Lecturer: Shaling Li
Acc&Fin Dept, PBS
University of Portsmouth
15 October, 2009
What is Finance?
Real
Investment
Investment
Finance
Corporate
Finance
Financial
Investment
Resources
of money
Usage of
money
Financial
Market and
Financial
Institutions
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Financing
decision
Investment
& Dividend
decisions
Global financial
systems: banks,
equity/debt markets
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Why study Finance?
 Finance is important to economy
 Economy allocates money to its highest valued use (e.g.
stock market)
 Good business get more money (e.g. bank lending &
interests)
 Finance is important to individual
 Manage your money: borrow/debt
 Different needs for money in different life stages: young,
middle age, retired
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How to study finance?
 Finance as a subject in Science
 Science:
 Science refers to a system of acquiring knowledge. This
system uses observation and experimentation to
describe and explain natural phenomena.
 The purpose of science is to produce useful models of
reality.
 Scientific methods
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Theory and Practice
Theoretical
world:
Assumptions
General rules
Results
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Real world:
Full of myteries
Expected
Unexpected
results
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The theoretical world in Finance
 The assumptions of the theoretical world of Finance
1. Rational self-interest
Theoretical world:
2. Frictionless financial markets


3.
4.
No transactions costs.
No public information costs
Financial markets are liquid
Minimal role for government
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Assumptions: IF
General
rules/models:
THEN
Results: SO
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How realistic are the assumptions
of the finance textbook world?
 UK London stock market
 The FTSE 100 companies are the 100 biggest UK
companies by market capitalisation
 Checking the assumptions in the UK markets
 Assumption1: Rational self-interest



Self-interest: only focus on and seek self benefits (egotism –
altruism)
Rational: logic manner
Professional investors: pension fund, insurance company,
investment companies
 Check: yes or no?
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How realistic are the assumptions
of the finance textbook world?
 Checking the assumptions in the UK markets
 Assumption 2: Frictionless financial markets


No transaction cost: commission fee exists, 0.35% of
selling/buying
No public information cost: internet, newspaper, TV
 Check: yes
 Assumption 3: Financial markets are liquid
 The total market capitalisation of all FTSE 100 stocks is well over
£1,000 billion
 The total daily trading volume runs into the millions of shares
traded
 Check: Yes
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How realistic are the assumptions
of the finance textbook world?
 Checking the assumptions in the UK markets
 Assumption 4: Minimal role for government


Government: a ‘night watchman’.
systems of internal controls: professional ethics, the strict
legal and regulatory framework
 Check: yes
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Theory and Practice
What is
that??
Theoretical
world:
Rationality
Frictionless
market
Liquidity
Government role
+
Models, results
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Real world:
UK London exchange
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Arguments on the assumptions
 The rationality assumption is the most important
assumption of our textbook world model
 Three arguments challenging this assumption
Argument 1: the ‘blockheads’ argument:
 Question: Blockheads are many and not rational
 Explanation: On average the blockheads cancel each
other out
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Arguments on the assumptions
Argument 2: the rational arbitrageurs argument:
Question: when blockheads are not even numbered at
short time, mispricing exists
Explanation: rational arbitrageurs will enter the market,
forcing stocks back to their fair value.
Argument 3: winner and loser argument
Question: Are there more blockheads than smart guys
Explanation: blockheads will tend to lose money over
time, and that smart investors will tend to make
money
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Arguments on the assumptions
Conclusions: The existing of blockheads does not
influence the market and the assumption of
rationality.
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How closely does the real world
resemble the world of theory?
Theoretical world:
Rationality
Frictionless market
Liquidity Government
role
+
Models, results
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Real world:
UK London exchange
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How closely does the real world
resemble the world of theory?
 Whatever is thought and found in the theory world
has two types of results if matched/applied to the
practical world:
 Yes, largely
 The model (rules) can be applied to the practice with expected
results most of time
 However, this does not mean everyone gains in the market
 There are always exceptions in the real world
 No, basically
 If it does not work, why? Proper assumptions, models?
 However, this also does not mean there is no random gain.
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How closely does the real world
resemble the world of theory?
 Example: US market & Successful investors
 A mutual fund, the Vanguard S&P500 Tracker


In the early 1970s in America John Bogle decided to apply the
textbook world finance theory that was developed by finance
scholars during the 1960s
looking at the thirty-year record, the investment returns on the
Vanguard S&P500 Tracker fund have beaten those of every
other stock market mutual fund in the United States.
 Mr. Buffett’s personal wealth is around $40 billion and
the funds he manages are far larger
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How closely does the real world
resemble the world of theory?
 Russian market in 1990s
 Investment model & investment results

US/UK model  likely to lose or does not work
 Checking the assumptions




Information was expensive
Reliable information hardly existed
Trading had to stopped during some period (liquidity)
Have a well-developed legal and regulatory framework
on paper, the lack of an enforced legal and regulatory
framework
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The approach to studying finance
We always start off with a problem, or a question.
2. Next we give the theoretically correct solution to the
problem
3. The next step is empirical research
1.
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Summary
 Finance and its key elements
 The theoretical world in Finance + four assumptions
 The realistic degree of the assumptions of the finance
textbook world
 How closely does the real world resemble the world of
theory (yes or no examples)
 Approach to study finance
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Seminar for next week
 Please see the attached.
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