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Basics for market microstructure Stock market is a slough of fear and greed untethered to corporate realities – Warren Buffet What is finance? Capital markets Portfolio management Asset pricing Time and cross dimensions Risk management Financial engineering Performance evaluation

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Basics for market microstructure l.jpg

Basics for market microstructure

Stock market is a slough of fear and greed untethered to corporate realities – Warren Buffet


What is finance l.jpg

What is finance?

  • Capital markets

    • Portfolio management

    • Asset pricing

      • Time and cross dimensions

    • Risk management

    • Financial engineering

    • Performance evaluation

    • Market microstructure

MM 2006/7


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What is finance?

  • Corporate finance

    • Capital budgeting

      • Project valuation

    • Capital structure

    • Mergers and acquisitions

      • Company valuation

    • Going private / public (IPO)

    • Corporate governance

MM 2006/7


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Potential employer / job function

  • Investment bank

    • Corporate finance: help companies to raise capital

    • M&A: value companies, structure deals, negotiate

    • Trading equity, FI, FX, derivatives

    • Structured finance: create new instruments

    • Analyst / research

  • Commercial bank

    • Loans to individuals and companies

    • Mortgage

    • Private banking

MM 2006/7


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Potential employer / job function

  • Money management: mutual / pension / hedge funds

    • Portfolio manager: select investments

    • Investment advisor

    • Analyst

  • Corporate finance dept in a company

  • Audit company

MM 2006/7


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Market microstructure

  • Financial markets

  • Financial instruments

  • Financial intermediaries

MM 2006/7


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Financial markets

  • Primary vs secondary

  • Exchanges vs OTC

  • Dealership vs (batch / continuous) auction

  • Listing/Depositary receipts

MM 2006/7


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Financial markets

  • Objective: facilitate trading to allow

    • Money transfer over time

    • Risk sharing

    • Price discovery

  • Issues: transaction costs

    • Info asymmetry

    • Liquidity

    • Informational efficiency

MM 2006/7


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Financial instruments

  • Basic: stocks and bonds

  • Derivatives: forwards, futures, options, swaps, etc.

  • Indices

MM 2006/7


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Financial instruments

  • Objectives

    • Marketable

    • Give specific payoff in a given state of the nature

  • Issues

    • Specifics vs liquidity/ simplicity

    • Counterparty risk

    • Bad incentives

MM 2006/7


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Financial intermediaries

  • Brokers / dealers

  • Commercial banks

  • Investment banks

  • Mutual / pension / hedge funds

  • Wealth management

MM 2006/7


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Financial intermediaries

  • Objectives

    • Minimize transaction costs

      • Economies of scale

    • Solve information problems

    • Brokerage vs qualitative asset transformation

  • Issues

    • Agency problem

    • Coordination

    • Conflict of interest

MM 2006/7


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Jargon

  • Short sales

  • Spread

  • Insider

  • Market-maker

  • Listing

  • Liquidity

  • Securitization

  • Market efficiency

  • Arbitrage

MM 2006/7


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Books

MM 2006/7


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Further courses

  • Investment theory

  • Corporate finance

  • Econometrics of financial markets

  • Risk management

MM 2006/7


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Lecture 2: plan

  • Prices and returns

  • Why is the discount rate positive?

  • Index models and CAPM

  • Specifics of corporation

  • Stocks vs bonds

  • Financial statements and coefficients

MM 2006/7


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Prices and returns

-Why do prices rise?

- Because there are more buyers than sellers!


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Prices and returns

  • How to define returns?

    • for stocks / bonds

  • Why usually employ returns in models?

  • Why need stochastics?

  • How to account for transaction costs?

MM 2006/7


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Discount rate

  • Time preference

  • Inflation

  • Risk

MM 2006/7


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Models

The one investment certainty is that we are all frequently wrong


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Index models

  • Market model: Ri,t = αi + βiRM,t + εi,t,

    • where E(εi,t)=0, cov(RM, εi)=0

  • Risk management: ΔRi ≈ βiΔRM

  • Separation of total risk on systematic and idiosyncratic: var(Ri)=βi2σ2M+σ2(ε)i

    • Systematic risk depends on factor exposures (betas): βi2σ2M

    • Idiosyncratic risk can be reduced by diversification

  • Covariance matrix: cov(Ri, Rj) = βiβjσ2M

    • Assuming E(εiεj)=0 for i≠j

MM 2006/7


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CAPM

  • More restrictive model: E[Ri,t-RF,t] = βiE[RM,t-RF,t]

    • where E(εi,t)=0, cov(RM, εi)=0

  • The expected excess return of each asset is proportional to its beta

    • Investors require higher expected returns on assets with higher systematic risk

  • In the equilibrium, everybody invests in the market portfolio (of risky assets) and risk-free rate

MM 2006/7


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Мифы / Стереотипы

«Количественные модели объективны»

«Чем сложнее модель, тем лучше»

«Количественные модели могут дать точный прогноз»

«Модели дают прогноз и расчет стоимости компании раз и навсегда»

MM 2006/7


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Specifics of corporation

The most investor can lose is everything?


