Dorene Dang

AFM271
Wednesday May 9 2012

AFM271: Lecture One: Overview of the Financial System

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financial market: market where funds are transferred from people who have an excess
of available funds to people who have a shortage
o allows people with growth opportunities to expand
o key factor in economic growth
debt market: allows corporations and businesses to borrow in order to finance
activities
o also known as a bond market
o interest rate = the cost of borrowing
differences between financial markets and financial intermediaries:
o FM = raised through equity, collective place to buy and sell financial assets
ex: stocks, bonds
o FI = raised through debt, business that move money from individuals to FM
ex: banks, ins. companies, mutual and hedge funds

flow of funds:
direct finance: borrowers borrow
directly from lenders by selling
securities in FM
indirect finance: borrowers borrow
funds from the FM through FI

functions of financial markets:

o 1) aggregates and centralizes buyers and sellers of financial assets to facilitate
price formation
stock exchanges centralize buyers all around the world
centralize global wealth (Igloo example)
important because it limits competition and has market completeness
o 2) provides a mechanism for investors to sell a financial asset
FM makes it easier to sell shares
if youre not guaranteed a seller, youd expect a higher refund
there is a large outstanding amount of shares to ensure people buy
there is a trading minimum that must be met for each company if
not, the company is removed from the exchange
liquidity provision: because there are so many buyers and sellers,
there is an ease of selling an asset at fair market value
o 3) reduces search and information costs of transacting in financial assets
finding out how much a company is worth can be done easily by
buyers and sellers

Dorene Dang
AFM271
Wednesday May 9 2012

reduces information asymmetry: both buyer and seller have

information to come up with a value
o 4) creates small denomination / aggregated instrument
lets you buy a small amount of the company
you cant afford Apple Inc. alone
asset aggregation allows many people to buy
higher liquidity
if bankruptcy, lowers loss per person
financial intermediaries:
o 1) depository institutions (banks, lending institutions)
o 2) contractual savings institutions (insurance companies, pension funds)
o 3) investment intermediaries (finance companies, mutual funds)
roles of financial intermediaries:
o 1) Liquid provision and economies of scale
FI have expertise and are large they can take advantage of
economies of scales to lower transaction costs
liquidity for lenders to FI chequing accounts
o 2) Mitigation of adverse selection costs
information asymmetries occur between borrowers and lenders
managers of a business know more about the firms prospects than
investors
because of this, the ability to interpret and evaluate firm
communications varies across investors
FI act on the behalf of investors with their expertise (ex: mutual
funds)
o 3) Mitigation of moral hazard
moral hazard: not knowing what a company is using an investors
funds for
FI can monitor the actions of managers inexpensively via economies
of scale
also will have more influence than a single investor
components of risk:
o 1) time: inflation + deferred consumption
o 2) uncertainty: payoff uncertainty
unifying principles of finance:
o assumption of a perfect market
broad set of financial assets are being trades, contracts are
enforceable, participants are free to enter and exit, no frictions with
trading
o 1) Markets are arbitrage free
with no initial investment, there are non-negative payoffs
you dont get a free lunch
o 2) Each investor has a preference sequence expressed by his expected utility
investors do not go in blind
utility: total satisfaction received from consuming a good or service
o 3) Each investor seeks to optimize his utility
o 4) Market equilibrium determines prices in terms of fundamentals

Dorene Dang
AFM271
Wednesday May 9 2012

there is an expectation of future cash flow and investors lean towards

investing where they will get cash flow

AFM271: Lecture Two: Overview of Security Types

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1) Interest-bearing
o fixed-term, non-negotiable
o requires regular interest payments that are deductible for the firm
o no ownership on the firm
o debt holders are paid off before equity holders in the event of bankruptcy
1) money market instruments: less than 1 year, purchased at a
discount, no fixed payments, extremely liquid
2) fixed income instruments: more than a year, purchased at face
value, interest payments and principle at the end
ex: bonds: issued at coupon rate, coupon frequency
o face value at maturity are also realized
2) Equity
o no fixed-term lifespan of company
o payments in the form of dividends, not mandatory by the company however
non-deductible
o represents ownership of the firm
1) common stock: ownership with voting rights), dividends issued
2) preferred stock: (same as common stock) dividends usually
become fixed at some point in time
at bankruptcy, preferred stocks are paid out at face value
before distribution to common stockholders
value of stocks = value of company
3) Derivative
o value is derived by an underlying asset
1) future: binding contract (obligations) to buy or sell at a future point
in time
features: quantity
delivery logistics (date, time, place)
2) option: premium paid by buyer or seller for them to have the right
but not obligation to buy or sell
call option: buyer has choice
put option: seller has choice
o used for:
hedging: offsetting some risk associated with a given market
commitment
insurance: reduces or eliminates downside exposure