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Introduction to Finance
Road Map
Main Issues
• Financial Challenges.
• Unifying Principles.
Contents
1 What is Finance? . . . . . . . . . . . . . . . . . . . . . . . . 1-3
2 Time and Risk . . . . . . . . . . . . . . . . . . . . . . . . . 1-8
3 Unifying Principles of Finance . . . . . . . . . . . . . . . . . 1-10
3.1 Assumption of A Perfect Financial Market . . . . . . . . . . . . . 1-10
3.2 First Principle: No Arbitrage . . . . . . . . . . . . . . . . . . . . 1-11
3.3 2nd Principle: Preference . . . . . . . . . . . . . . . . . . . . . . 1-13
3.4 3rd Principle: Optimization . . . . . . . . . . . . . . . . . . . . . 1-15
3.5 4th Principle: Market in Equilibrium . . . . . . . . . . . . . . . . 1-18
4 Opportunity Cost of Capital and PV . . . . . . . . . . . . . . 1-19
4.1 Opportnity Cost of Capital . . . . . . . . . . . . . . . . . . . . . 1-19
4.2 Present Value (PV) . . . . . . . . . . . . . . . . . . . . . . . . . 1-20
4.3 Net Present Value and Decision Rule . . . . . . . . . . . . . . . . 1-22
5 Role of Financial Market . . . . . . . . . . . . . . . . . . . . 1-25
5.1 Financial Market at Center of Universe . . . . . . . . . . . . . . . 1-25
5.2 Function of Financial Markets . . . . . . . . . . . . . . . . . . . . 1-27
6 Objectives of Financial Manager . . . . . . . . . . . . . . . . 1-31
7 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1-37
8 Homework . . . . . . . . . . . . . . . . . . . . . . . . . . . 1-38
1 What is Finance?
– Valuation of assets.
– Management of assets.
c Jiang Wang
° Fall 2003 15.407 Lecture Notes
1-4 Introduction to Finance Chapter 1
• Savings decision:
- How to allocate wealth over time?
• Investment decision:
- How to grow wealth?
- How to allocate wealth over states?
• Financing decision:
- How to finance consumption and investment?
• Investment decision:
- What projects to invest in?
• Financing decision:
- How to finance a project?
• Payout decision:
- What to pay back to shareholders?
Assets/Liabilities
Real Economic
Household (4’) – bonds
Activities
– stocks
- -
(3’) (5’) – mortgages . . .
c Jiang Wang
° Fall 2003 15.407 Lecture Notes
1-6 Introduction to Finance Chapter 1
(2) (1)
Investors
Firm’s Financial
(4) – individuals
Operations Manager – institutions
- - – etc.
(3) (5)
• Payout: (5).
c Jiang Wang
° Fall 2003 15.407 Lecture Notes
1-8 Introduction to Finance Chapter 1
Time: 0 1 2 ···
Cash out: CF 0 · · ···
Cash in: · CF 1 CF 2 ···
Net cash flow: −CF 0 CF 1 CF 2 ···
1. Time.
Example. $1,000 today verses $1,000 next year.
$1,000 $1,000
6 6
- -
0 1 time 0 1 time
2. Risk.
Example. $1,000 for sure vs. $0 and $2,000 with equal odds.
$1,000 $2,000
$1,000 0
c Jiang Wang
° Fall 2003 15.407 Lecture Notes
1-10 Introduction to Finance Chapter 1
• Free access.
• No frictions/constraints in trading.
$2 0 $2.5
$1 $1 $2
0 $1 $1
c Jiang Wang
° Fall 2003 15.407 Lecture Notes
1-12 Introduction to Finance Chapter 1
(b) Value of the given asset must equal the market price of the
traded security.
$2 0 $2.5
$1 $1 ?
0 $1 $1
Given any
c º c0 or c ¹ c0.
c º c0 , c º c00 ⇒ c º c00 .
c º c0 ⇔ u(c) ≥ u(c0 ).
c Jiang Wang
° Fall 2003 15.407 Lecture Notes
1-14 Introduction to Finance Chapter 1
Further simplification:
1 0
6 º 6
- -
0 1 time 0 1 time
Thus, u0 ≥ 0.
