Finance lecture 1 Flashcards
What is Finance?
Finance is the study of how individuals, businesses and organisations allocate and use scarce financial resources across time
What are some of the pratical finiancial questions which are asked?
If you would like to buy a car, should you use cash or borrow?
The metholodgy for pricing of assets is based on what?
The law of one price and abscence of arbitarge.
What is the law of one price and arbitartage?
Law of one price: all assets and risk must be priced consisitently so that assets with the same risk yield the same return.
Arbitartage: If the law of one price exists there should be no arbitarge, so obtaning a net profit without incurring any risk( due to mispricing of assets)
If the law of one price doesnt hold then what?
arbitartage opportunites arise.
What do economic agents use to make decisions?
Financial systems.
What is the fianancial system?
the set of markets and other insitutions used for financial contracting and exchange of assets and risk.
What are financing decisions for firms?
Consumption and saving decisions
Investments decisisons
Finance decisions
Risk management decisions
What are 3 types of finance decisions for firms?
1) Investment decisions - capital budgeting - what long term investments will you make?
2) Finance - capital structure - where will you get long term financing for your long term projects( debt or equity )
3) Liqudiity working capital - How will you manage your everyday activities.
What is the goal for financial managers?
1) Manage risk( minimising or maximising risk)( avioding bankruptcy)
2) Maxmise share price
What are some financial insitutions that provide financial services and products in the financial system?
Commerical banks( intertemediaries, loans)
Innsurance companaies ( travel insurance)
Penision funds
Hedge funds.
So financial decisions are what?
implemented through the financial system, the financial system is the oil in the wheels to plumbing the economy.
The more developed the country the more likely what?
The more likely and deeper there financial system.
What are the princples at the core of the financial system of capitalist market economies?
1) Time value is money
2) Risk requires compensation
3) Information at the core decisions
4) Markets determine prices and allocate resources
5) Stability improves welfare.
What does time value money mean?
Time has an opportunity cost in financial terms • You pay interest to a bank for a loan because you are compensating the lender for the opportunity cost of the time you use those financial resource
What does risk requires compensation mean?
states that people are generally unwilling to accept any danger in regards to potential losses to their financial instruments, unless they are rewarded in some way.
What does information at the core of decisions mean?
The collecting and processing of information is at the core of the financial system. Financial systems also provides ways to reduce the need for information collections.
What does Markets determine prices and allocate resources?
through supply and demand we get information about prices and this allows us to allocate capitala, markets need to be perceived as fair, hence they are organised and governed.
What does stability improves welfare mean?
Economic or market stability improves welfare in the economy. Central banks work to keep markets and the financial system stable, which is better for all individuals
We have seen that there are many financial transcations that occur in economies, how do we find out about these transcations?
are consolidated financial accounts that are used to track the net inflows and outflows of money to and from various sectors of a national economy.
So we say a flow of funds is a pitcutre of flows inflows from those units who are net savers to those who need funds, what does units actually mean?
Households
Government
Firms
Foreign investment( might borrow from other countries or lend to other countries)
How does a consolidated flow of funds look like on a diagram?
So households with suprlus funds, provide some money to the bank as depositis, then these banks, lend to deficit units, then maybe go to the stock market.
What is the idea of securitisation?
Securitization is the process of selling loans or accounts receivable to investors who buy them for their interest income.
The intermediary will bring together all these fianancial cotracts and sell them to other financial insitutions.
What is disintermediation?
Sometimes the transaction costs of using markets and intermediaries cannot be justified, and surplus units and deficit units contract directly
Calculate the net flow of funds
Households = 70 ( Net providers)
Firms = -60 ( Net users)
Government = ( Net users)
What does future value mean?
The amount an investmment is worth after one or more periods.
How do you calculate future value for investing for t periods?
What is the present value formula?
100/1.1^25 = 9.23
Maybe its enoughto draw customers but its certianity not 100
our company proposes to buy an asset for £335. This investment is safe, no risk. You would sell off the asset in three years for £400. You know you could invest the £335 elsewhere at 10 per cent also with no risk. What do you think of the proposed investment?
in(10000000) - In(2300000)/In(1.05) = 30.12
At 16% = In( 10000000) - In(2300,000) / In (1.16) = 9.902 years.
Find the future value in Year 5 of €2,000 invested at the end of each of the next five years. The current balance is zero, and the rate is 10 per cent per year.
So in year 1 you do 2000 X 1.1^4 years remaining
In year 2 you do 2000 x 1.1^3 remaining
In year 3 you do 2000 x 1.1^2 years remaining
In year 4 you do 2000 x 1.1^1 year remaining
In year 5, you dont compound
Add the totals up to get an answer of 12,210.00
If you deposit 100 Swedish kroner (SKr) in one year, SKr200 in two years, and Skr300 in three years, how much will you have in three years if interest rate is 7 per cent ?
Now we are going to look at the present value of mutiple cash flows?
Suppose you have an investment that pays back €1,000 each year for 5 years. If you can earn 6 per cent on your money, what is the present value of that investment?
So what is the general formula of calculating PV of a discounted stream of timed cash flows?
You are offered an investment that will pay you £200 in one year, £400 the next year, £600 the next year, and £800 at the end of the fourth year. You can earn 12 per cent on similar investments. What is the most you should pay for this investment today if the Law of One Price holds?
We have to find present value here
You are offered an investment that will make three €5,000 payments. The first payment will occur four years from today. The second will occur in five years, and the third will follow in six years. If you can earn 11 per cent, what is the most this investment is worth today?
Suppose we were examining an asset that promised to pay £500 at the end of each of the next three years. The cash flows from this asset are in the form of a three‐year £500 annuity. If interest rate is 10 per cent, how much would you have to pay for this annuity?
What is a shortcut to find the PV of a annutiy?
After carefully going over your budget, you have determined you can afford to pay €632 per month toward a loan for home improvements. You call up your local bank and find out that the going rate is 1 per cent per month for 48 months. How much can you borrow (i.e. PV)?
Now we are going to see how we can work out the constant payment of annuity formula?
You ran a little short on your springbreak, so you put €1,000 on your credit card. You can afford only the minimum payment of €20 per month. The interest rate on the credit card is 1.5 per cent per month. How long will you need to pay off the €1,000?
What is the formula for real interest rate?
How do you work out the effective annual rate?
Your credit card charges you 12 per cent compounded monthly. Is the Effective Annual Rate of Interest greater or smaller than 12%?
A bank is offering 12 per cent compounded quarterly. If you put £100 in an account, how much will you have at the end of one year? What’s the EAR? How much will you have at the end of two years?
The effective annual rate = [1 + Quoted rate/m]^m -1
[1+0.12/4]^4 = 1.12550881 ]
the end of 2 years = 100 x 1.03^8 = 126.68
or
100 x 1.125^2 = 126.88
As a lender, you know you want to earn effectively 18 per cent on a particular loan. You want to quote a rate that features monthly compounding. What rate do you quote to your borrower?
