Financial Management Handouts

Financial Management
Aneel Keswani
Topic 1: Introduction to the Financial

Markets
COURSE OBJECTIVES
Course provides an overview of various
financial instruments and the marketplaces in
which they are traded and a detailed analysis of
stock, bond and derivative valuation.
Alternative pricing models and their
limitations, the tradeoffs between risk and
return will be analysed.
COPYRIGHT ANEEL KESWANI 2
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CONTACTING ME:
Best method email

Email: a.keswani@city.ac.uk
Will normally reply in 24 hours
What You Need
a. Texts:
Investments, Bodie, Kane, and Marcus, 6th Edition,
Irwin/McGraw-Hill.
b.Additional Reading Material
i. Reading Pack available from undergraduate office.
ii. Any additional material will be distributed to you
before you require it.
c. Calculator:
A scientific calculator is required. Your calculator
must be able to calculate exponential functions and
natural log functions.
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Outline of Lecture 1
Real versus Financial investments
The players in the financial markets
The taxonomy of markets
Calculating returns
Realised versus expected returns
Real versus nominal rates of return
Arithmetic versus geometric returns
Returns on indices
Historical evidence on risk and return
characteristics of stocks & bonds
Real versus Financial Investments

Wealth of economy determined by the
goods and services that can be provided to
its members
Production capacity is a function
(dependent on) of the real assets of the
economy
Land, buildings, human capital, machinery
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Real Investment
Inputs
Capital Income
Labour Companies &
Final goods
Land Wealth
Raw materials
Real versus Financial Investments

Financial assets are claims on the incomes
of real assets
Financial assets define the allocation of
income or wealth among investors.
Do not contribute to wealth of a society
directly.
They contribute indirectly
How do financial assets contribute to wealth
of society then? More broadly, how do they
enhance social welfare?
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Financial assets allow us to make the most of
the real assets in the economy by allowing:
1. Efficient risk allocation:
A diversity of financial assets means that
investors can self-select the securities with
the risk-return that suits them
The risk inherent in all investments is borne
by investors most willing to bear risk
Good for firms: means that each security
can be sold for the best possible price
Example: Efficient Risk Allocation

Older people may like risk less
Can select securities that are less risky
Old Less Risky
Young More Risky
Young can select riskier investments if they

like
Older person would pay less than a younger
person for an investment in a risky project
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Financial assets allow us to make the most of
the real assets in the economy by allowing:
2. Separation of management and ownership
If a firm was managed and owned by the
same person, then if he chooses to sell it
affects the management of the firm
However if a firm is owned by shareholders
and run by managers, then shareholders can
sell without any impact on the management
of the firm
Financial assets contribute to social welfare

by allowing:
3. Consumption Smoothing
Financial assets allow us to shift purchasing
power from high earnings periods to low
earnings period
Buy financial assets when earn well and sell
when do not
Can shift consumption through course of
lifetime
Assets help to improve welfare of society in
this way
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Summary: Real vs Financial
1. Real assets are income generating. Financial
assets are claims on the income of real assets.
Financial assets define the allocation of
income or wealth among investors.
2. Financial Assets contribute to social welfare
by allowing:
Efficient risk allocation
Allow separation of ownership & management of
companies
Consumption Smoothing
The Players
Households
Non financial business sector
Financial intermediaries
Government sector
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Households
Households choose how much to consume and
how much to save.
Not interested in their consumption vs saving
decision. Our concern is with which assets
households wish to hold
What determines which financial assets
households want? Many things. Including:
Differences in risk tolerance-create demand for
assets with different risk-return combinations
Tax situation-High tax bracket investors seek tax
free investments.
Financial Innovation
Development of new financial assets driven
by needs of people to protect themselves
against a variety of risks
E.g. Consider person from New York who
wishes to retire to Florida in 15 years.
Exposed to risk that relates to the relative price
of New York vs Florida housing
Florida real estate investment trusts (REITs)
developed as a result. They increase in value
when house prices in Florida increase
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Non-Financial Business sector
Primarily concerned with how to raise

money by selling financial claims on their
real assets for investment purposes
In doing so they want to achieve 2 things:
Get the best price for their securities. Helped by
diversity of financial assets
Reduce the costs of security issuance. Farm out
security issuance to a firm that specialises in
issuing such securities and therefore has
economies of scale
Financial Intermediaries
The financial problem facing households is
how to invest their funds
Difficult for a small investor to advertise
and say that they have funds available to
lend to companies
Financial intermediaries e.g. banks,
investment companies, pension funds, act to
bring the business sector and households
together
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The Matching Problem
Households Business Sector
HH 1 Project 1
Different Different
HH 2 Financial Project 2
wealth risks
HH 3 Intermediaries Project 3
and and
HH 4 Project 4
preferences sizes
HH 5 Project 5
Roles for Financial Intermediaries?

