Session 1 - Kolb - Ethical implications of finance

Question 1

Give the key assumptions in finance

Answer 1

1. Rationality and self-interest : preferring more to less, maximisation, individual pursuit of pecuniary wealth, all in monetary terms. Finance knows it is not realistic
2. Financial theory of the firm : Corporate is the property of shareholders, managers are agents of the shareholders

Question 2

What is the constrained optimisation problem we are facing ?

Answer 2

Maximise shareholder wealth, subject to a variety of constraint

Question 3

Give the 9 important concepts in finance

Answer 3

1. Time Value of money : 1CHF today is worth more tomorrow
2. Risk, risk aversion and expected return : risky investments must have higher promised return than risk-less investments
3. Price of risk-bearing services : In finance, an investor is entitled to the risk-free rate and deserves a compensation for bearing undiversifiable risk.
4. Net present value and corporate financial management : firms should undertake projects that have a positive net present value
5. Finance, corporate governance and the goal of the firm : CAPM/SML showed that if projects benefit society is completely irrelevant in financial management
6. Efficient Market Theory (EMH) : EMH pertains to information efficiency in financial markets.
7. Option pricing theory : For every option, there must be a buyer and a seller, it is a zero-sum game
8. Risk management : it can reduce costs of a financial distress and bankruptcy, increasing the firm’s value
9. Behavioural Finance : departs from classic of rationality and attempts to understand human behaviour that fails to confirm to classic theories

Question 4

Which rate should the firm select to discount cash flows

Answer 4

The appropriate discount rate is given by the Security Market Line (SML), because a project with a given systematic risk should be discounted at the market’s equilibrium rate of return matching that systematic risk

Question 5

Explain when a market is efficient

Answer 5

A market is efficient with respect to a given information set if prices in that market at all times fully reflect that information

Question 6

Give the 3 versions of EMH (Fama, 1970)

Answer 6

1. Weak : security prices reflect all historical information
2. Semi-strong : security prices reflect all publicly-available information
3. Strong : Securities prices reflect all information whether public or private

Question 7

Give the main issue about EMH

Answer 7

If information is already reflected in prices, it must be because market participants have already absorbed that information and acted on it. The truth of the EMH depends on the immediate absorption of the information that the EMH holds to be irrelevant to guiding a trading strategy… If the semi-strong EMH is true, investors can be free-riders.