Topics in Financial Economics
Week 1) Basics and markets for interest rates
L1: Functions of financial institutions
L2: Theories of interest rates
L3: The term structure of interest rates
a. Functions of financial institutions
b. Properties and pricing of financial assets
c. Theories of interest rates and the term structure of interest rates
Week 2) Asset Pricing
L4: Asset pricing and mean-variance
L5+6: Capital Asset Pricing model
a. Asset Pricing
b. Mean-Variance Portfolio Theory
c. The Capital Asset Pricing Models
d. Arbitrage Pricing Theory Model
e. Fama-Frech Three factors Model
Week 3) The efficient market hypothesis (EMH), momentum trading, return reversals, and
herding.
L7: Primary and secondary markets
L8+9: Market efficiency
a. Structure and organization for markets
b. The EMH and the testing of the EMH
c. Momentum and herding
Week 4) Measuring risk preferences
L10: Measuring risk preferences and its problems
L11: Alternative measures
Week 5) Investor risk perception
L12+13: Risk perception
Week 6) Expected utility theory, prospect theory, and inter-temporal choices
L14: EUT and PT
L15: Decision making under ambiguity
L16: Inter-temporal decision making
a. Decision making under ambiguity
b. Inter-temporal choices
,Week 1, Basics and markets for interest rates
a. Functions of financial institutions
b. Properties and pricing of financial assets
c. Theories of interest rates and the term structure of interest rates
25-1, Lecture 1, Functions of financial institutions
Some basics
Some basic concepts
Why do we need markets?
- In a market economy, where financial resources are allocated through single markets, the
allocation of economic resources is the outcome of many private decisions.
- These individual decisions take place in an institution called markets (supply and demand).
* whether to provide capital, borrow, how much, etc.
- Prices are the signals operating in a market economy that direct economic resources to
their best use. Tells you how scarce a product is.
* when something is expensive you only use it if it will give great benefit
* ALSO: government can allocate resources (more fair but may be less efficient because they
don’t know the exact demand and supply for the equilibrium through markets more
efficient but can create inequality)
- There are mainly two types of markets:
1. The product market, the market for manufactured goods and services, consumers.
2. The factor market, the market for the factors of production, such as labor and capital.
- The financial market is one (important) part of the factor market, capital market
Definition
- An asset is any possession that has value in an exchange.
- A tangible asset is one whose value depends on particular physical form.
* e.g. a car, once you break it the value decreases or vanishes
- An intangible asset is a legal claim to some future benefit. Their value bears no relationship
to the forms, physical or otherwise, in which these claims are recorded.
* financial assets (financial instruments/securities) are intangible assets: stocks, bonds,
options, contracts
* issuers of the financial asset: the entities that agree to make future cash payments
e.g.: bond issuer promises to back interest rate and principal; mortgage issuer is the
person who buys the house, has to pay the mortgage back monthly
* investors: the owners of the financial assets: expect future payments
Examples of financial assets
Debt instruments obligate the issuer to repay a fixed amount of money during a specified
period.
- A bond issued by the Dutch Central Bank; by the city of Nijmegen; by ABN AMRO; by the
government of Japan.
* the issuer of the bond is the borrower
,Equity instruments obligate the issuer to repay an amount based on earnings over indefinite
period after holders of debt instruments have been paid.
* more risky than debt because the amount of money isn’t fixed and you don’t know when
* debt holder are paid first, after that the equity holders, so not even sure if you get money
- A share of common stock issued by ABN AMRO; by Honda Motor Company.
- A loan by ABN AMRO to you when you want to buy a car.
* issuer is the person buying the car because it promises to pay back
* ABN AMRO is the investor because it expects to receive repayment and interest
Higher systematic risk higher return.
- Two most important characteristics when analysing financial assets.
Some securities fall into both categories (both features of equity and debt):
- Preferred stocks: stock is some sort of equity because indefinite period of time, but the
amount of payment is fixed so debt.
- Convertible bonds: can be converted to equity (stocks) when certain conditions satisfy.
For example, consider a Company XYZ bond with a $1, 000 par value that is convertible
into Company XYZ common stock.
- It has a coupon of 6%, payable annually.
- The bond’s prospectus specifies a conversion ratio, which is the number of shares that the
investor will receive if he chooses to convert.
- Company XYZ’s convertible bond has a conversion ratio of 20 and the investor is effectively
purchasing 20 shares of Stock XYZ for $50 per share.
- The bondholder keeps the bond for two years and collects a $60 interest payment each
year.
- At the end of year two, he elects to convert his bond into 20 shares of stock. By this time,
the stock price has risen to $75 per share. The bondholder converts his bond to 20 shares at
$75 per share, and now his investment is worth $1, 500.
Definition
- Both debt and preferred stock that pay fixed amounts are called fixed-income instruments.
- A basic economic principal: the price of any financial asset is equal to the present value of
its expected cash flow, even if the cash flow is not known with certainty.
- Although the price of financial assets can be calculated in an exact way, in practice, the
pricing is difficult.
* difficult to apply because estimating future CF is difficult
Pricing of Financial Assets
The price of financial assets and risk
Expected rate of return: if the price of a financial asset is €100, and its only cash follow is
€105 one year from now, then its expected rate of return would be 5% return on
investment that an investor expects to receive.
* (final wealth – initial investment) / initial investment
Future cash flows always have some uncertainty. Mainly three kinds of risks:
1. Purchasing power risk (inflation risk): the potential purchasing power of the expected
, cash flow, due to inflation, is not known.
* e.g. Dutch central bank bond has certain CF (won’t default) but purchasing power of the CF
is uncertain
2. Credit risk (default risk): the issuer or borrower will default on the obligation to pay.
* car loan might have uncertainty about the CF/whether it can repay
* ABN AMRO share is uncertain about amount to be paid and timing of dividend payments
3. Foreign exchange risk: the exchange rate is uncertain.
* Japanese government bond has certain CF but may be denominated in Yen
The role of financial assets
- Financial assets (intangible) versus tangible assets:
* both are expected to generate future cash flow
* the cash flow for a financial asset is generated by some tangible asset financial asset
relies on tangible asset
- The role of financial assets:
* to transfer funds from surplus parties to those who need to invest in tangible assets
e.g. an investor invests money to an engineer, the engineer develops a product, sells to
the market, makes profit and that goes back to generating CFs
* to transfer funds in such a way as to redistribute risks: portfolio management
27-1, Lecture 2, Theories of interest rates
Financial markets
Definition:
- A financial market is a market where financial assets are exchanged.
- The market in which a financial asset trades for immediate delivery is called the spot
market or cash market.
The role of financial markets:
1. Price discovery process: the interactions of buyers and sellers in a financial market
determine the (equilibrium)price of the traded asset.
* when you have information that the price is going up, people are going to buy and price
really goes up price reflects information in the market
2. Providing liquidity: financial markets provide a mechanism for an investor to sell a
financial asset.
* one form of liquidity: the bid-ask spread
* when you need money you can always sell and get liquidity quickly
3. Financial markets reduce the cost of transaction, search costs and information costs.
* search costs involve explicit costs (money spent to make advertisement) and implicit costs
(time spent to locate a counter party)
* information costs of collecting information to assess the investment merits of a financial
asset
