Lecture 1 - The Role of Financial Markets Flashcards
1
Q
Real Assets
A
- They are used to produce goods and services
- Tangible (real estate) and non tangible (patents)
- E.g. Real estate, natural resources, land, machines, patents, factories, intellectual property, human capital/talent
2
Q
Financial Assets
A
- Do not contribute directly to productive capacity
- Claims on future economic outputs (on the income generated by firms real assets)
- Holding a firms equity confers ownership of part of the company and entitles the owner to part of the income/cash flows generated from using real assets
- E.g. stocks, bonds, deposits
3
Q
Security
A
- A security is a tradable financial asset that represents a claim on the issuers future income or assets
- It grants the holder ownership rights to a portion of the issuers property or financial resources
4
Q
Household Wealth
A
Real assets + Financial assets
5
Q
Deposit
A
A deposit in a bank is an asset for the holder while it is a liability for the bank which owes you the amount of your deposit
6
Q
Bond
A
A bond is an asset for its owner and a liability for the issuer
7
Q
Real vs Financial Assets
A
- Real assets generate net income to the economy
- Financial assets define the allocation of income or wealth among investors so indirectly contribute to the productive capacity of the economy
- They wont produce goods/services but create an environment where capital is efficiently distributed to productive uses
- Financial assets and the ability to sell/buy these assets in secondary financial markets allow the seperation of ownership and management
- Financial assets are liabilities for the issuers of the securities
- At the aggregate level, financial assets and liabilities cancel each other out leaving only real assets as the net wealth of the economy
8
Q
Balance Sheets
A
- Households’ vs total economy’s real assets different as the real assets held by firms are included in households balance sheets as financial assets
- Households own more financial than real assets
- Real assets only in the asset side of the balance sheet
- Financial assets both on the asset and liabilities side of the balance sheet
9
Q
Examples of real assets
A
Intellectual property, factory, university degree
10
Q
Example of financial assets
A
Lease obligation, money
11
Q
An efficient financial system
A
- Provides options for savers to mitigate risks they are unwilling to bear typically through fair priced mechanisms such as insurance contracts (referred to as risk shifting)
- It is not possible to completely eliminate risk without incurring additional costs as financial assets with lower risk typically come with higher prices or lower expected returns to compensate for the reduced uncertainity
12
Q
An efficient financial system also
A
- Allows diversification
- Facilitates the sharing of risks often achieved through processes like asset transformation
13
Q
Why do we need financial markets?
A
- Financial markets channel funds from savers (those with surplus funds) to borrowers (entrepreneurs and firms needing capital)
- They ensure resources are allocated to their most productive uses promoting economic growth
- Enable entrepreneurs and firms to finance their ideas, research and expansion plans - Financial markets help in price discovery for financial assets improving decision making for investors
- Directly improve the well being of consumers by allowing them to smooth spending over time (mortgage for home, student loans)
- Facilitate diversification and the transfer or risks through different financial assets
- Provide liquidity by enabling quick buying and selling of assets
14
Q
Price discovery
A
Is the process by which the market determines the price of a financial asset through the interaction of buyers and sellers
15
Q
Financial Intermediaries
A
- Bring the suppliers of capital (investors) together with the demanders of capital (primarily corporations and the federal government)
- Move funds from one sector to another: that is why their assets are mostly financial
- Banks raise funds by taking deposits (borrow) and lending money –> interest rates differential creates profits
16
Q
There is an apparent conflict of interest
A
- Lenders want risk free, liquid and low cost assets + Borrowers need long term risk bearing capital = Underinvestment
- Financial intermediaries facilitate the flow of funds by lowering the cost
17
Q
Financial intermediaries: indirect finance
A
- Financial intermediaries lower transaction costs
- Low transaction costs allow reduction of risk
18
Q
Financial intermediaries lower transaction costs
A
- By leveraging economies of scale: their large scale operations allow them to spread fixed costs over a broad customer base, making financial services most cost effective and accessible for both savers and borrowers
- By acting as brokers and minimising search costs: through their expertise and networks, they efficiently connect buyers and sellers, streamlining the process of finding suitable financial opportunities and enhancing market liquidity ultimately benefiting participants in the financial ecosystem
19
Q
Low transaction costs allow reduction of risk through
A
- Risk sharing/maturity and volume transformation (asset transformation)
- Create financial instruments with risk and maturity - profiles that people are comfortable with and sell it to them e.g. deposits –> purchase other assets with longer maturity and higher risk e.g. mortgages earning a profit on the spread between returns on riskier assets and those from the less risky instruments initially sold to customers
- Diversification of their portfolio by pooling a collection of assets into a new asset and then selling it to individuals
20
Q
Information Asymmetries
A
- Decisions are made ex ante (beforehand) based on less than complete info and sometimes with counterparties who have superior info (info asymmetry) with the potential of exploitation
- But, info is not free
- Info asymmetries manifest in two phases: before a transaction (adverse selection) + after a transaction (moral hazard)
- Adverse selection relates to the uneven distribution of info between parties prior to a deal, while moral hazard involves a lack of info control after the transaction is completed
21
Q
Adverse selection in financial markets
A
- The potential borrowers more likely to produce an undesirable (adverse) outcome e.g. those who are in financial distress/poor credit history/get-rich-quick schemes are the ones most actively seeking out a loan and are thus most likely to be selected
- More likely that loans might be made to bad credit risks, lenders may decide not to make any loans even though there are good credit risks seeking out funds for responsible purposes in the marketplace
22
Q
Moral hazard in financial markets
A
- Is the problem created by asymmetric info after the
transaction occurs - The risk (hazard) that the borrower might engage in activities that are undesirable (immoral) from the lender’s point of view because they make it less likely that the loan will be paid back
- More accurately borrowers’ actions influence the expected return on the investment
- Because moral hazard lowers the probability that the loan will be repaid, lenders may decide that they would rather not make a loan
23
Q
Examples of moral hazard
A
- Bailouts of financial institutions/firms/countries.
