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Welcome to ECO358!
Financial Economics I
Lecture 1.1: Introduction
September 15, 2015

Course Resources
Instructors:
Professor Katya Malinova
katya.malinova@utoronto.ca; Max Gluskin House 211.

TA support: TBA, highly qualied econ MA and PhD students.

Textbook: Corporate Finance, Berk and DeMarzo, 3d Canadian EdiVon.

Note: the same textbook will be used in ECO359 (St. George).

Slides: to be posted on Blackboard (portal.utoronto.ca).

Oce Hours:
Professor Malinova:
Drop-in: Tuesdays 11-noon (excepVons will be noted on the class website)
By appointment: excepVonal cases only, schedule via TimeTrade, instrucVons
to be posted on Blackboard.

TA oce hours: TBA.

Grading and Evaluation

Two term tests and nal exam
Term tests, 2 hour each:
October 13, 3-5pm and 5-7pm
November 24, 3-5pm and 5-7pm
LocaVons TBA, NOT in this classroom!
(Comprehensive) Final Exam:
During the December nal exam period, to be scheduled by U of T

Default Weights: course grade = 30% x test 1 + 30% x test 2 + 40% x nal.
ExcepVon: the nal counts for 70% and your best term test counts for 30%
if both of the following condiVons are saVsed:
your nal grade your worst midterm grade, AND
your lowest term test grade is 30%.

Term tests are compulsory.

In excepVonal cases when you miss a term test for a legiVmate reason, the

weight from the missed term test may be shifed to the nal; please see the
syllabus for details.

Course Logistics
Regular Lectures and Occasional TA-led Tutorials
Problem sets will be posted on Blackboard to provide you with an
idea of how test/exam quesVons will look like.

Please consult Blackboard for the lecture and tutorial schedule (to
be posted within a week)

Next four weeks:

September 22: 3-hour lecture
September 29: 2+ hour lecture
October 6: 2-hour tutorial/Q&A session
Vme slot TBA, in this classroom

October 13: term test I

3-5pm and 5-7pm, locaVon TBA (not necessarily this classroom!!!)

Course Logistics (Contd)

Course Road Map

Slides will be posted on Blackboard prior to lecture.

Overview of Financial Instruments and Trading.

Major correcVons/modicaVons based on in-lecture discussions

Basic Tools for Making Financial Decisions.

will be announced.

Slides are organized by topic (i.e., not by lecture).

This means that you may have mulVple sets of slides for one lecture
and/or we may use more than one lecture to cover a set of slides.

Chapter numbers will be provided to you, but you are responsible for
nding the relevant subsecVons within each Chapter based on the
material presented on the slides.

Exam quesVons will be primarily based on the material presented

on the slides, in pracVce problems, or discussed in lecture. You
are further required to follow the business news & current
events.

The Law of One Price & the Absence of Arbitrage (Ch. 3).
The Time Value of Money & Interest Rates (Ch.4-5).

Basic ValuaVon:
Valuing Bonds (Ch. 6).
Basics of Financial Statements (Ch. 2). Valuing Stocks (Ch. 7).

The Trade-o between Risk and Return.

Pricing of Risk (Ch. 10)
OpVmal Porrolio Choice. The Capital Asset Pricing Model. (Ch. 11-12).
Arbitrage Pricing Theory & MulV-Factor Models. Market Eciency (Ch. 13).

Basics of DerivaVves (focusing on opVons and pricing of opVons). Ch. 14-15.

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What is (are) the role(s) of

Hinancial markets?

The Investment Process

Companies raise capital by issuing nancial assets (bonds
and stocks).

Only trade with the company the rst Vme these assets are
issued (primary market) (or when the company
repurchases them, e.g., b/c it has excess capital).

All later trades are between investors who exchange these

assets among themselves (secondary market).

Historical Returns

... the long-term growth in stocks

has been exponential.

Note: Despite what you may think ...

The Investment Decisions

Investors hold porrolios of assets.
Asset AllocaVon/Porrolio Choice: choose assets based on

the risk/return trade-o.

Stocks, bonds, cash, other?
Which stocks/bonds to include in porrolio?
ValuaVon of nancial assets (e.g., is Apple or Blackberry more
atracVvely priced?).

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Types of Financial Instruments

Debt

Debt
An I owe you.

Short-term (under one year): money market instruments.

Long-term: bonds; bond market is also known as xed
income capital market.

Equity.

Buying a debt instrument can be loosely interpreted as

signing a contract that promises you (in exchange for you

lending the money):
a pre-specied payment during a pre-specied period
(maturity) at pre-specied intervals (e.g., monthly, semi-
annually)
a repayment of the pre-specied amount at the end of this
period (at maturity).

DerivaVves.

Short-Term Debt: Money

Market Instruments
Example: Central Bank issues a note promising to pay the holder a
one-o payment on a given day.

Features:
Short-term: 30, 60, 90 days, maximally 1 year.
No interim payments (i.e., receive a single payment ``at maturity'').

Long-Term Debt: Bonds

Features:
Longer term (more than year).
receive a xed monthly, annual, semi-annual etc. payment
(coupon).

receive a xed repayment (``face value'') at maturity.

Examples:

Examples:
T-bill (government)
Commercial Paper (corporaVons).
Repo (repurchase agreement): a form of very short, typically

overnight borrowing, using a government bond as a collateral:

you give me the money, in exchange I give you my government bond

to hold Vll tomorrow; tomorrow I repay you your money with interest
and you return my bond to me.

