3. 3
What is Finance
โข Finance is about the bottom line of business
activities
โข Every business is a process of acquiring and
disposing assets
โ Real asset โtangible and intangible
โ Financial assets
โข Objectives of business
โ Valuation of assets
โ Management of assets
โข Valuation is the central issue of finance
4. 4
Money vs. Finance
Monetary Economics Financial Economicsvs.
Money / Credit
Creation
Return / Risk
Allocation
International
Finance
Money &
Banking
Corporate
Finance
Investments
(Capital
Markets)
Central
Bank
Commercial
Banking
Non-Bank
Financial
SectorLiquidity
Money
Control
5. 5
What is Financial Engineering?
โข Financial Engineering refers to the bundling
and unbundling of securities.
This is done in order to maximize
profits using different combinations of
equity, futures, options, fixed income,
swaps.
โข They apply theoretical finance and computer
modeling skills to make pricing, hedging,
trading and portfolio management decisions.
9. 9
What is Financial Engineering?
โข Generalizing: Financial Engineering involves
the design, the development, and the
implementation of innovative financial
instruments and processes, and the
formulation of creative solutions to problems
in finance.
โข Specializing: Financial Engineering is risk
management via creative structural tools.
10. 10
Type of Asset Exp. R of R Risk Level
1 Bank accounts 2.5-3% No risk of deposit loss. Inflation risk.
2 Money-market deposit
accounts
3.5-4% No risk of deposit loss. Rates geared to
inflation
3 Money-market funds 4.5-5% Very little. Rates vary with inflation.
4 Special 6-month
certificates
5% Early withdrawals subject to penalty. Rates
geared to expected inflation.
5 High-quality corporate
bonds
8-8.25% Very little if held to maturity. Rate geared to
expected long-run inflation rate.
6 Diversified portfolio of
blue-chip common stocks
(e.g., index fund)
9% Moderate to substantial. In any one year, the
actual return could be negative. Diversified
portfolios have at times lost 25% or more of
their actual value.
7 Diversified portfolios of
risky stocks such as
aggressive growth mutual
funds
9-10% Substantial. Diversified portfolios have at
times lost 50% or more of their actual value.
8 Real estate similar to
common
stocks
Cannot be sold quickly. Hard to diversify.
Good inflation hedge if bought at reasonable
price levels. For long-term investors.
9 Gold unpredictable Substantial. Believed to be a hedge against
hyperinflation. Can help to balance a
diversified portfolio.
11. 11
Unifying Principles of Finance
โข No arbitrage
โข Preference
โข Optimization
โข Market in equilibrium
12. 12
Principle of Financial
Engineering
โข No arbitrage
โข Market in
equilibrium
โข Principles of Financial
Engineering
โข Preference
โข Optimization
โข Principles of Finance
13. 13
Unifying Equation of Valuation
โข P=E(mx)
โ Where m is state-dependent discount factor
โ X is the state dependent payoff (cash flow)
โข Consequence of no arbitrage equilibrium
โ Conservation law of value of cash flow: the
whole is equal to the sum of components
โ Composition and de-composition of cash flow
17. 17
What is a security?
๏A security is a fungible, negotiable
instrument representing financial value.
๏Securities are broadly categorized into
debt and equity securities
such as bonds and
common stocks,
respectively.
21. 21
Debt
Debt securities may be called debentures, bonds,
notes or commercial paper depending on their
maturity and certain other characteristics.
The holder of a debt security is typically entitled to
the payment of principal and interest, together with
other contractual rights under the terms of the issue,
such as the right to receive certain information.
Debt securities are generally issued for a fixed term
and redeemable by the issuer at the end of that term.
22. 22
Equity
๏ถAn equity security is a share in the capital stock of a
company (typically common stock, although preferred
equity is also a form of capital stock).
๏ถThe holder of an equity is a shareholder, owning a
share, or fractional part of the issuer. Unlike debt
securities, which typically require regular payments
(interest) to the holder, equity securities are not entitled
to any payment.
๏ถEquity also enjoys the right to profits and capital gain.
23. 23
Weighted average cost of capital
The Weighted Average Cost of Capital
(WACC) is used in finance to measure a
firm's cost of capital.
24. 24
The cost of capital is then given as:
Kc = (1-ฮด) Ke + ฮด Kd
Where:
Kc The weighted cost of capital for the firm
ฮด The debt to capital ratio, D / (D + E)
Ke The cost of equity
Kd The after tax cost of debt
D The market value of the firm's debt, including bank loans and leases
E The market value of all equity (including warrants, options, and the equity
portion of convertible securities)
In writing:
WACC = (1 - debt to capital ratio) * cost of equity + debt to capital ratio * cost
of debt
Formula
25. 25
The Modigliani-Miller Theorem
The basic theorem states that, in the absence of
taxes, bankruptcy costs, and asymmetric
information, and in an efficient market, the value
of a firm is unaffected by how that firm is
financed. It does not matter if the firm's capital is
raised by issuing stock or selling debt. It does
not matter what the firm's dividend policy is.
Therefore, the Modigliani-Miller theorem is also
often called the capital structure irrelevance
principle.
26. 26
Proposition
y = C0 + D/E (C0 โ b)
* y is the required rate of return on equity, or
cost of equity.
* C0 is the cost of capital for an all equity firm.
* b is the required rate of return on
borrowings, or cost of debt.
* D / E is the debt-to-equity ratio.
