introduction to finance · paolo vitale luiss university [email protected] paolo vitale introduction...

Motivations and ObjectivesFinancial Assets

Financial MarketsIntermediaries and Financial Institutions

Introduction to FinanceFinancial Markets and Intermediaries

Paolo Vitale

LUISS University

[email protected]

Paolo Vitale Introduction to Finance



Outline

Motivation and Objectives

Financial Assets

? The Role of Financial Assets

Financial Markets

? The Role of Financial Markets

? Separation of Ownership and Management

? Financial Markets Classification

Intermediaries and Financial Institutions

? Financial Agents

? The Role of Financial Intermediaries

? Investment Companies




Motivations and Objectives

In the next lectures we examine the following issues:

The role and general characteristics of financial assets;

The role and institutional aspects of financial markets;

The role and activity of financial agents.




The Role of Financial Assets

Financial Versus Real Assets

Differently from real assets, financial assets, such as bondsand stocks, do not have an intrinsic value.

Financial assets are intangible assets which provide holderswith a claim on real assets and the income such real assetsgenerate.

Financial assets are contracts between issuers (corporations,financial institutions, governmental agencies) and investors(households, mutual and pension funds), which transfer therights on part of the income generated by real assets from theformer to the latter.





Bonds and Stocks

Fixed-income securities promise a given stream of income de-termined according to a specific formula.

Common stock or equity represents an ownership share of agiven corporation. The holders are not promised a particularpayment, but receive payments in form of dividends payout ofthe corporation’s earnings.

Derivative securities, such as futures, options and swaps, pro-vide the holders with payments which depend on the prices ofother assets.

Preferred stock, convertibles and warrants combine charac-teristics of bonds and equity.






Financial assets transfer resources from savers (households) toborrowers (firms and governments).

Financial assets transfer resources overtime and across statesof the world.

? Financial assets allow to store purchasing power and hencesmooth agents’ consumption overtime.

? Financial assets allow agents to allocate risk.

Financial assets change the nature of liabilities/investment.

These functions are facilitated by financial markets and inter-mediaries (commercial and investment banks, pension andmutual funds).





Transfer Resources Over Time

Consider an individual who lives for two dates: now (t = 0) andlater (t = 1).

She is endowed with $100 now (t = 0) and $25 later (t = 1).

Her utility depends on a combination of her consumption now,C0, and later, C1, e.g.:

U(C0,C1) ≡ ln(C0) + ln(C1).

? She prefers a smoother consumption path over time.

In the presence of financial markets, she can borrow and lendat the interest rate r .

⇒ If (for simplicity) r = 0, the optimum is reached when she con-sumes equal amounts now and later.





Consumption Over Time Without Financial Markets

6

-125

125

100

25

50

50

U

She consumes her endowment

C0

C1

ª

Figure 1: Consumption allocation without financial markets

1

Here a representation of the agent’s preferences and endow-ment over time.





Consumption Over Time With Financial Markets

6

-125

125

100

25

She reaches the optimal allocation

U

C0

C1

62.5

62.5

U+

C0 + C1 = 125

ª

Figure 2: Consumption allocation with financial markets

1

Here a representation of the agent’s preferences and budgetconstraint with financial markets when r = 0.





Transfer Resources Across Time

At the optimum she is indifferent between $1 later and $1now.

This is coherent with what the market says:

? The interest rate is r = 0.

Claim

At the margin, agents agree on the time value of money, which isthe market interest rate: Their marginal rate of substitutions areequal to the relative price of current and future consumption,

MRS ≡ UC0/UC1 = (1 + r).





Transfer Resources Across Different States

Consider an individual who lives one period.

The economy can be in state a or b with equal odds.

She is endowed with $100 in state a and $25 in state b.

Her (expected) utility depends on the combination of herconsumption in the two states of the world, Ca and Cb, e.g.:

U(Ca,Cb) ≡ 12 ln(Ca) + 1

2 ln(Cb).

She would like to smooth consumption over states:

? When insurance is free, she can trade $1 of consumption instate a with $1 of consumption in state b.

