There is no limit to the number of potential owners of a company, so the management of a
firm is efficiently exercised by a group of individuals referred to as the board of directors
The board of directors have the authority when making decision and are elected by the
shareholders, each shareholder of common stock have voting rights
In small business with one or a few owners the owner’s objective and incentives tend to
align, but in large corporations this may not always be the case
The principal-agent problem mainly arises due to:
o Information asymmetry – when there’s a lack of information shared between the 2
parties
o Moral hazard – where someone has an incentive to take on risk as another party
bears the cost
The simplest way to deal with the principal-agent problem is to assume good faith in both
parties but this may not be realistic
Rationally we can assume that the party’s interests won’t align, since they aim to maximise
their utilities
The easiest ways to mitigate the agency problem whereby shareholder’s interests are
aligned with manager’s agendas are:
o Close monitoring
o Compensation packages
o Causes written in when designing a contract
The costs associated with mitigating the principal-agent problem are referred to as agency
costs
There are 3 types of agency costs according to Jensen and Meckling, including:
o The monitoring expenses – this includes any effort of the principal to control
behaviour of the agent through close monitoring, budgeting restrictions, etc
o Bonding expenditures – anything that ‘bonds’ the agent to the firm
o The residual loss – any divergence in the reduction or principal’s welfare due to the
agent diverging from the ‘ideal’ principal decisions
The optimal contract theory aims to tie performance compensation in a way that aligns
principal’s and agent’s incentives, it does this with 3 main aspects:
o Attracting and retaining high quality executives
o Providing executives with incentives to exert sufficient effort and to make decisions
that serve shareholders’ interests
o Minimizing overall costs
The main issue with optimal contract theory is that it can be hard to find the ‘optimal’ point
from a provision perspective
There are many issues when attempting to align incentives, for example a clause may mean
that managers focus on the short-term which can affect the long-term performance of the
firm, so tying in a clause can have the opposite effect and CEOs could be very risk-averse
meaning they have an adequate performance
Badly designed contracts can not alleviate the principal-agency problem
The managerial power approach suggest that executives have large opportunities to affect
their own pay and terms when setting these contracts
,Behavioural Finance
In relation to finance rationality, is to say investors are maximising their utility, have self-
control and aren’t affected by cognitive errors due to behavioural attributes
A study of s sample of Swedish household investments found that almost half of their
portfolio’s volatility was due to firm-specific risk
A second study conducted in the US found that in the early 2000s, 50% of households that
held stocks had only up to 4 in their portfolio and 90% of households had up to 10
Multiple other studies had similar results, so we can determine the overall performance of
individual investors is often poor
Firm-specific risk is diversifiable and Markovitz’s ‘modern portfolio theory’ clearly shows that
risk can be minimised through diversification
There is a list of psychological factors that affect aspects of trading at an individual level,
which lead to investors to undiversify/underperform, which are:
o Familiarity bias – investors favour investments in companies they are familiar with
o Relative wealth concerns – investors care most about the performance of their
portfolio relative of that to their peers
o Overconfidence bias – where uniformed individuals tend to overestimate the
precision of their knowledge
o Sensation seeking – this is an individual's desire for novel and intense risk taking
These biases then explain certain behavioural patterns in trading, which are:
o The disposition effect – this is an investor’s tendency to sell stocks that have risen in
value and hold stocks that have lost value
o Attention, mood and experience effects
o Herding behaviour – where investors actively try to follow each other's behaviour
o The informational cascade effect – which is where investors ignore their own
information, hoping to profit from the information of others
There are several behavioural concepts that help us grasp the imperfect nature of humas,
including:
o Heuristics/anchoring - one of the heuristic biases is called anchoring which is the
tendency in ambiguous situations to allow your decision to be affected by an
‘anchor’
o Mental accounting – mental accounting is defined as ‘the set of cognitive operations
used by individuals and households to organize evaluate and help track of financial
activities’, it is the idea that a person places different value on the same amount of
money based on subjective criteria
o Prospect theory – this is the idea that people value losses and gains irrationally,
people need much bigger gains to be happy than the happiness they lose from much
smaller loses
Bonds With Coupons
, Price Of The Bond = Face Value / (1+YTM ) ^ N
When YTM goes up and face value is fixed, the price goes down
When the bond price is greater than FV we say the bond trades at a premium this happens
when CR is bigger than YTM
When the bond price is less than the FV we say it’s at discount/below par this occurs when
the coupon rate is less than the YTM
Credit rating agencies are borrowers according to likelihood of default
There are 2 broad categories of credit ratings:
o Investment grade
o Speculative grade
Dividend Valuation Model
The value of a company’s stock is based on present value of cash flow received by the holder
There are 2 sources of cash flow from owning a stock dividends and capital gain
A dividend is a token reward paid to the shareholders for their investment in a company’s
equity and usually originate from the company’s net profits
Capital gain is the capital received from selling a stock
Total return on a stock = Dividend yield + Capital gain (selling price)
Total rate of return on a stock = Dividend yield + Capital gain rate - 1
The future CF in present value is calculated by: Price0 = (Dividend1 +Price1) / (1+re)
To calculate total return on a stock as a percentage you need:
o Dividend Yield = Dividend1 / Price0
o Capital Gain Rate = (Price1 - Price0) / Price0
There are 2 major challenges to applying a dividend discount model:
o Predicating future dividends
o Estimating the appropriate discount rate
The easiest way to counter the issue of predicting future dividends would be by assuming
dividends grow at a constant rate
If someone holds a stock forever the will receive constant dividends but never receive a
capital gain
To calculate the value of dividends assuming they grow at a constant rate: Price0 =
(Dividend1 / (1 + re)) + (((Dividend1 * (1 + g)) / (1 + re)) + (Dividend1 + (((1 + g)^2) / (1 + re))
+ … or we can write it as ∑ Dividend1 * ((1 + g)^n / (1 + re)^n)
Financial Markets, Institutions And Instruments
Markets are where buyers and sellers come together to exchange goods so financial markets
are places where financial products are traded
Financial products are commonly referred to as securities and instruments
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