The Financial Environment

Chapter 1
Content
▶ Finance and Financial Environment
▶ What is Finance?
▶ Financial Environment
▶ Financial Institutions
▶ Financial Markets
▶ Why to Study Finance?
▶ 6 Principles of Finance
▶ Financial System
▶ Definition
▶ Components
▶ Major Types of Financial Markets
Three motivational questions
1. What is finance?
2. Why is it important?
3. Why study finance?
What is finance?

Finance is a study of how individuals, institutions,

governments and businesses acquire, spend and manage
financial resources.
What is finance?
Finance has its origins in Economics and Business:

Economists use a supply and demand framework to

explain how the prices and quantities of goods and
services are determined in a free-market economic
system.

Accountants provide the record-keeping mechanism for

showing ownership of the financial instruments used in
the flow of financial funds between savers and borrowers.
Why is it important?

Understanding Finance is important to all students

regardless of the discipline or area of study because all
businesses and economic decisions have financial
consequences and implications.

On a personal level - decision to spend or consume now

(for new clothes or dinner at fancy restaurant) rather than
save or invest (for spending or consuming more in the
future) is an everyday decision that we all face
Why study finance?
To make informed economic decisions
▶ We elect officials who have the power to alter the
financial system by laws, rules and regulations and then
influence economic activities.
▶ You want a balanced budget, lower taxes, free
international trade, low inflation and full employment?
▶ We will study the roles of financial institutions and
markets, and how the financial system works
Why study finance?
To make informed personal and business investment
decisions
▶ Finance helps to understand how institutions,
government or businesses finance their operations;
▶ Understanding of investments will help you to better
manage your financial resources;
▶ To make better investments you will need to
understand factors that influence interest rates and
security prices.
Why study finance?
To make informed career decisions based on a basic
understanding of business finance
▶ We all interact with finance professionals in firms or
organizations
▶ Doing so will require a basic knowledge of the concepts,
tools and applications of financial management
Finance and Business
Business is organised effort of individuals to produce and
sell, for a profit, the goods and services that satisfy the
society's needs
Production process:
Finance and Business
Efficient methods of production and specialisation of
labor can exist only if there is an effective means of
paying for raw materials and final products

Businesses can obtain money needed to buy capital

goods such as machinery and equipment only if a
mechanism has been established for making savings
available.
Financial Environment
The Financial Environment
Definition:

Financial system, institutions, markets, businesses,

individuals and global interactions that help the economy
operate efficiently

The 3 areas of Finance we will study this semester

▶ Institutions & Markets,
▶ Investments,
▶ Financial Management
All of them interact or intersect with each other and we
will see how.
Financial Institutions
Financial Institutions are the intermediaries that help the
financial system operate efficiently and transfer funds
from savers to individuals, businesses and governments
that seek to spend or invest the funds
Depository institutions Non-depository institutions
Commercial banks Insurance companies
Credit unions Pension Funds
Mutual banks Investment banks
Saving & Loan associations Securities companies
Mutual Funds
Finance companies
Financial Institutions
Type of Primary Liabilities Primary Assets
intermediary
Commercial Banks Deposits Business and consumer loans
Mortgages
Government Securities
Municipal Bonds
Credit Unions Deposits Consumer loans
Mutual Banks Deposits Mortgages
Savings and Loan Deposits Mortgages
Associations
Insurance companies Premiums Corporate bonds
Municipal bonds and stocks
Government bonds
Pension funds Employer and Employee Corporate bonds and stocks
contributions
Finance companies Stocks, bonds Consumer and business loans
Mutual Funds Shares Stocks and Bonds
Financial Markets
Financial market is a broad term describing any
marketplace where trading of securities including equities,
bonds, currencies and derivatives occur.

