
8.8%
19.8%
51.6%
9.5%
89.7%
373.9
721.0
1,094.9
3.1%
5.9%
9.0%
12,157.3
100.0%
Other assets
Intangible assets
Other
Total other assets
TOTAL
Note: Column sums may differ from total because of rounding error.
SOURCE: Federal Deposit Insurance Corporation, www.fdic.gov, July 2011.
Net worth
Balance Sheet of Nonfinancial U.S. Business, 2011
Assets
$ Billion
% Total
Real assets
Equipment and software
Real estate
Inventories
Total real assets
4,109
7,676
1,876
13,661
14.6%
27.2%
6.7%
48.5%
Financial assets
Deposits and cash
Marketable securities
Trade and consumer credit
Other
Total financial assets
TOTAL
1,009
899
2,388
10,239
14,535
28,196
3.6%
3.2%
8.5%
36.3%
51.5%
100.0%
Liabilities and Net Worth
Liabilities
Bonds and mortgages
Bank loans
Other loans
Trade debt
Other
Total liabilities
Net worth
Note: Column sums may differ from total because of rounding error.
SOURCE: Flow of Funds Accounts of the United States, Board of Governors of the Federal Reserve System, June 2011.
$ Billion % Total
5,321
538
1,227
1,863
4,559
13,509
18.9%
1.9%
4.4%
6.6%
16.2%
47.9%
14,687
28,196
52.1%
100.0%
Exercise: Examine the balance sheets of the banks and of the non-financial firms shown in the
preceding tables.
a. What is the ratio of real assets to total assets for banks?
b. What is that ratio for non-financial firms?
c. Why should this difference be expected?
Prof. Dr. Franke-Viebach
31
(3) Systemic perspective
 FIs’ “primary social function is to channel household savings to the business sector”
 we may call this channeling of funds from surplus units to deficit units “indirect finance”
 a financial system that is dominated by indirect finance is called a “bank-based
system”
 in practice, …
o … financial systems are a mixture of direct/market-based finance and of
indirect/bank-based finance
o … FIs are not only at the basis of indirect finance, but they are also active in
financial markets, i. e. they act as buyers and sellers of financial assets side by side
with original lenders and borrowers
- this is illustrated in the next slide which is taken from a publication of the European
Central Bank http://www.ecb.europa.eu/pub/pdf/other/monetarypolicy2011en.pdf?806851948acaa66136356457a4641a6c
Prof. Dr. Franke-Viebach
32
Prof. Dr. Franke-Viebach
33
(4) Types of FI
 commercial banks
 investment companies
 insurance companies
Exercise: Give an example of three financial intermediaries, and explain how they act as a
bridge between small investors and large capital markets or corporations.
Prof. Dr. Franke-Viebach
34
(5) Benefits from financial intermediation
(a) Pooling of resources
by collecting the funds of many small investors, FIs can lend big amounts of money to
borrowers who are in need of such big amounts
(b) Reduction of risk
- FI specialize in financial analysis → they can assess and manage risk better than
individual investors
- diversification of risk: by lending to many borrowers, they can reduce the overall risk of
their total funds → this benefits lenders as well as borrowers:
o lenders
o borrowers
(c) Cost reductions: by collecting and distributing large funds/dealing with many savers
and borrowers, FI benefit from economies of scale
Prof. Dr. Franke-Viebach
35
1.6.3 Investment Bankers
(1) General features
- they are no banks in the traditional sense
- they support corporations in the sale of newly issued securities, i. e. in primary market
activities
(2) Details
 they advise corporations and other issuers of securities…
o … on the price and on the interest rate of the security
o … on the timing of the issuance
o … on attractive investors for the securities etc.
- they usually “underwrite” the issue:
Prof. Dr. Franke-Viebach
36
- they usually “underwrite” the issue:
o they buy the securities from the issuer
o then, they re-sell them to investors
(3) Secondary market
Exercise: Firms raise capital by issuing shares in the primary markets. Does this imply that
that they can ignore trading of previously issued shares in the secondary market?
Prof. Dr. Franke-Viebach
37
1.6.4 Venture Capital (VC) and Private Equity
- Young companies can not raise funds directly from the markets;
reasons: (i) their financial needs are too small
(ii) nobody knows them
- VC funds give VC: this is also called “private equity” because they take an ownership
stake in the firm → they …
o … take a seat in the board of directors
o … help to recruit managers
o … provide business advice
- VC funds also help to raise VC from other investors: business angels, pension funds
- Private-equity investors usually earn money by selling their stakes in the start-up
company after a couple of years
Prof. Dr. Franke-Viebach
38