1). Co-ordinate lenders and borrowers
A bank raises funds by accepting deposits. It lends that money.
Lenders and borrowers do not need to be matched together-
simply come to common intermediary
2). Pool resources of investors enabling large loans
3). Allow diversification in lending-can make risky loans
4). Allow greater investment diversification for households
Expensive to buy one share in each company-transactions costs.
Economical for shares to be purchased in blocks. e.g. Investment
companies, Unit trusts, Mutual Funds
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Government sector
Governments have existing stock of debt
(national debt) and also incur new debts each
year if expenditure exceeds tax receipts
Can use borrowing in financial markets to pay
debts
Raise money in financial markets
Cant sell shares in themselves
Borrow money via various types of debt market
securities that pay a pre-determined set of cash flows
Regulate financial markets
Taxonomy of Markets
Debt Markets
US Treasury Bills, Notes, Bonds
UK Government Gilts
Corporate bonds
Equity Markets
Derivative Securities
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Debt Markets
Companies and governments can raise money by
selling debt or bond securities
The issuer sells the security to a buyer today
For the security, the issuer receives money today
The issuer is borrowing money from the buyer
Thus we can call the buyer the lender & the issuer the
borrower
The issuer will promise to repay the lender
either in one go in the future or will pay a sequence of
interest payments & then will repay the outstanding loan
itself COPYRIGHT ANEEL KESWANI 23
Debt vs Loans
Sells Debt Loan
Borrower Lender
Initially Borrower Lender
= =
Issuer Buyer
Pays for
debt security
interest interest
Time
interest interest
Borrower Repayment Lender Repayment

Maturity Borrower Lender
= =
Issuer Buyer
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Debt Markets
Size of cashflows paid on debt securities is
predetermined at the time of issue
Either fixed in advance in cash terms (10 per year)
Or determined as a function of a reference interest-rate
(market interest rate + premium)
Issuer or borrower can choose to default or not
default. Cant determine size of repayment
If required to pay 10 issuer cant decide to pay only 5
Market enhanced by fact that debt can be sold on by
initial buyer: sold on at price that reflects market
conditions at time of sale
US Treasury market
The United States Treasury regularly issues
debt securities with maturities ranging from
a few days to 30 years
Such securities are known as Treasury
securities
These are regarded by the investment
community as risk free
This is because US government stands ready to
pay the necessary obligations to any investor
who buys the securities
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US Treasury market
Securities issued by the Treasury with the maturity of
less than or equal to one year at the time of issue are
called Treasury bills or T-Bills
such securities do not pay any coupons and may be purchased
at a discount to their face value
Treasury securities that pay coupons and have maturities
in the range of 1 to 10 years at the time of issuance are
called Treasury notes
Treasury securities that have maturities in excess of 10
years are called Treasury bonds .
Maturities of Treasury bonds generally extend to 30
years. The 30 year T-Bond is known as the Long Bond
UK Government Gilts
Gilt edged stock or gilts are British government
debt securities
Standard gilts carry fixed, annual coupons and pay
the face amount at maturity
In addition to the standard gilts, the British
government issues:
Index-linked gilts: coupon and face amounts
indexed to the UK retail price index
Perpetuals: Perpetuals have no maturity date:
just pay coupons
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Corporate bonds
The main risk of investing in corporate bonds
is that the issuer may choose to default on the
bonds
This risk is known as default or credit risk
As a result if we were to compare a corporate
bond with identical cashflows to a US Treasury
bond, the corporate bond would trade at a
lower price reflecting these additional risks
Equity Securities
Represent shares in companies.
Most shares can be traded on stock exchanges
An investor earns money from equity
securities through
Dividends: Paid regularly: size at discretion of
company issuing shares
Capital gains-increase in price of the share
between buying and selling
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Two most important features of equity are:
Residual claim:
Shareholders are last in line of all of those who
have a claim on the company-if a firm goes
bankrupt then shareholders have a claim after tax
authorities, suppliers, bondholders have been paid
Limited Liability
Shareholders own part of the firms they invest in.
Thus shareholders are like owners
BUT shares are limited liability which means that
the most that can be lost by shareholders is the
value of the security: cant take their house
Payoffs dependent on values of other assets

