Finance and Financial Management Notes
Lecture 1: The Basics
What is Finance and how does it relate to Economics?
• What is Economics ?
o Economics: The social science that studies the production, distribution, and
consumption of goods and services.
o Focused on analysing behaviour and maximising welfare
(Positive vs Normative analysis) → This module will look @ (+ve) analysis
• Natural Question :
o What if there were money in this economy → (Where finance comes in, the study of
money in an economy)
o Standard reasons for money: store of value (money doesn’t depreciate that fast), medium
of exchange, unit of account (way of comparing goods)
• The traditional model for Economics vs New model for Economics (Includes money)
The money part of the model – can now buy
stocks of that firm
What is Academic Finance? How does it differ from Practice?
What is finance:
• Finance is the study of investments
,What is the purpose of financial markets?
• Setting prices → The aggregation of information into financial prices
• Transferring Risk → Hedging your risk (i.e. if you lose your job or the prices of things
changing) you can offset the risk by investing in a company
What is the purpose of academic finance: (The six biggest fields)
• Asset Pricing (time and risk value of money): How to value assets. Allocation across time
(debt and equity) and states (risk and portfolio management). → The biggest subfield
of finance & what we mainly focus on in this module
• Corporate Finance: How firms fund themselves. Capital structure and management.
• Market Microstructure: Understanding how people trade. Types of traders,
motivations from trade, and effects of trading processes on the market.
→Understanding how prices are set and what they mean
• Financial Economics: Embedding a financial market in a real one - trying to
understand feedback between the two. → Putting a financial market into an
economic model
• Mathematical Finance: Modelling price movements and/or security fundamentals
with mathematical formulae. → derivative contracts
• Behavioural Finance: Understanding the ‘non-rational’. → However in the class we
are looking at rational investors
What are important assumptions in the models we use?
• Agents(people) are selfish → People only care about maximising their own utility, not other
peoples
• Investors prefer more to less → In terms of money
• Investors don’t like risk → True for most cases
• Investors prefer money now to later
• No such thing as a free lunch → Meaning most arbitrage opportunities are short lived and
we assume we don’t have access to these arbitrages
• Financial Market Prices shift to set S = D → Eventually supply will equal demand (market
equilibrium)
• Risk Sharing and Frictions are central to Financial Innovation. → Meaning because of all
these financial risks in the real world, people try to financially innovate to minimise their
own risk exposure
• Don’t say that a model is unrealistic!
Types of Securities:
Debt Instruments: Ways to borrow and lend money
• Also called fixed income because the cash flows on the debt is fixed (we already know all the
details of the repayment i.e. regular known payments) (coupons = interest payments)
• The only cash flows are the purchase, coupons, and principal:
Graphical way of looking at an asset
,Examples of debt instruments:
• Bonds:
o Treasuries → Debts/Loans issues by a Government
Seen in term structure of interest rates – (below)
Has the backing of a Gov
o Corporates → Debts/Loans issued by a Company
Seniors get paid first, so juniors get a slightly better deal
than seniors because seniors get first dibs in a company’s
assets if it goes bankrupt while juniors don’t. But seniors get
a lower return on investment in exchange
Corporates can go bankrupt (more risk involved)
Credit Risk Liquidity Risk
The Bond Market:
The Yield Curve: The term structure of interest rates
The higher the term structure for a bond the higher the
return, so 30 years typically has the highest return
For the spikes where 3 or 6 months, takes over 10 or 30
years can be justified by people seeing more worth in a
bond where they can get their money back sooner and with
an extra bonus on top that’s less than what you’d get if you
waited for a 10 year bond and (at lease their money isn’t
locked up for 10 years →( Time Value of Money )
, • Equity → Issuing of shares: so selling a part of your company for some money
o No maturity
o Cash flows are stochastic → They’re random so a business can flop or be successful
o Cash flows are subordinate to debt - senior, junior
o Equity Indices :
Take the price of 30 diff stock
& average them
Total size of each
company & average that
• The Equity Market :
• Derivatives → A financial asset whose value is derived from other assets (stocks, bonds, currencies)
Each of these derivatives tend to serve a
place in the hedging and speculative
worlds
• The VIX→ An index calculated by option prices (also called the fear index)
Options trading market → that tells us
what market participants expect the
volatility of the S&P to be over the next
30 days (forward looking measure)
Lecture 1: The Basics
What is Finance and how does it relate to Economics?