1 1
6 º 6
- -
0 1 time 0 1 time
Thus, ρ ≤ 1.
1 1+δ
º
1 1−δ
Thus, u00 ≤ 0.
Consider a household:
c Jiang Wang
° Fall 2003 15.407 Lecture Notes
1-16 Introduction to Finance Chapter 1
• For rF = 0, c0 = c1 = 62.5.
1
max E[u(c̃)] = [u(ca) + u(cb )]
2
s.t. cb = 25 + (100 − c0)pa/pb.
c Jiang Wang
° Fall 2003 15.407 Lecture Notes
1-18 Introduction to Finance Chapter 1
Example. CAPM.
Investment Trade-off:
' $
Investment
opportunities
Project ¾ CASH -
available
in financial
& % markets
Invest Invest
c Jiang Wang
° Fall 2003 15.407 Lecture Notes
1-20 Introduction to Finance Chapter 1
- Holder of the asset pays $PV and receives $1,000 in one year.
- Holder of the asset pays $PV now and expects to receive $1,000
in one year.
c Jiang Wang
° Fall 2003 15.407 Lecture Notes
1-22 Introduction to Finance Chapter 1
Decision:
c Jiang Wang
° Fall 2003 15.407 Lecture Notes
1-24 Introduction to Finance Chapter 1
Decision:
Individuals
(own real and financial assets)
& %
' $
Corporations
& %
' $
' $ ' $
Financial Insurance
Banks Market Companies
& % & %
& %
' $
Other Intermediaries
& %
' $
Individuals
(own real and financial assets)
c Jiang Wang
° Fall 2003 15.407 Lecture Notes
1-26 Introduction to Finance Chapter 1
1. Allocating resources
• Allocate resources across time
• Allocate resources across different states of economy.
2. Communicating information
• Market prices reflect available information.
c Jiang Wang
° Fall 2003 15.407 Lecture Notes
1-28 Introduction to Finance Chapter 1
2. With credit market, she lends $37.5 now and receives $37.5
later, achieving consumption (c0, c1) = (62.5, 62.5).
Dollars, date 1
125 @
@
@
@
@
@
@
@
@ (62.5, 62.5) - optimal consumption
62.5 @
@
@
@
@ (100, 25) - endowment
25 @
@
@
@
62.5 100 125 Dollars, date 0
2. With the securities market, she sells 37.5 units of A for 37.5
units of B, achieving consumption (ca, cb) = (62.5, 62.5).
Dollars, state b
125 @
@
@
@
@
@
@
@
@ (62.5, 62.5) - optimal consumption
62.5 @
@
@
@
@ (100, 25) - endowment
25 @
@
@
@
62.5 100 125 Dollars, state a
c Jiang Wang
° Fall 2003 15.407 Lecture Notes
1-30 Introduction to Finance Chapter 1
Conclusions:
c Jiang Wang
° Fall 2003 15.407 Lecture Notes
1-32 Introduction to Finance Chapter 1
You, your dad and your grandma jointly own a controlling interest
in Solid State Inc. (SSI), which is traded on NASDAQ. You are
asked to evaluate two alternatives, A and B, to expand SSI’s
current business. After a week of analysis, you conclude:
• A pays off in three years and B starts to payoff after ten years.
“Kid, you missed one thing: I am 85 now and probably could not
wait to see any payoff if we take B.”
c Jiang Wang
° Fall 2003 15.407 Lecture Notes
1-34 Introduction to Finance Chapter 1
• New plan is very risky: If successful, the plan could lead SSI
into a much higher latitude. But it could also bring SSI to the
ground if fails.
c Jiang Wang
° Fall 2003 15.407 Lecture Notes
1-36 Introduction to Finance Chapter 1
Conclusions:
Practical Issues:
• Agency problems
- Management may put their own interest first
• Other stakeholders
7 Summary
Key Points:
Key Assumptions:
2. No agency problems.
c Jiang Wang
° Fall 2003 15.407 Lecture Notes
1-38 Introduction to Finance Chapter 1
8 Homework
Readings:
• BKM Chapters 1, 2, 3.
• BM Chapters 1, 2.