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Forms of Business Organization

  • Sole proprietorship

  • Partnership

  • Corporation

    Evaluate by

  • The life of the entity

  • The ability to raise capital

  • The owners' liability

MM 2006/7


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Modern Corporation

  • Advantages

    • Limited liability

      • 1811: general act of incorporation in NY

    • Easy transfer of ownership

    • Unlimited life

    • Ability to raise large amounts of money

MM 2006/7


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Modern Corporation

  • Disadvantages

    • Start-up can be costly

    • Earnings subject to double taxation

    • The agency problem

      • Separation of control and ownership

      • The leverage effect of debt

MM 2006/7


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Equity vs Debt

  • Shareholders

    • Control rights (e.g., elect directors)

    • Limited liability

    • Residual claim on assets (after paying up liabilities)

    • Dividends (fully taxable)

  • Debtholders

    • Fixed contractual claim against the corporation

    • No voting power unless the debt is not paid

    • Interest on debt is tax-deductible

MM 2006/7


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Basic Financial Statements

  • Balance Sheet

  • Income Statement

  • Statement of Cash Flows

    Objectives:

  • current status and past performance information

  • set performance targets and impose restrictions on the managers

  • template for financial planning

MM 2006/7


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The Balance Sheet

Assets ≡ Liabilities + Shareholder’s Equity

  • Tabulates a company’s assets and liabilities at a specific point in time

  • Sorting

    • Assets by liquidity

    • Liabilities by maturity

  • Assets and liabilities are represented by historical costs

    • The original cost adjusted for improvements and aging = Book Value

    • Avoid using market value, since is too volatile and easily manipulated

MM 2006/7


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U.S. COMPOSITE CORPORATION

Balance Sheet

20X2 and 20X1

(in $ millions)

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 2006/7


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The Income Statement

Revenue – Expenses ≡ Income

  • Summarizes the company’s profitability during a time period

  • Categorization of expenses:

    • Operating: provide benefits only for the current period

      • Also included: depreciation (based on historical cost) and R&D

    • Financing: arising from non-equity financing (interest expenses)

    • Capital: generate benefits over multiple periods (depreciated)

MM 2006/7


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U.S. COMPOSITE CORPORATION

Income Statement

20X2

(in $ millions)

Total operating revenues

$2,262

the firm’s revenues and expenses from principal operations

Cost of goods sold

- 1,655

Selling, general, and administrative expenses

- 327

Depreciation

- 90

Operating income

$190

Other income

29

all financing costs, such as interest expense

Earnings before interest and taxes

$219

Interest expense

- 49

Pretax income

$170

the amount of taxes levied on income.

Taxes

- 84

Current: $71

Deferred: $13

Net income

$86

Retained earnings: $43

Dividends: $43

MM 2006/7


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The Statement of Cash Flows

CF(firm) ≡ CF(debt) + CF(equity)

  • Reports how much cash is generated during a period

    • Indicates where the cash comes from and what the firm did with that cash

  • Cash flow statements are independent of accounting methods

    • Accounting rules have a second-order effect on cash flows through taxes

MM 2006/7


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U.S. COMPOSITE CORPORATION

Financial Cash Flow

20X2

(in $ millions)

Cash Flow of the Firm

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

Operating 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 Firm

Debt

$36

(Interest plus retirement of debt

minus long-term debt financing)

Equity

6

(Dividends plus repurchase of

equity minus new equity financing)

Total

$42

MM 2006/7


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Financial Ratio Analysis

Trend / Cross-Sectional Analysis

  • Profitability Ratios

  • Activity Ratios

  • Liquidity Ratios

  • Financial Leverage Ratios

  • Market Value Ratios

MM 2006/7


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Profitability Ratios

  • Net Return on Assets (ROA) = Net Income / Total Assets

  • Gross (Pretax) Return on Assets (ROA) = EBIT / Total Assets

  • Return on Equity (ROE) = Net Income / BV(equity)

  • Gross Profit Margin = EBIT / Sales

  • Net Profit Margin = Net Income / Sales

MM 2006/7


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Activity Ratios

Measuring the efficiency of working capital management:

  • Total Asset Turnover = Sales / Total Assets

MM 2006/7


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Liquidity Ratios

Measuring short-term liquidity:

Current Ratio = Current Assets Current Liability

MM 2006/7


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Financial Leverage Ratios

Measuring the firm’s capacity to service its debt and long-term liquidity:

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

  • Debt-to-Equity Ratio = Debt / Equity

    • Can be based on BV or MV

    • Similarly: long-term debt ratios

MM 2006/7


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Market Value Ratios

  • Price-to-Earnings Ratio = PS/EPS

    • Stock market price to earnings per share

  • Dividend Yield = Div/PS

    • Latest dividend to current stock price

  • Market-to-Book Value = MV/BV

    • Similarly: Market-to-Book Equity = ME/BE

  • Tobin's Q = MV / Replacement Value

MM 2006/7


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Asset pricing

P = Σt CFt/(1+R)t

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

  • Stocks

  • Project

  • Company

MM 2006/7


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Conclusions

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