• What is Economics ?
o Economics: The social science that studies the production, distribution, and
consumption of goods and services.
o Focused on analysing behaviour and maximising welfare
(Positive vs Normative analysis) → This module will look @ (+ve) analysis
• Natural Question :
o What if there were money in this economy → (Where finance comes in, the study of
money in an economy)
o Standard reasons for money: store of value (money doesn’t depreciate that fast), medium
of exchange, unit of account (way of comparing goods)
• The traditional model for Economics vs New model for Economics (Includes money)
The money part of the model – can now buy
stocks of that firm
What is Academic Finance? How does it differ from Practice?
What is finance:
• Finance is the study of investments
,What is the purpose of financial markets?
• Setting prices → The aggregation of information into financial prices
• Transferring Risk → Hedging your risk (i.e. if you lose your job or the prices of things
changing) you can offset the risk by investing in a company
What is the purpose of academic finance: (The six biggest fields)
• Asset Pricing (time and risk value of money): How to value assets. Allocation across time
(debt and equity) and states (risk and portfolio management). → The biggest subfield
of finance & what we mainly focus on in this module
• Corporate Finance: How firms fund themselves. Capital structure and management.
• Market Microstructure: Understanding how people trade. Types of traders,
motivations from trade, and effects of trading processes on the market.
→Understanding how prices are set and what they mean
• Financial Economics: Embedding a financial market in a real one - trying to
understand feedback between the two. → Putting a financial market into an
economic model
• Mathematical Finance: Modelling price movements and/or security fundamentals
with mathematical formulae. → derivative contracts
• Behavioural Finance: Understanding the ‘non-rational’. → However in the class we
are looking at rational investors
What are important assumptions in the models we use?
• Agents(people) are selfish → People only care about maximising their own utility, not other
peoples
• Investors prefer more to less → In terms of money
• Investors don’t like risk → True for most cases
• Investors prefer money now to later
• No such thing as a free lunch → Meaning most arbitrage opportunities are short lived and
we assume we don’t have access to these arbitrages
• Financial Market Prices shift to set S = D → Eventually supply will equal demand (market
equilibrium)
• Risk Sharing and Frictions are central to Financial Innovation. → Meaning because of all
these financial risks in the real world, people try to financially innovate to minimise their
own risk exposure
• Don’t say that a model is unrealistic!
Types of Securities:
Debt Instruments: Ways to borrow and lend money
• Also called fixed income because the cash flows on the debt is fixed (we already know all the
details of the repayment i.e. regular known payments) (coupons = interest payments)
• The only cash flows are the purchase, coupons, and principal:
Graphical way of looking at an asset
,Examples of debt instruments:
• Bonds:
o Treasuries → Debts/Loans issues by a Government
Seen in term structure of interest rates – (below)
Has the backing of a Gov
o Corporates → Debts/Loans issued by a Company
Seniors get paid first, so juniors get a slightly better deal
than seniors because seniors get first dibs in a company’s
assets if it goes bankrupt while juniors don’t. But seniors get
a lower return on investment in exchange
Corporates can go bankrupt (more risk involved)
Credit Risk Liquidity Risk
The Bond Market:
The Yield Curve: The term structure of interest rates
The higher the term structure for a bond the higher the
return, so 30 years typically has the highest return
For the spikes where 3 or 6 months, takes over 10 or 30
years can be justified by people seeing more worth in a
bond where they can get their money back sooner and with
an extra bonus on top that’s less than what you’d get if you
waited for a 10 year bond and (at lease their money isn’t
locked up for 10 years →( Time Value of Money )
, • Equity → Issuing of shares: so selling a part of your company for some money
o No maturity
o Cash flows are stochastic → They’re random so a business can flop or be successful
o Cash flows are subordinate to debt - senior, junior
o Equity Indices :
Take the price of 30 diff stock
& average them
Total size of each
company & average that
• The Equity Market :
• Derivatives → A financial asset whose value is derived from other assets (stocks, bonds, currencies)
Each of these derivatives tend to serve a
place in the hedging and speculative
worlds
• The VIX→ An index calculated by option prices (also called the fear index)
Options trading market → that tells us
what market participants expect the
volatility of the S&P to be over the next
30 days (forward looking measure)