such as bond, stock, commodity prices and
even market indices
These assets are derived from the price of
other assets. That is why they are called
derivatives. Also called contingent claims.
The asset that a derivative is based on is
known as the underlying security
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Options: Give the holder the right to buy or
sell an asset for a price called the strike or
exercise on or before the maturity date
A put option gives the option holder the
right to sell the asset at the strike
A call option gives the option holder the
right to buy the asset at the strike
Note: options do not have to be exercised
Futures
Buyer of future agrees to buy the underlying
at a fixed future date at an agreed upon price.
Seller of future agrees to sell the underlying at
a fixed future date at an agreed upon price.
Holder is obliged to buy/sell at the agreed
upon price.
He does not have the option to back out.
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The Form of Returns
We make the distinction between capital

gains and income of a security
The capital gain/loss is the difference
between the buying price and the selling
price.
The income is the additional money that is
earned on the security whilst it is held
e.g. In the case of shares this is dividends
Realised versus Expected returns

Realised or ex post returns are returns that
have occurred
e.g. BT shares earned 4% return last year
Expected or ex ante returns are expected to
occur in the future
e.g. we expect returns on BT shares 8% this year
If historical returns are used to predict future
returns, we are implicitly assuming that
process generating returns remains constant
through time.
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Calculating Realised Returns
Return on a security between date (t-1) and date (t) is
the sum of the change in value between the two dates
and any additional income earned between (t-1) and
(t) divided by the initial price
Pt Pt 1 + I t
Rt =
Pt 1
Rt=rate of return between t-1 and t
Pt = price of asset at t
It=income of asset between t-1 and t
Example: Realised Returns

Pt Pt 1 + I t
Rt =
Pt 1
BT priced at 11, 1 year ago
Today BT priced at 12
BT shares earned dividends of 20p over last year
Realised returns?
12 11 + 0 . 20 1 . 20
Rt = = = 10 . 9 %
11 11
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Calculating Expected Returns
The expected return of an asset is the

probability weighted average of its return in
all scenarios.
Let p (s) the probability of each scenario
and r(s) the rate of return in each
scenario,where scenarios are indexed by s,
the expected return is
E (r ) = s
p (s)r (s)
Example expected returns:

A share in Arsenal football club is currently priced at
100. You expect each share to pay a dividend of 4 in
the next year in all states of the world
The price of Arsenal shares in one year depends on the
state of the economy in the next year:
BOOM: 0.25 probability.
Share price 140 in 1 year.
NORMAL: 0.5 probability
Share price in 1 year of 110.
SLUMP: 0.25 probability
Share price in 1 year of 80.
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STATE PROBABILITY RETURN

BOOM 0.25 (140+4-100)/100
=44%
NORMAL 0.5 (110+4-100)/100

=14%
SLUMP 0.25 (80+4-100)/100

=-16%

STATE PROBABILITY RETURN
BOOM 0.25 44%
NORMAL 0.5 14%
SLUMP 0.25 -16%
Expected return?
= (0.25 x 44%)+(0.5 x 14% )+ (0.25 x-16%)
=11+7-4=14%
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Inflation Adjusted Rates of Return
Inflation causes investors to lose purchasing
power when they wish to sell their financial
assets to buy goods and services.
The consumer price index (CPI) measures
the cost of living and is useful for
determining the inflation rate.
The change in the CPI over a given time
period represents the percentage change in
the price of a specified basket of goods
during this time period.

For example, in September 2002 the CPI
was 181.0 and in September 2003 it was
185.2
The inflation rate between September 2002
and 2003 is then:
Inflation rate = CPI2003 CPI2002 = 185.2 181 2.32%

CPI2002 181
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Inflation reduces the purchasing power of
an investment
e.g. You earn 10% on an investment project
and inflation is more than 10% over same
period. Your purchasing power has dropped.
To include inflation in our calculations we
must determine the real rate of return.
The real rate of return is the nominal rate of
return (what we have been calculating so
far) adjusted for inflation.