Some financial markets are small with little activity, while

some financial markets like the New York Stock Exchange
(NYSE) trade trillions of dollars of securities daily.
Money and Capital Markets
Money Markets are where debt securities with maturities
of one year or less are issued and traded

These markets are generally characterized by high

liquidity

Money market securities can be easily sold / traded with

little loss of value
Money and Capital Markets
Capital Markets are where debt instruments or securities
with maturities longer than one year and corporate stocks
or equity securities are issued and traded

Capital Market securities are generally issued to finance

▶ purchase of homes by individuals
▶ buildings and equipment by businesses
▶ infrastructure by government
Money and Capital Markets
Business firms and government issue long term debt
securities - bonds to finance operations

Mortgages are issued to finance homes and buildings

Corporations issue stocks to meet their financing needs

Primary and Secondary Markets
▶ Primary Market
▶ New securities (stocks and bonds) sold to initial buyers in the
form of Initial Public Offering (IPO)
▶ Usually underwriting firm creates prospectus outlining the
price and other details of the securities to be issued
▶ Companies hire investment bankers to sell all their stocks as
soon as possible in a short period of time
▶ This can be done only to large investment companies and
small investors are not often able to purchase securities at
this point
▶ Process of marketing and convincing the investors to buy
stocks is called a “road show” or “dog and pony show”
Primary and Secondary Markets
▶ Secondary Market
▶ Is where securities are traded after the company has sold all
the stocks and bonds offered on the primary market;
▶ Markets such as New York Stock Exchange (NYSE), London
Stock Exchange or Nasdaq are secondary markets;
▶ Brokers – agents of investors who match buyers with sellers of
securities
▶ Dealers link buyers and sellers by buying and selling securities at
stated prices
▶ The issuer of the securities does not benefit or lose from
these transactions
▶ Divided into short-term (money) and long-term (capital)
market
Classification of Financial Markets
Types of Financial Markets
1. Debt securities markets
▶ Where money market securities, bonds and mortgages are
originated and traded
▶ Bond is a debt security
▶ Buying a bond means loaning the company. It gives a right for
repayment of principal and interest on the bond.
2. Equity securities markets
▶ Where ownerships rights in the form of common stocks are
initially sold and traded (private placement & public offering)
▶ Stock is an equity security
▶ Buying a stock is buying a piece of company. It gives a profit if the
company profits and loss if the company loses.
Types of Financial Markets
3. Derivative securities markets
▶ Markets for financial contracts or instruments that derive
their values from underlying debt and equity securities
▶ Opportunity to buy or sell a firm’s equity for a specified price
and within a certain amount of time
4. Foreign exchange markets (FOREX)
▶ Electronic markets in which banks & institutional traders buy
and sell various currencies
▶ Firms often use the currency exchange markets to reduce the
risk of holding too much of many currencies
▶ Is the largest and most liquid market in the world (traded
value exceeds $1.9 trillion/day
▶ Includes all of the currencies in the world. 
Mortgage Markets
Mortgage: a loan backed by real property as buildings
or houses

Mortgage markets: mortgage loans are created to

purchase buildings and houses, are originated in
primary markets and traded in secondary markets
Types of Mortgages
Fixed-rate mortgage has a fixed interest rate and
constant monthly payments over the life of the loan (15-
30 years)

Adjustable rate mortgages has an interest rate that

changes or varies over time with market-determined
interest rates on a Governmental treasury bill.
Securitization of Mortgages
Mortgages can be securitized and traded in the market

Securitization is the process of pooling and packing

mortgage loans into debt securities.

Mortgage backed security is a debt security created by

pooling together a group of mortgage loans whose
periodic payments belong to the holders of the security.
Investments
Investment is the process of laying out money now to receive
more money in the future.

Investment process is associated with risk:

Financial Management
Financial management - is a strategic planning how a
business should earn and spend money.

This includes decisions about raising capital, borrowing

money and budgeting.

