Basics for market Basics for market microstructuremicrostructureStock market is a slough of fear and greed untethered to corporate realities – Warren Buffet

MM 2006/7MM 2006/7 22

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What is finance?What is finance? Capital marketsCapital markets

– Portfolio managementPortfolio management– Asset pricingAsset pricing

• Time and cross dimensionsTime and cross dimensions– Risk managementRisk management– Financial engineeringFinancial engineering– Performance evaluationPerformance evaluation– Market microstructureMarket microstructure

MM 2006/7MM 2006/7 33

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What is finance?What is finance? Corporate financeCorporate finance

– Capital budgetingCapital budgeting• Project valuationProject valuation

– Capital structureCapital structure– Mergers and acquisitionsMergers and acquisitions

• Company valuationCompany valuation– Going private / public (IPO)Going private / public (IPO)– Corporate governanceCorporate governance

MM 2006/7MM 2006/7 44

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Potential employer / Potential employer / job functionjob function Investment bankInvestment bank

– Corporate finance: help companies to raise Corporate finance: help companies to raise capitalcapital

– M&A: value companies, structure deals, M&A: value companies, structure deals, negotiatenegotiate

– Trading equity, FI, FX, derivativesTrading equity, FI, FX, derivatives– Structured finance: create new instrumentsStructured finance: create new instruments– Analyst / researchAnalyst / research

Commercial bankCommercial bank– Loans to individuals and companiesLoans to individuals and companies– MortgageMortgage– Private bankingPrivate banking

MM 2006/7MM 2006/7 55

NES

Potential employer / Potential employer / job functionjob function Money management: mutual / Money management: mutual /

pension / hedge fundspension / hedge funds– Portfolio manager: select investmentsPortfolio manager: select investments– Investment advisorInvestment advisor– AnalystAnalyst

Corporate finance dept in a Corporate finance dept in a companycompany

Audit companyAudit company

MM 2006/7MM 2006/7 66

NES

Market microstructureMarket microstructure Financial marketsFinancial markets Financial instrumentsFinancial instruments Financial intermediariesFinancial intermediaries

MM 2006/7MM 2006/7 77

NES

Financial marketsFinancial markets Primary vs secondaryPrimary vs secondary Exchanges vs OTCExchanges vs OTC Dealership vs (batch / Dealership vs (batch /

continuous) auctioncontinuous) auction Listing/Depositary receiptsListing/Depositary receipts

MM 2006/7MM 2006/7 88

NES

Financial marketsFinancial markets Objective:Objective: facilitate trading to allow facilitate trading to allow

– Money transfer over timeMoney transfer over time– Risk sharingRisk sharing– Price discoveryPrice discovery

Issues: Issues: transaction coststransaction costs– Info asymmetryInfo asymmetry– LiquidityLiquidity– Informational efficiencyInformational efficiency

MM 2006/7MM 2006/7 99

NES

Financial instrumentsFinancial instruments Basic: stocks and bondsBasic: stocks and bonds Derivatives: forwards, futures, Derivatives: forwards, futures,

options, swaps, etc.options, swaps, etc. IndicesIndices

MM 2006/7MM 2006/7 1010

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Financial instrumentsFinancial instruments ObjectivesObjectives

– MarketableMarketable– Give specific payoff in a given state Give specific payoff in a given state

of the natureof the nature IssuesIssues

– Specifics vs Specifics vs liquidliquidity/ simplicityity/ simplicity– Counterparty riskCounterparty risk– Bad incentivesBad incentives

MM 2006/7MM 2006/7 1111

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Financial Financial intermediariesintermediaries Brokers / dealersBrokers / dealers Commercial banksCommercial banks Investment banksInvestment banks Mutual / pension / hedge fundsMutual / pension / hedge funds Wealth managementWealth management

MM 2006/7MM 2006/7 1212

NES

Financial Financial intermediariesintermediaries ObjectivesObjectives

– Minimize transaction costsMinimize transaction costs• Economies of scaleEconomies of scale

– Solve information problemsSolve information problems– Brokerage vs qualitative Brokerage vs qualitative asset transformationasset transformation

IssuesIssues– Agency problemAgency problem– Coordination Coordination – Conflict of interestConflict of interest

MM 2006/7MM 2006/7 1313

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Jargon Jargon Short salesShort sales SpreadSpread InsiderInsider Market-makerMarket-maker Listing Listing Liquidity Liquidity SecuritizationSecuritization Market efficiencyMarket efficiency ArbitrageArbitrage