Example:
BT earned a realised return of 10.9% over the last
year (see earlier slide). The nominal rate of return is
10.9%
Inflation was 3% over the last year
The real rate of return is calculated as:
1 + rnominal
rreal = 1
1 + inf
rreal = 1 + 0.109 1 = 1.0767 1 = 0.0767 or 7.67%

1 + 0.03
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Averages of returns:
A security earns 10% returns in year one

and 5.66% returns in year two. What is the
arithmetic average return?
Simple average=(10+5.66)/2=7.83%
If we have N observations: r1..rN
Arithmetic average=(r1+r2+.rN)/N
Suppose returns are reinvested?

Consider the same security again
If you had invested 1 in the security after one
year it would be worth 1.10
If you invest that 1.10 in 2nd year in the security
Worth 1.10 x1.056=1.1616 end 2nd year
The compound annual growth rate rG is the
calculated solution to the following equation
(1 + rG )2 = (1.10)(1.056 )
rG = 0.0781
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Geometric Average
What we have solved for is the geometric
average return
The general formula for the geometric
average return is the following:
(1 + rG ) = [(1 + r1 ) (1 + r2 ) ...(1 + rN )]
1
N
rG = [(1 + r1 ) (1 + r2 ) ...(1 + rN ) ] 1
1
N
Arithmetic versus Geometric

Geometric average represents the constant rate
of return we would have needed in each year by
to match actual performance over some past
investment period.
It is an excellent measure of past performance
If our focus is on future performance, then the
arithmetic average is the statistic of interest
It is an unbiased estimator of the portfolios
expected future return
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Consider a stock that will either double in value
with Probability 0.5 (return =100%) or halve in
value with Probability 0.5 (return=-50%)
If we get these returns over 2 years, stock ends up
where it started
Geometric? [(1+1)(1-0.5)]1/2-1=0 rG=0%
Suppose that the stocks performance over a 2
year period is characteristic of the probability
distribution. Can calculate expected returns.
Expected returns in this case are (100-50)/2=25%
which is the size of the arithmetic average return

Profit in good year more than offsets loss in
bad year
Arithmetic average recognises this and
hence is positive
Geometric average more sensitive to bad
outcomes and hence is zero
Arithmetic average is unbiased estimate of
future returns
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Stock Indices
When we have a collection of securities, & we are
interested in measuring returns an index is often used.
Stock market indices provide guidance as to the
performance of the overall stock market.
In the UK the most commonly referred to stock index
is the FTSE-100
In the USA the most commonly reported indices are
the Dow Jones Industrial Average, Standard & Poors
Composite 500 (S&P 500), New York Stock
Exchange (NYSE) composite, National association of
securities dealers automatic quotations (NASDAQ)
service composite
Calculating Returns on Indices
When an index is used, a base year is

normally defined when the index is at 100.
Returns on the index can then be calculated
accordingly
There are a number of ways of calculating
returns on an index
We will discuss three methods: price
weighted, equally weighted, price-weighted
and value-weighted
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Equally Weighted Returns
Initial Final Shares Initial Value Final value
Stock Price Price (Million) outstanding stock outstanding stock
ABC $25 $30 20 $500 $600

XYZ 100 90 1 100 90
TOTAL $600 $690
Equally weighted returns weight the returns of each

security in the index equally
Returns on ABC are 20%. Returns on XYZ are-10%.
Here the returns of ABC and XYZ are weighted equally.
Returns on an equally weighted index are?
=(1/2)x20%+(1/2)x-10%=5%
Value Weighted Indices

In order to give more importance to the
firms in an index that are more valuable, a
value weighted index is often used
This involves weighting the returns of each
firm by its share of the market value of the
index
The FTSE, NYSE, S&P 500 are value
weighted indices
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Value Weighted Returns
Initial Final Shares Initial Value Final value
Stock Price Price (Million) outstanding stock outstanding stock
ABC $25 $30 20 $500 $600

XYZ 100 90 1 100 90
TOTAL $600 $690
Returns on ABC are 20%. Returns on XYZ are-10%.

In this case, the returns of ABC are weighted as 5/6 &
XYZ are weighted as 1/6.
Returns on value weighted index =(5/6)x20%+(1/6)x-
10%=15%
Price Weighted Returns

Price weighted returns weight the returns of each
stock by its price
Returns on ABC are 20%. Returns on XYZ are -
10%
P 25
The weight on ABC is Sum of Prices = 125 = 0 .2
ABC
The weight on XYZ is Sum PofXYZPrices = 100

125
= 0 .8
Price weighted returns on the index are

= (0.2) x 20% + (0.8) x -10%
= -4%
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Long and Short Positions
Definition: Long and short positions
A long position is one where you make
money when the price increases and a short
one is where you make money when the
price decreases.
Examples: Actual Position Description
You will receive a Ferrari today Long a Ferrari
You owe your friend a gold ring Short Gold
Example: Short Positions
Suppose I borrow one BT share from you today.