The goal of a financial manager:

▶ Profit organization
▶ maximize the owner’s wealth;

▶ Non-profit organization
▶ optimize costs while keeping high level performance.
Financial Management History
Financial management became separate field of study from
finance function in the early stages of 20th century.
The evolution of financial management can be separated into
three stages:
Traditional stage (up to 1940)
▶ Formation, expansion, mergers and liquidation of the firm
▶ From the perspective of investment bankers, lenders
Transactional stage (after 1940)
▶ Similar to previous + fund analysis, planning and control
Modern stage (after 1950)
▶ Proper utilization of funds to maximise shareholder wealth
▶ Capital budgeting, valuation models, dividend policy, option pricing
theory, behavioral finance and etc.
6 Principles of Finance
Principles act as a guideline for investment and financing
decision:

1. Money has a time value

2. Higher returns are expected for taking on more risk
3.Diversification of investments can reduce risk
4.Financial markets are efficient in pricing securities
5.Manager and stockholder objectives may differ
6.Reputation matters
6 Principles of Finance
▶ Help us to understand how managers and investors
incorporate time and risk into their decisions

▶ Why the desire to earn excess returns leads to

information-efficient financial markets

▶ Desire to earn excess returns leads individuals to take

risks and to behave unethically
Principle 1: Time Value of Money
“Money in hand today is worth more than the promise of
receiving the same amount in the future”

▶ If you have $1,000 today and you place it at the bank with
6% interest rate it will be worth $1,060 after a year

This helps us to understand the economic behavior and

decision of individuals, institutions and businesses
Principle 2: Risk vs. Return
Trade offs exist between risk and expected return in all
types of investments (assets and securities)
▶ Risk: uncertainty about the future
▶ You invest money in a business and you do not know if you
will lose your investment or if you will double your
investment in a year

▶ Investors / business managers have to deal with this

problem
▶ For example when they choose between projects in which
they could invest
Principle 2: Risk vs. Return
There are 2 options to invest $1,000.

1. In a business venture today which is risky, but in a year

you can lose your money or earn $2,400.

2. You can invest $1,000 in a US government security,

where after one year the value may be $950 or
$1,100.

Which one would you choose?

Principle 2: Risk vs Return (example)
Less risk (less interest rate):
▶ Cash and Cash equivalents
◻ CE – can be easily converted to cash (<3m)
▶ Government Bonds
▶ Money markets and bank accounts

Average risk (average interest rate, stable return):

▶ Real estate (high cost and long PB period)
▶ Equity mutual funds
▶ Large and small cap stocks

High risk (provide higher interest rate, there is possibility to fail):

▶ Options and futures
Principle 3: Diversification of risk
Investment risk is never the same
Some risk can be removed or diversified

Instead of investing $ 1000 in 1 business, we divide this

amount between two businesses:

Possible Probability Combined Possible returns Combined

outcomes investment return
Outcome 1 25% $500 + $500 $0 + $0 $0
Outcome 2 25% $500 + $500 $0 + $1,200 $1,200
Outcome 3 25% $500 + $500 $1,200 + $0 $1,200
Outcome 4 25% $500 + $500 $1,200 + $1,200 $2,400
Principle 4: Financial markets are efficient
Assume a firm’s stock is currently trading at $20 per share.

If the market is efficient both buyers and sellers know that the
price of $20 is fair.

Now, assume that the firm announces new product that will
increase sales and profits.

This might increase the price of shares to $25 reflecting the

reaction of investors.
Principle 4: Financial markets are efficient
This principle is based on the Efficient Market Hypothesis
EMH formulated by Eugene Fama in 1970 and a desire of
an investor to beat the market:

“At any given time, prices fully reflect all available

information about a particular stock or market”

Fama was awarded the Nobel Memorial Prize in Economic

Sciences in 2013.
Principle 5: Management vs Owner
objectives
▶ Owners or investors always want to maximise the
returns on their investments and hire professional
managers to run their firms
▶ Managers may seek to improve own income, to have
bigger bonuses, corporate helicopters and jets and so
on
▶ In order to bring manager objectives in line with the
owner objectives it is necessary to tie manager
compensation to the overall company performance
▶ Portion of ownership
▶ Stock options
▶ Bonuses tied to stock performance
Principle 6: Reputation matters
Ethical behavior is how an individual or organization treats
others legally, fairly and honestly.