MM 2006/7MM 2006/7 1414

NES

Books Books Description Library Scanned

Бригхем, Гапенски. Финансовый менеджмент x

Sharpe, Alexander, Baily. Investments x x

Grinblatt, Titman. Financial Markets and Corporate Strategy x

Megginson. Corporate Finance Theory x

Haugen. Modern Investment Theory x

Hull. Options, Futures, and Other Derivatives x x

Малюгин. Рынок ценных бумаг: Количественные методы анализа

Энциклопедия финансового риск-менеджмента. Под ред. Лобанова и Чугунова

x

Jorion Financial Risk Manager Handbook x

CFA study notes x

MM 2006/7MM 2006/7 1515

NES

Further coursesFurther courses Investment theoryInvestment theory Corporate financeCorporate finance Econometrics of financial Econometrics of financial

marketsmarkets Risk managementRisk management

MM 2006/7MM 2006/7 1616

NES

Lecture 2: plan Lecture 2: plan Prices and returnsPrices and returns Why is the discount rate positive?Why is the discount rate positive? Index models and CAPMIndex models and CAPM SpSpeecifics of corporationcifics of corporation Stocks vs bondsStocks vs bonds Financial statements and Financial statements and

coefficientscoefficients

Prices and returnsPrices and returns-Why do prices rise?-Why do prices rise?- Because there are more buyers - Because there are more buyers than sellers!than sellers!

MM 2006/7MM 2006/7 1818

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Prices and returnsPrices and returns How to define returns?How to define returns?

– for stocks / bondsfor stocks / bonds Why usually employ returns in Why usually employ returns in

models?models? Why need stochastics?Why need stochastics? How to account for transaction How to account for transaction

costs?costs?

MM 2006/7MM 2006/7 1919

NES

Discount rateDiscount rate Time preferenceTime preference InflationInflation RiskRisk

ModelsModelsThe one investment certainty is The one investment certainty is that we are all frequently wrongthat we are all frequently wrong

MM 2006/7MM 2006/7 2121

NES

Index modelsIndex models Market model: Market model: RRii,,tt = = ααii + + ββiiRRM,tM,t + + εεii,,tt, ,

– where E(εwhere E(εi,ti,t)=0, cov()=0, cov(RRMM, ε, εii)=0)=0 Risk managementRisk management: ΔR: ΔRii ≈ β ≈ βiiΔΔRRMM Separation of total risk on systematic and Separation of total risk on systematic and

idiosyncraticidiosyncratic: : varvar((RRii)=)=ββii22σσ22

MM++σσ22((εε))ii– Systematic risk depends on factor exposures (betas)Systematic risk depends on factor exposures (betas): :

ββii22σσ22

MM

– Idiosyncratic risk can be reduced by diversificationIdiosyncratic risk can be reduced by diversification Covariance matrixCovariance matrix: : covcov((RRii, , RRjj) = ) = ββiiββjjσσ22

MM– Assuming Assuming E(εE(εiiεεjj)=0 )=0 forfor i≠j i≠j

MM 2006/7MM 2006/7 2222

NES

CAPMCAPM More restrictive model: More restrictive model: E[E[RRii,,tt--RRFF,,tt] ] = =

ββiiE[RE[RM,tM,t--RRFF,,tt]] – where E(εwhere E(εi,ti,t)=0, cov()=0, cov(RRMM, ε, εii)=0)=0

The expected excess return of each asset is The expected excess return of each asset is proportional to its betaproportional to its beta– Investors require higher expected returns on Investors require higher expected returns on

assets with higher systematic riskassets with higher systematic risk In the equilibrium, everybody invests in the In the equilibrium, everybody invests in the

market portfolio (of risky assets) and risk-market portfolio (of risky assets) and risk-free ratefree rate

MM 2006/7MM 2006/7 2323

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Мифы / СтереотипыМифы / Стереотипы

«Количественные модели «Количественные модели объективны»объективны»

«Чем сложнее модель, тем лучше»«Чем сложнее модель, тем лучше»«Количественные модели могут «Количественные модели могут

дать точный прогноз»дать точный прогноз»«Модели дают прогноз и расчет «Модели дают прогноз и расчет

стоимости компании раз и стоимости компании раз и навсегда»навсегда»

Specifics of Specifics of corporation corporation The most investor can lose is The most investor can lose is everything?everything?