Its price is 3. I promise to give you back the BT
share in one year.
What I am doing is going short one BT share
Today I can sell the BT share for 3 and invest the
money elsewhere
If the price of BT shares is less than 3 in 1 year, I
can buy the BT share back on the market for less
than 3 and give it back to you
I have gained although the price of BT shares has fallen
30
Risk & Return Characteristics of Stocks
and Bonds
Dimson, Marsh & Staunton examine Risk

and return in the 20th and 21st centuries
Examine data for 12 countries between
1900-2000
Examine some of their findings
Equities best performing asset class
In every country, equities proved to be the

best performing investment over the 20th
century.
If you had invested 1 in 1900 in the UK
and had reinvested the proceeds would have
earned
16496 in equities
188 in bonds
140 in bills
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Inflation was a major force in the 20th century
1 in 1900 had the same purchasing power as
54 today.
UK inflation averaged 4.1 per cent per annum
over the 20th century.
If you had invested 1 in 1900, your
purchasing power would have grown by
315 times in equities
3.5 times in bonds
2.6 times in bills (see figure 1 of Dimson article)
The Impact of Income

Over the course of a year, equities are so volatile
that most of an investors performance is
attributable to share price appreciation or
depreciation
Dividend income adds a modest amount to each
years gain or loss
While year to year performance is driven by capital
appreciation, long term returns are influenced
primarily by reinvested income
1 invested where capital is reinvested is worth
16,946 whilst if dividends are taken is worth only
161
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Equities had highest risk
Although equities gave highest return in
each country, returns from shares far more
volatile than bonds
Volatility (standard deviation) of UK real
equity returns in the 20th century 20 per
cent per annum.
Although bonds had lower return had lower
risk in UK: 14.6% standard deviation for
govt bonds and 6.6% for govt bills
Bond Performance
UK long-term government bonds (gilts)

provided a disappointing return of 6.4 per
cent per annum or just 1.3 per cent after
inflation.
Across all 12 countries, average real
government bond returns was 0.6 per cent
per annum.
33
Summary
Financial versus real investments
The players in the financial markets
The taxonomy of markets
Calculating Returns
Realised versus expected returns
Real versus nominal rates of return
Arithmetic versus geometric returns
Returns on indices
Historical evidence on risk and return
characteristics of stocks & bonds
34

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Financial Management

Topic 1: Introduction to the Financial

COPYRIGHT ANEEL KESWANI 2

Best method email

COPYRIGHT ANEEL KESWANI 3

What You Need

Real versus Financial Investments

COPYRIGHT ANEEL KESWANI 6

COPYRIGHT ANEEL KESWANI 7

Real versus Financial Investments

Example: Efficient Risk Allocation

Young can select riskier investments if they

Financial assets contribute to social welfare

COPYRIGHT ANEEL KESWANI 13

COPYRIGHT ANEEL KESWANI 14

COPYRIGHT ANEEL KESWANI 16

Primarily concerned with how to raise

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Households Business Sector

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Roles for Financial Intermediaries?

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Borrower Repayment Lender Repayment

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Payoffs dependent on values of other assets

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We make the distinction between capital

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Realised versus Expected returns

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Example: Realised Returns

The expected return of an asset is the

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Example expected returns:

STATE PROBABILITY RETURN

NORMAL 0.5 (110+4-100)/100

SLUMP 0.25 (80+4-100)/100

Example expected returns:

Inflation Adjusted Rates of Return

Inflation rate = CPI2003 CPI2002 = 185.2 181 2.32%

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Inflation Adjusted Rates of Return

rreal = 1 + 0.109 1 = 1.0767 1 = 0.0767 or 7.67%

A security earns 10% returns in year one

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Suppose returns are reinvested?

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Arithmetic versus Geometric

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Arithmetic versus Geometric

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Calculating Returns on Indices

When an index is used, a base year is

ABC $25 $30 20 $500 $600

TOTAL $600 $690

Equally weighted returns weight the returns of each