In order to be successful a company should have good

reputation among customers, employees, owners,
community and society

Laws and regulations exist to ensure minimum levels of

protection and the difference between unethical and
ethical behavior
Principle 6: Reputation matters
Greed for excess returns might lead to illegal activities.

High-quality ethical behavior involves treating others

fairly and honestly and goes beyond just meeting legal
and regulatory requirements.
The end
Financial System

Complex mix of financial intermediaries, markets,

instruments policy makers and regulations that interact to
facilitate the flow of financial capital from savings into
investment
Characteristics of Financial System
Effective Financial System should have:

Policy makers pass laws and make decisions related to

fiscal and monetary policies

Monetary system composed of a CENTRAL BANK and a

BANKING SYSTEM
▶ create and transfer a stable medium of exchange
called money
Financial system
Policy Makers
(President, parliament and etc.)
Role: pass laws and set fiscal and
monetary policies

Monetary system
(Federal Reserve, Central Bank,
Commercial Banks)
Role: Create / transfer money
Characteristics of Financial System
Effective Financial System should have:

Financial institutions (Financial intermediaries) support

capital formation by
▶ by channeling savings into investment in physical
assets;
▶ by fostering direct financial investments by individuals
in financial institutions and businesses

The process of accumulating and then lending and

investing savings is referred to as the savings-investment
process.
 Financial system
Policy Makers
(President, parliament and etc.)
Role: pass laws and set fiscal and
monetary policies

Monetary system
(Federal Reserve, Central Bank,
Com.Banks)
Role: Create / transfer money

Financial Institutions
(Depository Institutions,
Securities Firms, Finance Firms)
Role: accumulate and lend or
invest savings
 Financial system
Policy Makers
(President, parliament and etc.)
Role: pass laws and set fiscal and
monetary policies

Monetary system
(Federal Reserve, Central Bank,
Com.Banks)
Role: Create / transfer money

Financial Institutions Financial Markets

(Depository Institutions, (Debt securities markets
Securities Firms, Finance Firms) Equity securities markets
Role: accumulate and lend or Derivative securities markets)
invest savings Role: market and facilitate
transfer of financial assets
 Financial Functions

Monetary system
Creating money

Transferring money

Financial Institutions Financial Markets

Accumulating savings Marketing financial assets

Lending /Investing savings Transferring Financial Assets

Functions of Monetary System
Creating money

Money is the most generalized claim to wealth, since it

can be exchanged for almost anything else.

In the case of the U.S. FED is responsible for the amount

of money that is created.
Functions of Monetary System
Transferring money
Individuals & Businesses usually hold money in Checkable
Deposits at depository institutions for payments.

Check is an order to the depository institution to transfer

money to the party who receives the check.

Transfers can also be made by phone, via the ATMs, via

the Internet.
Functions of Financial Institutions
Accumulating Savings
Most individuals, businesses and organizations do not
want to take the risks involved in having cash on hand.

Even relatively small cash amounts are put into a

depository institution for safekeeping.

When all the deposits are accumulated in one place, they

can be used for loans and investments in amounts much
larger than any individual depositor could supply.
Functions of Financial Institutions
Lending & Investing Savings
Money accumulated in DI can be lent to individuals,
businesses and government.

Credit can be for varying period and for different

purposes.

Some institutions provide all types of credits, some

others are specialized in a certain type.
Functions of Financial Markets
Marketing Financial Assets
As we know, new financial instruments and securities are
created and sold in the primary securities market.

For example, a business that is want to sell shares to

general public is usually not specialised in selling stocks.

Doing so might be difficult, costly and time consuming,

However for an investment banking firm merchandising is

the main type of activity
Functions of Financial Markets
Transferring Financial Assets

For this purpose organized stock exchanges and over-the-

counter market provide active secondary markets for
existing securities.

The ability to buy and sell securities both quickly and at

fair-market values is important in an efficient financial
system.
Homework
Read chapter 1