- Government bailouts of banks create moral hazard by encouraging them to expect rescue during crises
- This expectation reduces their incentive to lend cautiously or monitor risk, effectively rewarding
reckless behavior - Deposit insurance might lead to an exaggerating appetite for risk
- People who buy insurance are more likely to take risks
24
Q
Information asymmetries: in practice
A
- If a lender wants to pursue a higher expected return strategy she will always charge a higher interest rate on the loan
- Low-risk borrowers will increasingly withdraw from the market as interest rates rise
- Rising interest rates prompt low-risk borrowers to exit the market preferring to consume their resources rather than accept high rates
- This results in a diminishing pool of creditworthy applicants, lowering the average creditworthiness of the lender’s remaining applicant pool
- The size of the adverse selection premium faced by low-risk borrowers (the amount of interest low-risk borrowers have to pay in excess of what their project risks warrant) becomes larger with each interest rate rise because the interest rate must compensate for the default risk of an ever-worsening pool of borrowers
25
Q
Higher interest rates impact lender returns in 2 ways
A
- First, they directly boost the lender’s return for a specific pool of borrowers
- However, as interest rates rise, there’s an indirect consequence: the average quality of the lender’s applicant pool decreases, leading to a lower expected return on individual loans
- Over time, this adverse selection effect, where the quality of borrowers diminishes may surpass the initial positive impact of higher interest rates
- Only the most risky borrowers will be ready to accept a loan at a very high price
26
Q
Corporation
A
- Is a legal entity that is separate and distinct from its owners (shareholders)
- It is created under the laws of a particular jurisdiction and is granted certain legal rights and responsibilities
- A corporation is owned by its shareholders but is legally distinct from them
- Therefore, the shareholders have limited liability, which means that they cannot be held responsible for the corporation’s debts
27
Q
Seperation of ownership and management
A
- In theory, shareholders as owners of the firm control its operations
- In practice, firms have tens of thousands of shareholders
- So, firms’ shareholders elect a board of directors which hires + supervises the management of the firm
- Even if the managers change, the corporation continues its operations
- Ownership structure does not affect firms’ management
- Stability: a corporation has an indefinite lifespan + its existence is not dependent on the status of its individual shareholders
28
Q
What should be the overriding objective of corporations?
A
- The company should make investment and financing decisions with the aim of maximising long term shareholder wealth
- Financial markets in a free-market system provide some discipline
- It’s worth noting that maximizing shareholders’ wealth doesn’t imply disregarding the interests of other stakeholders such as employees, customers, creditors, managers, and society as a whole
- Instead, it recognises that a company’s success is often reflected in its ability to generate value for its shareholders while considering the broader impact on society and the environment
29
Q
Public companies
A
- Public companies are those whose ownership shares are available to the general public through public stock exchanges
- These companies have gone through an IPO issuing shares of stock to the public in exchange for capital investment
- Public companies have their shares listed on stock exchanges NYSE or the London Stock Exchange (LSE)
- This allows investors to buy and sell shares through the exchange
30
Q
Investment decision =
A
Purchase of tangible and intangible real assets (capital budgeting decisions also called capital expenditure or CAPEX decisions)
31
Q
Financing decision =
A
Sale of financial asset
32
Q
Investment within a firm
A
- Investment within a firm needs to create value for its shareholders
- Allocating money to a particular division or project → generate cash inflows in the future significantly greater than the amount invested.