? Then, she will consume an equal amount in both states.





Consumption Across States Without Financial Markets

6

-125

125

100

25

50

50

U

She consumes her endowment

Ca

Cb

ª

Figure 3: Consumption allocation without financial markets

1

Here a representation of the agent’s preferences and endow-ment across states.





Consumption Across States With Financial Markets

6

-125

125

100

25

She reaches the optimal allocation

U

Ca

Cb

62.5

62.5

U+

Ca + Cb = 125

ª

Figure 4: Consumption allocation with financial markets

1

Here a representation of the agent’s preferences and budgetconstraint with financial markets when pa = pb.





Transfer Resources Across Different States

At the optimum, she is indifferent between $1 in state a and$1 in state b.

This is coherent with what the market says:

? Same price for state-a (pa) and state-b (pb) contingent-claims.

Claim

At the margin, agents agree on the relative value of money in dif-ferent states, ie. the market price of different state contingentclaims.




The Role of Financial MarketsSeparation of Ownership and ManagementFinancial Markets Classification

Functions of Financial Markets

Financial markets allow agents to allocate resources

? over time

? and across different states of the economy.

Financial markets play a price discovery role, in that equili-brium prices for assets are found via the trading process.

Financial markets provide liquidity, as they allow agents totrade assets quickly and with limited execution risk.

Financial markets reduce transaction costs, for agents can buyand sell assets with a small impact on transaction prices.





Perfect Financial Markets

These functions are best served, when

Financial markets are “perfect”, as:

? A rich set of securities is traded (markets are complete).

? Traders are price-taker (markets are competitive).

? There are no transaction costs, short-sell constraints, capitalcontrols (markets are frictionless).

Access to financial markets is free.





Separation of Ownership and Management

For most firms ownership and management are distinct.

Management does not have to know the specifics of thestockholders preferences towards timing and riskiness.

Anyhow, well functioning financial markets allow any investorto choose investments with any desired

? time pattern (preferences over time),

? riskiness of cash flows (preferences over risk).

Claim (Fisher’s Separation Principle)

Management must concentrate on maximizing the firm’s value.





Investment Decisions with Financial Markets

Consider an individual with wealth W0 in period 0.

She can invest her wealth in a financial asset which pays in-terest rate r to transfer purchasing power to period 1.

Her preferences over current, C0, and future consumption, C1,are represented by utility function U(C0,C1).

Her budget set is

C1 = (1 + r) (W0 − C0).

The optimum investment is reached when the marginal rate ofsubstitution between current and future consumption is equal tothe corresponding relative price,

MRS ≡ UC0/UC1 = (1 + r).





Investment Decisions with Financial Markets (cont.ed)

.................

...........................................E

U

U

W1

C0

C1

C∗1

C∗0

−(1 + r) C1 = W1 − (1 + r)C0

W0

Figure 5: Financial Markets and Utility Maximization

1

The optimality condition is identified by point E, where

MRS = (1 + r).





Investment Decisions with Production Opportunities

In a Robinson economy there are no financial markets butproduction opportunities.

A production opportunity set (the PP on next page’s Figure)is obtained by choosing

? first the production projects with the highest rates of return

? and then adding those with smaller rates of return.

The optimum investment is reached when the marginal rate ofsubstitution is equal to the marginal rate of transformation,

MRS ≡ UC0/UC1 = MRT .





Investment Decisions with Production Opportunities

.............................

E

U

U

MRS=MRT

A

C1

W0 C0

P

P

Figure 6: Production Opportunities and Utility Maximization

1


MRS = MRT .





Fisher’s Separation Principle

When financial markets and production opportunities coexist theagent invests in all production projects which yield rates of returnexceeding the interest rate, r . From the Figure on next page wesee that:

Investing JW0 in production projects, she obtains OG in pe-riod 1, with net present value (NPV) W0K0.

If she wants to invest more, she will find it more convenient tobuy financial assets, since further projects have negative NPV.

If she desires to consume more than 0J in period 0 she willundertake all projects with positive NPV and then borrow atthe interest rate r .