MM 2006/7MM 2006/7 2525

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Forms of Business Forms of Business OrganizationOrganization Sole proprietorshipSole proprietorship PartnershipPartnership CorporationCorporationEvaluate byEvaluate by The life of the entityThe life of the entity The ability to raise capitalThe ability to raise capital The owners' liabilityThe owners' liability

MM 2006/7MM 2006/7 2626

NES

Modern CorporationModern Corporation

AdvantagesAdvantages– Limited liabilityLimited liability

• 1811: 1811: general act of incorporation in NYgeneral act of incorporation in NY

– Easy transfer of ownershipEasy transfer of ownership– Unlimited lifeUnlimited life– Ability to raise large amounts of Ability to raise large amounts of

moneymoney

MM 2006/7MM 2006/7 2727

NES

Modern CorporationModern Corporation

DisadvantagesDisadvantages– Start-up can be costlyStart-up can be costly– Earnings subject to double Earnings subject to double

taxationtaxation– The agency problemThe agency problem

• Separation of control and ownershipSeparation of control and ownership• The leverage effect of debtThe leverage effect of debt

MM 2006/7MM 2006/7 2828

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Equity vs DebtEquity vs Debt ShareholdersShareholders

– Control rights (e.g., elect directors)Control rights (e.g., elect directors)– Limited liabilityLimited liability– Residual claim on assets (after paying up Residual claim on assets (after paying up

liabilities)liabilities)– Dividends (fully taxable)Dividends (fully taxable)

DebtholdersDebtholders– Fixed contractual claim against the corporationFixed contractual claim against the corporation– No voting power unless the debt is not paidNo voting power unless the debt is not paid– Interest on debt is tax-deductibleInterest on debt is tax-deductible

MM 2006/7MM 2006/7

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Basic Financial Basic Financial StatementsStatements1.1. Balance SheetBalance Sheet2.2. Income StatementIncome Statement3.3. Statement of Cash FlowsStatement of Cash FlowsObjectives:Objectives: current status and past performance current status and past performance

informationinformation set performance targets and impose set performance targets and impose

restrictions on the managersrestrictions on the managers template for financial planningtemplate for financial planning

MM 2006/7MM 2006/7 3030

NES

The Balance SheetThe Balance SheetAssets ≡ Liabilities + Shareholder’s Assets ≡ Liabilities + Shareholder’s

EquityEquity Tabulates a company’s assets and liabilities at a Tabulates a company’s assets and liabilities at a

specific point in time specific point in time Sorting Sorting

– Assets by liquidityAssets by liquidity– Liabilities by maturityLiabilities by maturity

Assets and liabilities are represented by historical Assets and liabilities are represented by historical costscosts– The original cost adjusted for improvements and aging = The original cost adjusted for improvements and aging =

Book ValueBook Value– Avoid using market value, since is too volatile and easily Avoid using market value, since is too volatile and easily

manipulatedmanipulated

MM 2006/7MM 2006/7 3131

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(in $ millions)20X2 and 20X1Balance Sheet

U.S. COMPOSITE CORPORATION

Liabilities (Debt)Assets 20X2 20X1 and Stockholder's Equity 20X2 20X1

Current assets: Current Liabilities: Cash and equivalents $140 $107 Accounts payable $213 $197 Accounts receivable 294 270 Notes payable 50 53 Inventories 269 280 Accrued expenses 223 205 Other 58 50 Total current liabilities $486 $455 Total current assets $761 $707

Long-term liabilities:Fixed assets: Deferred taxes $117 $104 Property, plant, and equipment $1,423 $1,274 Long-term debt 471 458 Less accumulated depreciation -550 -460 Total long-term liabilities $588 $562 Net property, plant, and equipment 873 814 Intangible assets and other 245 221 Stockholder's equity: Total fixed assets $1,118 $1,035 Preferred stock $39 $39

Common stock ($1 per value) 55 32 Capital surplus 347 327 Accumulated retained earnings 390 347 Less treasury stock -26 -20 Total equity $805 $725

Total assets $1,879 $1,742 Total liabilities and stockholder's equity $1,879 $1,742

MM 2006/7MM 2006/7 3232

NES

The Income StatementThe Income StatementRevenue – Expenses ≡ IncomeRevenue – Expenses ≡ Income

Summarizes the company’s profitability during Summarizes the company’s profitability during a time period a time period

Categorization of expenses:Categorization of expenses:– Operating: provide benefits only for the current Operating: provide benefits only for the current

periodperiod• Also included: depreciation (based on historical cost) and Also included: depreciation (based on historical cost) and

R&DR&D– Financing: arising from non-equity financing Financing: arising from non-equity financing

(interest expenses)(interest expenses)– Capital: generate benefits over multiple periods Capital: generate benefits over multiple periods

(depreciated)(depreciated)

MM 2006/7MM 2006/7 3333

NES

(in $ millions)20X2

Income StatementU.S. COMPOSITE CORPORATION

Total operating revenuesCost of goods soldSelling, general, and administrative expensesDepreciationOperating incomeOther incomeEarnings before interest and taxesInterest expensePretax incomeTaxes Current: $71 Deferred: $13Net income Retained earnings: $43 Dividends: $43

the firm’s revenues and expenses from principal operations

$2,262- 1,655

- 327- 90

$19029

$219- 49

$170- 84

$86

all financing costs, such as interest expense

the amount of taxes levied on income.

