L1 - Introduction

Question 1

What is a Financial System?

Answer 1

• A set of institutions and markets permitting the exchange of contracts and the provision of services for the purpose of allowing the income and consumption streams of economic agents to be desynchronized—i.e., made less similar.
• Two dimensions to this function:
  
  • The time dimension
  • The risk dimension
• The time dimension allows smoothing consumption over time (The life-cycle patterns of income generation and consumption spending are not identical)
• In a timeless world, there would be no assets, no financial transactions, and no financial markets or institutions –> no difference between today and tomorrow then all assets would be worth the same over time as they do not need to account for any time or risk dimensions

Question 2

How can we represent an individuals wealth over a simple 2-period model?

Answer 2

• be compensated for the time you wait and the uncertainty of tomorrow

Question 3

What does the Consumption and Saving model look like?

Answer 3

• the financial system allows you to consume more than what you earn in period two as we can invest our income from period 1

Question 4

What is the risk dimension of desynchronisation?

Answer 4

• Financial decisions with implications (payouts) in the future are necessarily risky.
• Time and risk are inseparable. This is why risk is the second key word in finance.
• “Risk averse” individual would like to also experience similar consumption levels across all “future states of nature”, whether good or bad.
• By permitting economic agents to diversify, to insure, and to hedge their risks, an efficient financial system fulfills the function of redistributing purchasing power not only over time, but also across states of nature

Question 5

What is Financial Economics?

Answer 5

• Financial economics is a branch of economics that analyzes the use and distribution of resources in markets. Financial decisions must often take into account future events, whether those be related to individual stocks,
• Financial assets are claims to wealth generated by real assets.
• Indeed, it’s is nothing else than the right to future cash flows, whether these future cash flows are the result of interest payments, dividend payments, insurance payments, or the resale value of the asset.
• The key question in finance is, “How do we value a risky cash flow?”
• How a firm generates and protects the cash-flow streams is at the core of corporate finance. But all these decisions at firm level, individually and collectively, influence the firm’s free cash-flow stream and, as such, have asset pricing implications
• More risky an asset the more there is a fluctuation in price and the higher the return they generated

Question 6

Investment in alternative assets for differing time horizons?

Answer 6

Question 7

Why is diversification important?

Answer 7

• Due to the risk-return potential of different asset classes