15.

401

15.401 Finance Theory

MIT Sloan MBA Program

Andrew W. Lo
Harris & Harris Group Professor, MIT Sloan School

Lecture 1: Introduction and Course Overview

© 2007–2008 by Andrew W. Lo
 Critical Concepts 15.401

ƒ Motivation
ƒ Dramatis Personae
ƒ Fundamental Challenges of Finance
ƒ Framework for Financial Analysis
ƒ Importance of Time and Risk
ƒ Six Principles of Finance
ƒ Course Overview
ƒ How to Get the Most Out of This Course

Readings:
ƒ Brealey, Myers, and Allen Chapters 1–2

© 2007–2008 by Andrew W. Lo Slide 2

Lecture 1: Intro and Overview
 Motivation 15.401

Mathematics + $$$ = Finance

Photographs removed due to copyright restrictions.

James Simons Jack Welch Warren Buffett

Renaissance Technologies General Electric Berkshire Hathaway

© 2007–2008 by Andrew W. Lo Slide 3

Lecture 1: Intro and Overview
 Dramatis Personae 15.401

A Flow Model of the Economy

Households

Labor Product Financial

Capital Markets
Markets Markets Intermediaries

Nonfinancial
Corporations

The Financial System

© 2007–2008 by Andrew W. Lo Slide 4

Lecture 1: Intro and Overview
 Fundamental Challenges of Finance 15.401

All Business Activities Reduce To Two Functions:

ƒ Valuation of assets (real/financial, tangible/intangible)
ƒ Management of assets (acquiring/selling)

Business Decisions Involve Valuation and Management

ƒ “You cannot manage what you cannot measure”
ƒ Valuation is the starting point for management
ƒ Once value is established, management is easier

Objectives + Valuations ⇒ Decisions

ƒ Valuation is generally independent of objectives (why?)

ƒ Role of financial markets and the “price discovery” process

© 2007–2008 by Andrew W. Lo Slide 5

Lecture 1: Intro and Overview
 Fundamental Challenges of Finance 15.401

Valuation
ƒ How are financial assets valued?
ƒ How should financial assets be valued?
ƒ How do financial markets determine asset values?
ƒ How well do financial markets work?

Management
ƒ How much should I save/spend?
ƒ What should I buy/sell?
ƒ When should I buy/sell?
ƒ How should I finance the transaction?

Applies To Both Personal and Corporate Financial Decisions (How?)

© 2007–2008 by Andrew W. Lo Slide 6

Lecture 1: Intro and Overview
 The Framework of Financial Analysis 15.401

Accounting
ƒ The language of finance
ƒ Vocabulary, syntax, grammar, prose, and poetry!
ƒ Language frames and circumscribes the analysis
ƒ Basic concepts should be familiar to you by now
ƒ “Stock” (not equities) vs. “flow” variables

Balance Sheet and Income Statement Perspectives

ƒ Balance sheet: snapshot of financial status quo (stock)
ƒ Income statement: rate of change of the status quo (flow)
ƒ Financial status ⇔ balance sheet
ƒ Financial decisions ⇔ income statement
ƒ What about the “rate of change of the rate of change”?

© 2007–2008 by Andrew W. Lo Slide 7

Lecture 1: Intro and Overview
 The Framework of Financial Analysis 15.401

Balance Sheet

Assets Liabilities

Cash
Equity
Capital
Debt
Intangibles

Value Value

Income Statement

© 2007–2008 by Andrew W. Lo Slide 8

Lecture 1: Intro and Overview
 The Framework of Financial Analysis 15.401

Corporate Financial Decisions

1. Cash raised from investors (selling financial assets)
2. Cash invested in real assets (tangible and intangible)
3. Cash generated by operations
4. Cash reinvested
5. Cash returned to investors (debt payments, dividends, etc.)

2 1
Individual
Corporate Financial 4 and
Operations Manager Institutional
Investors
3 5

© 2007–2008 by Andrew W. Lo Slide 9

Lecture 1: Intro and Overview
 The Framework of Financial Analysis 15.401

Corporate Financial Decisions

1. Cash raised from investors (selling financial assets)
2. Cash invested in real assets (tangible and intangible)
3. Cash generated by operations
4. Cash reinvested
5. Cash returned to investors (debt payments, dividends, etc.)

Management
ƒ Real Investment: 2, 3
ƒ Financing: 1, 4
ƒ Payout: 5
ƒ Risk management: 1, 5
ƒ Objective: create and maximize shareholder value

© 2007–2008 by Andrew W. Lo Slide 10

Lecture 1: Intro and Overview
 The Framework of Financial Analysis 15.401

Personal Financial Decisions

1. Cash raised from financial institutions (selling financial assets)
2. Cash invested in real assets (tangible and intangible)
3. Cash generated by labor supply
4. Cash consumed and reinvested in real assets
5. Cash invested in financial assets

2 1 Financial
Assets and
Real Liabilities
Household 4
Economic (stocks,
Activities bonds,
3 5
mortgage,
etc.)

