Summary International Finance Theory Lectures ('21 - '22)
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Course
International Finance (4021126ENR)
Institution
Vrije Universiteit Brussel (VUB)
Comprehensive summary of the lectures for the course International Finance. Suitable for students International Business. Given by Kris Boudt and David Ardia at the Vrije Universiteit Brussel in the academic year . Allowed me to pass with 19/20 in the first session.
Summary:
Theory lectures International Finance
PROFESSOR: KRIS BOUDT & DAVID ARDIA
Gino Aytas | 1MA IB | Academic year 2021 – 2022
Version 1
,Practical information:
The final grade is composed out of a written exam representing 100% of the mark.
1. Behavioural Finance I
1.1. INTRODUCTION
In this part of the course we are going to try and understand how people make decisions.
• How to model the decisions of yourself and others?
• How to take advantage of the behaviour?
In economic textbooks people always make assumptions when making decisions. The
assumption is made that this “economic man” is fully rational and has knowledge of all
relevant aspects of his environment. This allows him to clearly via a set of preferences and
instructions rank each possible outcome and go for the most desirable one.
Such “Homo Economicus” does not exist in reality. Looking at how people make decisions
it becomes evident that it is not always fully calculated. Errors can occur (cognitive
limitations), information can be obscured, hidden or non-accessible (information
imperfection) and time is limited (time constraint).
This creates a bounded rationality in which we have to do sub-optimal decision
making.
Additionally we also have to take decisions “on the spot” being an example of this time
constraint. It gives us a limited time to fully calculate the best possibility and act
rationally.
Humans love group conformity, also called herding. If one member of the group has
done something, others will most likely follow as it is deemed the norm. An example of
this is that during the Covid-19 pandemics initial occurrence, massive herds of people
went out to buy toilet paper. This was because there was the general belief that there was
insufficient supply, which was not the case. However due to this behaviour it became true,
a self-fulfilling prophecy.
People also tend to be overconfident, thinking they are better than average. The so-called
“better-than-average-effect”. This also happens to company managers, it is not always
bad. It even tends to help people and companies in their career, as overconfident people
tend to work harder.
PAGE 1
,Humans also have an aversion to losing (loss aversion). Everyone “hates losing more than
loving winning”, which is quite irrational but true. This is very important when making
decisions regarding investments.
So far we have seen that people are not fully rational. What can be done to avoid this?
One can plan what it does in the future if something happens. This gives more time to
make a rational decision and rule out less desirable alternatives.
Understanding this irrationality brings us to behavioural finance. It looks at financial
decision making by normal people. This is a very complex matter:
• Uncertainty
o Uncertain future payoffs
o Random variables
• Heterogeneity across individuals
o Skills, preferences, attitudes, emotions, …
• Interaction between individuals, the economic system and technology
Understanding this system and the models of financial decision making can yield a great
advantage as it allows to take advantage of others behaviour.
In an organisation, when taking on the role of decision architect, by knowing about
biases and irrationalities in financial decision making one can:
• Set rules to avoid them
• Exploit mistakes of others
It is all about perception. In this image we see 2
identical hamburgers, however nobody is in the
que for the “25% fat” hamburger.
In 2017 Richard Thaler received a Nobel prize for
this theory on Nudging. Nudging is encouraging
people to make decisions that are in their broad
self-interest.
For example the fly in a men’s urinal. This led to a reduction of spillage on the floor by
about 80%.
In essence the stock market is in a sense a place where people compete based on their
skills to understand the system and how uncertainty works with the goal of yielding
beneficial returns.
During our lectures Behavioural Finance on financial decision making we will cover the
frameworks, impact on investors and impact on firm decisions.
PAGE 2
, 1.2. BASIC FINANCIAL LITERACY
1.2.1. Time Value of Money
The first concept is the time value of money. Meaning that consumers and firms are
willing to pay more than 1 dollar in the future in exchange for 1 dollar today. In other
words, the borrowers pays interest rate to a lender for use of their funds.
For this we use formulas for the future value and present value:
𝐹𝑢𝑡𝑢𝑟𝑒 𝑣𝑎𝑙𝑢𝑒 𝑎𝑡 𝑦𝑒𝑎𝑟 𝑇: 𝑉𝑇 = 𝑉0 ∗ (1 + 𝑟)𝑇
𝑉𝑇
𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒: 𝑉0 =
(1 + 𝑟)𝑇
This formula changes if there is compounding and interest is received on interest.
The required rate of return ® is higher if the risk free rate is higher (opportunity cost)
and if the cashflow is more risky (higher uncertainty about future cashflows).
𝑟 = 𝑅𝑓 + 𝑅𝑖𝑠𝑘 𝑃𝑟𝑒𝑚𝑖𝑢𝑚
If there is a higher rate of return required, the prise has to drop in the present time.
Financial assets are bundles of future expected cashflows. A way of valuation is the
following equation, when the required rate of return is r, investors are willing to pay:
𝑛 𝑒
𝐶𝐹𝑡+𝑗
𝑃𝑡 = ∑
(1 + 𝑟)𝑗
𝑗=1
With:
- 𝒏 holding periods
- Cash flow 𝑪𝑭𝒆𝒕+𝒋 received each period 𝒕 + 𝒋
1.2.2. Computing Returns
A return is the percentage change in value of the investment.
Suppose that your stock portfolio initially cost you €100 to setup. A month later you
decide to liquidate the entire portfolio and receive €110 for it. You made €10, in other
words a 10% return.
110 − 100
= 10%
100
But now suppose that the market drops by 50%, our portfolio is now worth €50. To
bounce back to our initial level of value, it needs to increase by 100% to €100.
PAGE 3
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