- Significantly greater: the time value of money + the investor’s opportunity cost (the sacrifice of the return available on the best forgone alternative)
- Investments must generate at least enough cash for all investors to obtain their required returns
- If they produce less than the investor’s opportunity cost then the wealth of shareholders will decline
33
Q
Time value of money
A
Compensation is required to induce people to make a consumption sacrifice
34
Q
Compensation will be required for at least 3 things:
A
- Impatience to consume
- Pure rate of interest rate: rate of exchange between certain future consumption and certain current consumption - Inflation
- Risk
35
Q
Total required return
A
Required return = risk free return (RFR) + risk premium
36
Q
Investor’s opportunity cost of capital
A
- Unless the company’s operations are risk free, its cost of capital should be higher
- The company could consider expected returns on assets with similar risk
37
Q
Capital structure decision
A
- A corporation can raise funds from lenders (debt) or from shareholders (equity)
- The decision is between debt and equity financing is called the capital structure decision
38
Q
Capital
A
Refers to the firm’s sources of long term financing
39
Q
Equity financing features
A
- Being an equity holder confers voting rights
- Shareholders receive dividends but are not promised any
- Shareholders are residual claimants
- An investment in equity is tied directly to the success of the firm and its real assets
40
Q
Being an equity holder confers voting rights
A
- Being an equity holder not only provides individuals with a share in the company’s ownership (have prorated ownership in the real assets of the firm) but also confers voting rights allowing them to participate in important decision making processes (for common shares it is normally 1 share - 1 vote)
- From the company’s perspective this is a disadvantage as entrepreneurs/current shareholders might lose control of their company (dilution of control)
41
Q
Shareholders receive dividends but are not promised any
A
- From company’s perspective this is:
- an advantage as company is not obliged to pay for their funds while interest payments are compulsory
- also a disadvantage as dividends are not tax deductible while interest payments on debt are
42
Q
Shareholders are residual claimants
A
Individuals or entities who hold the residual claim on the company’s earnings and assets after all obligations and claims have been satisfied
43
Q
An investment in equity is tied directly to the success of the firm and its real assets
A
- There is no guarantee that an ordinary shareholder will receive back the original amount invested
- From the company’s perspective this is an advantage as the capital invested does not have to be repaid to the shareholder while debt has a redemption date
- Equity capital is a shock absorber against adverse business conditions
44
Q
Debt financing
A
- If a company borrows, the lenders contribute the cash, and the corporation promises to pay a back the debt (principal) plus a fixed (but sometimes determined by a formula) rate of interest
- Debtholders of a company have a higher priority than shareholders in the case of liquidation
- A company with debt capital is required to regularly repay the capital borrowed plus interest regardless of its operational performance
- Debtholders typically have no official control over the company’s decisions
45
Q
Debt covenants
A
- Debt financing typically comes with debt covenants
- Debt covenants are contractual obligations incorporated into loan or debt agreements to safeguard the interests of lenders and ensure the borrower’s compliance with specific financial and operational terms
46
Q
Affirmative covenants
A
- These require the borrower to actively maintain certain conditions or take specific actions
- E.g. requirement to pay interest and principal, supply regular financial statements, maintain a minimum level of insurance coverage or adhere to certain operating practices
47
Q
Restrictive covenants
A
Restrict borrower from engaging in certain activities or behaviours that might jeopardize the lender’s interests
48
Q
Categories of Loan Stock
A
- Debentures
- Unsecured loan stocks
49
Q
Debentures
A
Loans that have been secured on some or all of the assets of the company
50
Q
2 types of debentures
A
- Mortgage debentures
- Floating charge debentures
51
Q
Mortgage debentures
A
- Fixed charge
- Specific and identifiable secured assets e.g. land and buildings
52
Q
Floating charge debenture
A
The company can change the secured assets in the normal course of business e.g. company’s current assets such as inventory and receivables
53
Q
Unsecured loan stocks
A
- With unsecured loan stocks there is no specific security for the loan
- In case of liquidation unsecured loan stockholders rank beneath debenture holders along with all other creditors
- Cost for the borrower is higher than debentures because of the additional risk for the unsecured loan stockholders
54
Q
Why is equity financing more expensive for the company than debt financing?
A
- Equity investors expect a return on their investment in the form of dividends (uncertain) and/or capital appreciation (uncertain but theoretically unlimited)
- In contrast, debt financing involves paying interest on the borrowed amount + return of principal (company is contractually obliged to deliver regardless of company’s profitability)
- So, equity investment is riskier than debt investment from the viewpoint of investors
- Equity investors are residual claimants in the event of liquidation or bankruptcy => they demand a higher return as compensation for the risk they undertake
- Interest payments on debt are typically tax-deductible, providing a tax shield for companies
- This reduces the effective cost of debt financing
- In contrast, returns to equity investors are not tax-deductible, making equity financing less taxefficient for the company
