Lecture 2- Basic Financial Concepts

Heriot-Watt University - Introduction to Finance

Basic Financial Concepts

Maximising Shareholder Information Asymmetry

Wealth Areas of Conflict

Agency Self Interest

Financial Signalling
Capital Market

Time Value of Money

Risk Aversion Risk Diversification

Efficiency Option Pricing

Heriot-Watt University - Introduction to Finance

Maximising Shareholder Wealth

The MAIN Objective of any firm should be to Maximise

Shareholder Wealth

Finance theory indicates that the manager of a firm should aim

to maximise the wealth of shareholders, which would indicate that share prices are key to their concern.

The assumption is that managers (including finance directors),

in charge of companies should maximise shareholders wealth, as their objective function. will be primarily in the interests of the shareholder.
Heriot-Watt University - Introduction to Finance

Following from this assumption they will take decisions which

Agency
A relationship in which the principal (in this case the

shareholders) gives an agent (the management team and or the board of directors) the right to act on the principal's behalf and to exercise some business judgment and discretion.
Agents owe very high degrees of loyalty, good faith,

and confidentiality to their principals, often expressed as fiduciary obligations.

Heriot-Watt University - Introduction to Finance

Areas of Conflict- Self Interest

Management acts as Agents for the Shareholders. This

relationship is called an Agency, where Management have a Fiduciary responsibility to make decisions that redound to the Benefit of the share holders. Areas of Conflict arise where; Managers can act in interests of shareholders but not bondholders Managers can act in own interests and not shareholders with regard to;
o Projects o Capital structure o Dividends o Remuneration

Heriot-Watt University - Introduction to Finance

Time Value of Money

Time has an effect on the value of money because of: o Inflation o Opportunity cost foregone of an investment o Risk o Consumption preference
This represents a fundamental concept on which investment

decisions are made.

The value of money is a function of the timing of its receipt or payment, with cash received or paid in the future, being worth less than cash received or paid today.
Heriot-Watt University - Introduction to Finance

Financial Risk
Financial risk an umbrella term for multiple types of risk associated with financing, including financial transactions that include company loans in risk of default.[Risk is a term often used to imply downside risk, meaning the uncertainty of a return and the potential for financial loss, but there is also upside risk.

It is important to make a distinction between:

Risk Certainty
o

The expected outcome is known for certain (probability = 1) - the returns on government bonds are considered certain. Uncertainty exists whenever one does not know for sure what will happen in the future.

Uncertainty
o

Certainty and uncertainty can be seen as opposites with risk in between.

Heriot-Watt University - Introduction to Finance

Risk Aversion
In analysing risk and risk behaviour most investor are

Risk Averse.
What is Risk Aversion? The principle of risk aversion is that individuals who make financial decisions will prefer, ceteris paribus (everything else being equal), given the choice between two investments with identical expected returns, to choose the alternative offering the lower expected risk.

Heriot-Watt University - Introduction to Finance

Risk Diversification
Since most investors are risk averse it is obvious that they would seek

methods by which they can reduce risk exposure. There are 2 main methods of reducing risk

Risk Diversification Diversification means reducing risk by investing in a variety of assets. If the asset values do not move up and down in perfect synchrony, a diversifiedportfolio will have less risk than the weighted average risk of its constituent assets, and often less risk than the least risky of its constituents Hedging Investing in a position intended to offset potential losses that may be incurred by a companion investment. ONLY RISK DIVERSIFICATION IS COVERED IN THIS COURSE
Heriot-Watt University - Introduction to Finance

Capital Market Efficiency

The simplest definition of market efficiency is that the price

already reflects the available information and thus buying or selling the stock should, on average, return you only a "fair" measure of return (after transaction costs) for the associated risk. On average you will make money, but the money you make is just enough to offset the risks you have assumed.
There are three basic types of information efficiency. Strong

form, Semi-strong form, and Weak form.

Possibly less academic in nature but more convincing in reality is

the fact that so few people or mutual funds either in the US, or abroad, do actually beat the market on a risk adjusted basis.
Heriot-Watt University - Introduction to Finance