© 2007–2008 by Andrew W. Lo Slide 11

Lecture 1: Intro and Overview
 The Framework of Financial Analysis 15.401

Personal Financial Decisions

1. Cash raised from financial institutions (selling financial assets)
2. Cash invested in real assets (tangible and intangible)
3. Cash generated by labor supply
4. Cash consumed and reinvested in real assets
5. Cash invested in financial assets

Management
ƒ Real investment: 2, 3
ƒ Consumption/financing: 1, 4
ƒ Saving/investment: 5
ƒ Risk management: 1, 5
ƒ Objective: maximize lifetime “happiness” or expected utility

© 2007–2008 by Andrew W. Lo Slide 12

Lecture 1: Intro and Overview
 Time and Risk 15.401

Two Other Factors That Make Finance Challenging

1. Time
ƒ Cashflows now are different from cashflows later
ƒ Time flows in only one direction (as far as we know)
ƒ How should we model temporal differences?
2. Risk
ƒ Under perfect certainty, finance theory is complete
ƒ Risk creates significant challenges
ƒ How should we model the unknown?

To Address These Two Issues:

ƒ Use historical data
ƒ Use mathematics (probability and statistics)
ƒ Challenges can easily overwhelm current mathematical abilities

© 2007–2008 by Andrew W. Lo Slide 13

Lecture 1: Intro and Overview
 Six Fundamental Principles of Finance 15.401

P1: There Is No Such Thing As A Free Lunch

P2: Other Things Equal, Individuals :

ƒ Prefer more money to less (non-satiation)
ƒ Prefer money now to later (impatience)
ƒ Prefer to avoid risk (risk aversion)

P3: All Agents Act To Further Their Own Self-Interest

P4: Financial Market Prices Shift to Equalize Supply and Demand

P5: Financial Markets Are Highly Adaptive and Competitive

P6: Risk-Sharing and Frictions Are Central to Financial Innovation

© 2007–2008 by Andrew W. Lo Slide 14

Lecture 1: Intro and Overview
 Course Overview 15.401

Four Sections
A. Introduction
ƒ Fundamental challenges of finance
ƒ A framework for financial analysis
ƒ Six principles of finance
ƒ Cashflows and the time-value of money
B. Valuation
ƒ Discounting and the mathematics of net present value
ƒ Pricing stocks, bonds, futures, forwards, and options
C. Risk
ƒ Measuring risk
ƒ Managing risk (portfolio theory)
ƒ Incorporating risk into valuation methods

© 2007–2008 by Andrew W. Lo Slide 15

Lecture 1: Intro and Overview
 Course Overview 15.401

Four Sections
D. Corporate Finance
ƒ Capital budgeting and project finance

Final Lecture: Market Efficiency (putting it all together)

ƒ Do financial markets always work well in discovering prices?
ƒ What about behavioral biases and human psychology?
ƒ How should finance theory be used in practice?

© 2007–2008 by Andrew W. Lo Slide 16

Lecture 1: Intro and Overview
 Course Overview 15.401

Course Requirements
ƒ Lectures and Readings (attendance and participation, 10%)
ƒ Acid Rain Case Study (10%)
ƒ Mid-Term (25%) and Final (55%) Examinations

Implicit Contract
ƒ Faculty should
– Come to class on time and be well prepared
– Provide clear and time-appropriate exposition of material
– Manage class discussions effectively
ƒ Students should
– Come to class on time and be well prepared
– Contribute to class discussions
– Refrain from non-class activities (email, newspapers, etc.)

© 2007–2008 by Andrew W. Lo Slide 17

Lecture 1: Intro and Overview
 How to Get the Most Out of This Course 15.401

Theory vs. Practice

ƒ Most of this course will be devoted to theory
ƒ What about practice?
ƒ The origins of theory is common elements deduced from practice!

Some Helpful Hints

ƒ Do readings ahead of time (skim textbook chapters in advance)
ƒ Take copious notes during lectures (lecture notes are not complete)
ƒ Review the lectures afterwards with your study group
ƒ Work on assignments in groups and alone
ƒ “Finance is not a spectator sport”
ƒ Ask Ask Ask Questions!

Finance Is One of The Most Difficult Subjects You Will Ever Love!

© 2007–2008 by Andrew W. Lo Slide 18

Lecture 1: Intro and Overview
 Critical Concepts 15.401

ƒ Motivation
ƒ Dramatis Personae
ƒ Fundamental Challenges of Finance
ƒ Framework for Financial Analysis
ƒ Importance of Time and Risk
ƒ Six Principles of Finance
ƒ Course Overview
ƒ How to Get the Most Out of This Course

© 2007–2008 by Andrew W. Lo Slide 19

Lecture 1: Intro and Overview
 Additional References 15.401

ƒ Bernstein, P., 1993, Capital Ideas. New York: Free Press.

ƒ Lo, A., 1999, “The Three P’s of Total Risk Management”, Financial Analysts Journal 55, 13–26.
ƒ Malkiel, B., 1996, A Random Walk Down Wall Street. New York: W. W. Norton and Company.

© 2007–2008 by Andrew W. Lo Slide 20

Lecture 1: Intro and Overview
MIT OpenCourseWare
http://ocw.mit.edu

15.401 Finance Theory I

Fall 2008

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