Fisher’s Separation Principle (cont.ed)

....................................................................

U

U

P

J0 ︸︷︷︸NPVW0

W1

K1

K0C0

G

C1

E

Figure 7: Production Opportunities and Financial Markets

1


MRS = (1 + r),

on the new budget constraint K0K1.





Fisher’s Separation Principle (cont.ed)

Her budget set shifts from W0W1 to K0K1. Analytically,

C1 = (1 + r) (W0 − C0) + W1K1.

The optimum investment is reached when the marginal rate ofsubstitution is equal to the relative price of present and futureconsumption:

MRS = (1 + r).

Conclusion: Corporate managers must maximize company valueswhatever the preferences of their shareholders, whichcan maximize their utilities by borrowing and lending.





Financial Markets Classification

Financial markets are classified with respect to:

the timing of delivery into spot markets and forward markets;

the type of securities traded into bonds, equities and deriva-tives markets;

the type of issue into primary and secondary markets;

the type of structure into over-the-counter, dealer and auctionmarkets.




Financial AgentsThe Role of Financial IntermediariesInvestment Companies

Financial Agents

Firms are net borrowers, which raise capital to invest in pro-duction opportunities. Their real assets yield income whichprovides returns to owners of the firms’ securities.

Governments are usually net borrowers, which raise funds viagovernment securities issues to cover their budgets deficits.

Households are net savers, which purchase the securitiesissued by firms, governments and other financial institutions.

Financial institutions, such as commercial and investmentbanks, mutual and pension funds, stand in between issuers ofsecurities and their ultimate owners.





The Services of Financial Institutions

Financial intermediation: as they transform existing securitiesin others with different characteristics.

Securities trading: as they purchase and sell financial assets

? on their own account (proprietary trading)

? or on behalf of their clients (brokerage service).

Securities underwriting: as they advise corporations on theterms of a securities issue and help selling it to investors.

Private banking: as they advise clients on their financialinvestments.

Portfolio management: as they manage portfolios of assets onbehalf of households and institutional investors.





The Role of Financial Intermediaries

Intermediaries transform financial assets with respect to theirmaturities and payments:

? This helps investors to reduce

− their risk-exposure,

− the cost of writing and enforcing contracts,

− the cost of collecting and processing information.

Intermediaries manage the payment system.





Investment Companies

Investment companies are intermediaries which

collect funds from individual investors and

pool and invest these funds into a wide range of real and fi-nancial assets.

Investment companies perform several functions, such as

? diversify risk and fractionize investment,

? reduce transaction costs,

? collect and process information.





Unit Investment Trusts

Investment companies comprise

? Unit investment trusts and

? Managed investment companies.

Unit investment trusts are pools of money invested into aportfolio of assets which is fixed for the life of the fund.

? A trustee buys a portfolio of securities deposited into a trust.

? Shares, or “units”, are sold to the public at a premium to theirnet asset value (NAV), ie. to the cost of the underlying assets.

? Investors can liquidate their holdings by selling the units backto the trustee at the NAV.





Managed Investment Companies

Managed investment companies comprise

? Closed-end funds and

? Open-end funds or mutual funds.

Management companies are hired to manage their portfolios.

Open-end funds are ready to redeem or issue shares at NAV.

Closed-end funds do not redeem or issue new shares: investorscan liquidate their shares by selling them to other investors.

Shares of closed-end funds can be traded a prices differentfrom NAV on organized exchanges.





Mutual Funds

Mutual funds are classified according to their investmentpolicies into money-market, equity, bond and index funds.

Index funds replicate the performance of a broad marketindex, by mimicking the portfolio of securities in the index.

Mutual funds impose a complex fee structure, inclusive of

? front-end load (entry) and back-end load (exit) commissions

? annual operating expenses and performance fees.





Hedge Funds

Hedge funds are a particular class of closed-end funds which

are open to wealthy and institutional investors,

differently from mutual funds are not regulated,

pursue aggressive investment strategies, relying on

− short sales, derivatives and leverage.


introduction to finance · paolo vitale luiss university [email protected] paolo vitale introduction...

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