Equity
Equity is a stock or any other security represenVng an
ownership interest.

Terms stocks and shares are ofen used

interchangeably.
Typically: shares is countable (e.g., you own stock of Apple
Inc. or 100 shares of Apple Inc.)
Also: stock is ofen more general (= equity).
I own stocks means I own equity of some companies.
I own shares prompts a quesVon in what company?

Treasury bonds (U.S. gov't); Canada bonds (Gov't of Canada)

Provincial or municipal bonds
Corporate bonds
Secured Bonds: have specic collateral backing in the event of
bankruptcy.

Debentures = unsecured bonds.

Equity (contd)
CorporaVons raise funds for their investments by issuing
stock or bonds.
If you buy bonds, you make a loan to the company.
If you buy stocks, you own a fracVon of a company

you can vote on major decisions of the corporaVon.

When a company receives income, it rst uses it to repay its

loans (i.e., pays interest to the debt holders).

Stockholders have a residual claim on the income and the

assets of company (afer the debt holders have been paid o).
Note: stockholders in a corporaVon have limited liability (cannot
lose more than your investment).

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Graphically: Debt and Equity

as Contingent Claims

Derivatives
A derivaVve:
A contract between two or more parVes whose value is based on an
agreed-upon underlying nancial asset, index or security.

Common underlying instruments include: bonds, commodiVes,

currencies, interest rates, market indexes and stocks.

Example: OpVons.
Terms: exercise or strike price, expiraVon date, underlying assets.
Call OpVon = a right to buy the underlying asset at the strike on (or
prior to, depending on the opVon type) the expiraVon date

Put OpVon = a right to sell.

Other examples: Futures, forwards, swaps, warrants.

Financial Markets
Primary versus Secondary Markets:

Primary Market

When a corporaVon issues securiVes, cash ows from investors to the rm.
Usually an underwriter is involved.
Any costs that are associated with issuance are paid by the rm => need to
understand the mechanisms & costs for security issuance (will touch upon
these in ECO359).

Secondary Markets
Afer the iniVal transacVon in the primary market, the shares conVnue to

trade in a secondary market between investors.

E.g., transacVons between investors on a stock exchange.
Trading costs are borne by investors/shareholders => not directly paid by the
rm.
Yet, it is sVll important to understand these. Why?

The Organization of a Secondary

Market (e.g., Stock Exchange)
In the past, most markets were intermediated. E.g., NYSE had a

specialist system. A specialist (market maker) would post:

a price at which they are willing to buy a security (bid)
a price at which they are willing to sell a security (ask)
typically: ask > bid.
e.g. Apple Inc. last price on Jan 30, 2015 was USD 117.16.
suppose that right now: bid = 117.06 and ask = 117.26.
I want to sell 100 shares & you want to buy 100 shares .
market maker: buys 100 from me at 117.06 & sells 100 to you at 117.26.
market maker makes: (117.26-117.06)x100 = $20
(ask bid) = bid-ask spread: typically viewed as a transaction cost.
Why? You and I could have (?) agreed to trade at 117.16 --- we would

Trading Costs
The stock market provides liquidity to shareholders.
Liquidity (extremely loosely):
The ability to easily sell (and buy) an asset.
low transaction costs
easy to find somebody to trade with

Liquidity is valuable: provides flexibility to investors regarding

the timing and the duration of their investments in a firm.

If it is difficult for shareholders to (re-)sell their shares, they

will require to be compensated & demand higher returns on
their investment.

=> Higher costs of equity capital for companies when raising

capital!
We will briefly discuss the organization of the market next, but
further discussion is beyond the scope of ECO358/ECO359.

Modern Stock Exchanges

These days, most equity markets worldwide are fully electronic.
No such thing as a human market maker standing ready to trade your
shares on the NYSE. Instead, a stock exchange oor looks like this:

have saved $10 each.

Thus, traditionally: bid-ask spread has been a very standard measure

of a transaction cost.

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Limit Order Books

Most equity markets worldwide operate as limit order books.
Each trader may either:
post a limit order: price and quanVty at which they are willing to trade
submit a market(able) order: accept the terms of an order that is already in the book.

Example: Blackberry (in USD) on BATS Exchange, Sep 14, 2015.

Trading Costs in Modern Markets

Limit Order Book Example

(Blackberry) & Trading Costs
What is the bid-ask spread?
What are your opVons if you want to buy 100 shares? 200? 500?
What are addiVonal things/costs to consider if you want to buy
10,000 shares?

Trading Costs: Price Impact

In modern markets, traders use both limit and market

orders.
Unclear whether bid-ask spread remains a good measure for
transacVon costs.

Many large orders are split over hours, days, or weeks

=> if a trader is buying a large quanVty, the price may increase
(i.e., the order will have a price impact).

=> Using the bid-ask spread as a sole measure of transacVon

costs will likely underesVmate the costs.

The price impact if parVcularly important in modern markets

where both bid and ask prices move very fast (so that the bid-
ask spread remains low).

Further Comments on the

Organization of Trading
AlternaVve systems for execuVng trades:
match incoming orders without publicly displaying them.
price impact for traders who use them may be lower.
referred to as dark pools.

PotenVal problems:
may not be able to nd a match in the dark pool (nobody knows that
you are interested in buying/selling).

if the price discovery aected if traders are able to hide their trading
intenVons?

Issues regarding the eects of the organizaVon of trading are

studied in the eld of nancial market microstructure.

=> will not discuss them further in ECO358/ECO359.