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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

Basics for market microstructure

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

what is finance
What is finance?
  • Capital markets
    • Portfolio management
    • Asset pricing
      • Time and cross dimensions
    • Risk management
    • Financial engineering
    • Performance evaluation
    • Market microstructure

MM 2006/7

what is finance3
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

potential employer job function
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

potential employer job function5
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

market microstructure
Market microstructure
  • Financial markets
  • Financial instruments
  • Financial intermediaries

MM 2006/7

financial markets
Financial markets
  • Primary vs secondary
  • Exchanges vs OTC
  • Dealership vs (batch / continuous) auction
  • Listing/Depositary receipts

MM 2006/7

financial markets8
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

financial instruments
Financial instruments
  • Basic: stocks and bonds
  • Derivatives: forwards, futures, options, swaps, etc.
  • Indices

MM 2006/7

financial instruments10
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

financial intermediaries
Financial intermediaries
  • Brokers / dealers
  • Commercial banks
  • Investment banks
  • Mutual / pension / hedge funds
  • Wealth management

MM 2006/7

financial intermediaries12
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

jargon
Jargon
  • Short sales
  • Spread
  • Insider
  • Market-maker
  • Listing
  • Liquidity
  • Securitization
  • Market efficiency
  • Arbitrage

MM 2006/7

books
Books

MM 2006/7

further courses
Further courses
  • Investment theory
  • Corporate finance
  • Econometrics of financial markets
  • Risk management

MM 2006/7

lecture 2 plan
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

prices and returns

Prices and returns

-Why do prices rise?

- Because there are more buyers than sellers!

prices and returns18
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

discount rate
Discount rate
  • Time preference
  • Inflation
  • Risk

MM 2006/7

models

Models

The one investment certainty is that we are all frequently wrong

index models
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

slide22
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

slide23
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

specifics of corporation

Specifics of corporation

The most investor can lose is everything?

forms of business organization
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

modern corporation
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

modern corporation27
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

equity vs debt
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

basic financial statements
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

the balance sheet
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

slide31
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

the income statement
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

slide33
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

the statement of cash flows
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

slide35
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

financial ratio analysis
Financial Ratio Analysis

Trend / Cross-Sectional Analysis

  • Profitability Ratios
  • Activity Ratios
  • Liquidity Ratios
  • Financial Leverage Ratios
  • Market Value Ratios

MM 2006/7

profitability ratios
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

activity ratios
Activity Ratios

Measuring the efficiency of working capital management:

  • Total Asset Turnover = Sales / Total Assets

MM 2006/7

liquidity ratios
Liquidity Ratios

Measuring short-term liquidity:

Current Ratio = Current Assets Current Liability

MM 2006/7

financial leverage ratios
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

market value ratios
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

asset pricing
Asset pricing

P = Σt CFt/(1+R)t

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

MM 2006/7

conclusions

Conclusions

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

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