MM 2006/7MM 2006/7 3434

NES

The Statement of Cash The Statement of Cash FlowsFlows

CF(firm) ≡ CF(debt) + CF(firm) ≡ CF(debt) + CF(equity)CF(equity)

Reports how much cash is generated Reports how much cash is generated during a periodduring a period– Indicates where the cash comes from Indicates where the cash comes from

and what the firm did with that cashand what the firm did with that cash Cash flow statements are Cash flow statements are

independent of accounting methodsindependent of accounting methods– Accounting rules have a second-order Accounting rules have a second-order

effect on cash flows through taxeseffect on cash flows through taxes

MM 2006/7MM 2006/7 3535

NES

(in $ millions)20X2

Financial Cash FlowU.S. COMPOSITE CORPORATION

Cash Flow of the FirmOperating cash flow $238 (Earnings before interest and taxes plus depreciation minus taxes)Capital spending -173 (Acquisitions of fixed assets minus sales of fixed assets)Additions to net working capital -23 Total $42

Cash Flow of Investors in the FirmDebt $36 (Interest plus retirement of debt minus long-term debt financing)Equity 6 (Dividends plus repurchase of equity minus new equity financing) Total $42

)()()(SCFBCF

ACF

Cash received from the firm’s assets must equal cash flows to the firm’s creditors & stockholders:

MM 2006/7MM 2006/7 3636

NES

Financial Ratio Financial Ratio AnalysisAnalysisTrendTrend / / Cross-SectionalCross-Sectional

Analysis Analysis Profitability RatiosProfitability Ratios Activity Ratios Activity Ratios Liquidity Ratios Liquidity Ratios Financial Leverage Ratios Financial Leverage Ratios Market Value RatiosMarket Value Ratios

MM 2006/7MM 2006/7

NES

Profitability RatiosProfitability Ratios Net Return on Assets (ROA) Net Return on Assets (ROA) = =

Net Income / Total AssetsNet Income / Total Assets Gross (Pretax) Return on Assets Gross (Pretax) Return on Assets

(ROA) (ROA) = EBIT / Total Assets= EBIT / Total Assets Return on Equity (ROE) Return on Equity (ROE) = Net = Net

Income / BV(equity)Income / BV(equity) Gross Profit Margin = EBIT / SalesGross Profit Margin = EBIT / Sales Net Profit Margin = Net Income / Net Profit Margin = Net Income /

SalesSales

MM 2006/7MM 2006/7

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Activity RatiosActivity Ratios

Measuring the efficiency of Measuring the efficiency of working capital working capital management:management:

Total Asset Turnover Total Asset Turnover = Sales / Total = Sales / Total

AssetsAssets

MM 2006/7MM 2006/7

NES

Liquidity RatiosLiquidity Ratios

Measuring short-term Measuring short-term liquidity:liquidity:

Current Ratio = Current Ratio = Current Current AssetsAssets Current LiabilityCurrent Liability

MM 2006/7MM 2006/7

NES

Financial Leverage Financial Leverage RatiosRatiosMeasuring the firm’s capacity to Measuring the firm’s capacity to

service its debt and long-term service its debt and long-term liquidity:liquidity:

Debt-to-Capital Ratio = Debt-to-Capital Ratio = Debt / (Debt + Equity)Debt / (Debt + Equity)

Debt-to-Equity Ratio = Debt / EquityDebt-to-Equity Ratio = Debt / Equity– Can be based on BV or MVCan be based on BV or MV– Similarly: long-term debt ratiosSimilarly: long-term debt ratios

MM 2006/7MM 2006/7

NES

Market Value RatiosMarket Value Ratios Price-to-Earnings Ratio = PPrice-to-Earnings Ratio = PSS/EPS/EPS

– Stock market price to earnings per shareStock market price to earnings per share Dividend Yield = Div/PDividend Yield = Div/PSS

– Latest dividend to current stock priceLatest dividend to current stock price Market-to-Book Value = MV/BVMarket-to-Book Value = MV/BV

– Similarly: Market-to-Book Equity = ME/BESimilarly: Market-to-Book Equity = ME/BE Tobin's Q = MV / Replacement ValueTobin's Q = MV / Replacement Value

MM 2006/7MM 2006/7 4242

NES

Asset pricingAsset pricingP = P = ΣΣtt CF CFtt/(1+R)/(1+R)tt

Bond with coupon C and face value Bond with coupon C and face value F (at T)F (at T)

Stocks Stocks ProjectProject CompanyCompany

ConclusionsConclusions

Если вам показалось, что я выразился слишком ясно, вы, должно быть, неверно меня поняли