lecture 2- intro to finance

8/2/2019 Lecture 2- Intro to Finance

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Lecture 2- Basic Financial Concepts

Heriot-Watt University - Introduction to Finance


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Basic Financial Concepts Maximising Shareholder

Wealth

Areas of Conflict Agency

Self Interest

Time Value of Money

Risk Aversion Risk Diversification

Information Asymmetry

Financial Signalling Capital Market

Efficiency

Option Pricing

Heriot-Watt University - Introduction toFinance


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Maximising Shareholder Wealth The MAIN Objective of any firm should be to Maximise

Shareholder Wealth

Finance theory indicates that the manager of a firm should aimto maximise the wealth of shareholders, which would indicatethat share prices are key to their concern.

The assumption is that managers (including finance directors),in charge of companies should maximise shareholders wealth, as

their objective function.

Following from this assumption they will take decisions whichwill be primarily in the interests of the shareholder.



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AgencyA relationship in which the principal (in this case the

shareholders) gives an agent (the management teamand or the board of directors) the right to act on theprincipal's behalf and to exercise some businessjudgment and discretion.

Agents owe very high degrees of loyalty, good faith,and confidentiality to their principals, often expressedas fiduciary obligations.



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Areas of Conflict- Self Interest Management acts as Agents for the Shareholders. This

relationship is called an Agency, where Management have aFiduciary responsibility to make decisions that redound tothe Benefit of the share holders.

Areas of Conflict arise where;- Managers can act in interests of shareholders but notbondholders Managers can act in own interests and not shareholders withregard to;

o Projectso Capital structureo Dividendso Remuneration



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Time Value of Money Time has an effect on the value of money because of:

o Inflation

o Opportunity cost foregone of an investment

o Risko Consumption preference

This represents a fundamental concept on which investmentdecisions are made.

The value of money is a function of the timing of itsreceipt or payment, with cash received or paid in the

future, being worth less than cash received or paid today.



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Financial Risk Financial risk an umbrella term for multiple types ofrisk associated

with financing, including financial transactions that include company loans inrisk ofdefault.[Risk is a term often used to implydownside risk, meaning theuncertainty of a return and the potential for financial loss, but there is alsoupside risk.

It is important to make a distinction between: Risk Certainty

o The expected outcome is known for certain (probability = 1) - the returns ongovernment bonds are considered certain.

Uncertaintyo Uncertainty exists whenever one does not know for sure what will happen in the

future.

Certainty and uncertainty can be seen as opposites with risk in between.

http://en.wikipedia.org/wiki/Riskhttp://en.wikipedia.org/wiki/Financehttp://en.wikipedia.org/wiki/Default_(finance)http://en.wikipedia.org/wiki/Financial_transactionhttp://en.wikipedia.org/wiki/Downside_riskhttp://en.wikipedia.org/wiki/Default_(finance)http://en.wikipedia.org/wiki/Downside_riskhttp://en.wikipedia.org/wiki/Downside_riskhttp://en.wikipedia.org/wiki/Default_(finance)http://en.wikipedia.org/wiki/Financial_transactionhttp://en.wikipedia.org/wiki/Financehttp://en.wikipedia.org/wiki/Risk


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Risk Aversion In analysing risk and risk behaviour most investor are

Risk Averse.

What is Risk Aversion? The principle of risk aversion is that individuals who

make financial decisions will prefer, ceteris paribus(everything else being equal), given the choice betweentwo investments with identical expected returns, tochoose the alternative offering the lower expected risk.



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Risk Diversification Since most investors are risk averse it is obvious that they would seek

methods by which they can reduce risk exposure. There are 2 mainmethods of reducing risk

Risk Diversification Diversification means reducing risk byinvesting in a variety ofassets.

If the asset values do not move up and down in perfect synchrony, adiversifiedportfolio will have less risk than theweighted average risk ofits constituent assets, and often less risk than the least risky of itsconstituents

Hedging Investing in a position intended to offset potential losses that may be

incurred by a companion investment.

ONLY RISK DIVERSIFICATION IS COVERED IN THIS COURSE

http://en.wikipedia.org/wiki/Financial_riskhttp://en.wikipedia.org/wiki/Investmenthttp://en.wikipedia.org/wiki/Assethttp://en.wikipedia.org/wiki/Portfolio_(finance)http://en.wikipedia.org/wiki/Weighted_meanhttp://en.wikipedia.org/wiki/Portfolio_(finance)http://en.wikipedia.org/wiki/Weighted_meanhttp://en.wikipedia.org/wiki/Weighted_meanhttp://en.wikipedia.org/wiki/Portfolio_(finance)http://en.wikipedia.org/wiki/Assethttp://en.wikipedia.org/wiki/Investmenthttp://en.wikipedia.org/wiki/Financial_risk


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Capital Market Efficiency The simplest definition of market efficiency is that the price

already reflects the available information and thus buying orselling the stock should, on average, return you only a "fair"measure of return (after transaction costs) for the associatedrisk. On average you will make money, but the money you makeis just enough to offset the risks you have assumed.

There are three basic types of information efficiency. Strongform, Semi-strong form, and Weak form.

Possibly less academic in nature but more convincing in reality isthe fact that so few people or mutual funds either in the US, orabroad, do actually beat the market on a risk adjusted basis.


lecture 2- intro to finance

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