Foundation of Finance

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Foundations of Finance: Overview

Prof. Alex Shapiro

Lecture Notes 1: Overview
This lecture introduces much of the terminology we will use in the course, and we will describe it in more detail later. For now, to set the stage, we will review it very briefly in class, but make sure to get the supplemental details from the textbook.

I.

Readings

II. Asset Classes
III. Characteristics of an Asset
IV. The Financial System
V.

Financial Markets

VI. Financial Intermediaries
VII. Trends
VIII. Additional Readings

Buzz Words:

(No) Arbitrage, Present Value,
Risk, Risk Aversion, Risk Adjustment,
Portfolios, Diversification,
Option Value, Equilibrium, Liquidity
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Foundations of Finance: Overview

I. Readings
A. BKM Chapter 1.
B. Skim BKM Chapter 2.
C. Articles distributed in class

Insert Figure 1-1:

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Foundations of Finance: Overview

II. Asset Classes
A. Real Assets
1. natural resources.
2. physical capital.
3. human capital.
4. “Cultural” Capital
5. Intellectual Property

B. Financial Assets (referred to as securities)
Specify level, timing and conditions for payment of cash, goods or other financial assets.

1. Money
a medium of exchange (a paper claim backed by the government), is held to allow the completion of transactions.

2. Debt
a claim to a predetermined payment stream, usually secured on a set of real or financial assets (maturity is time from issue to expiration).

3. Equity
residual claim to a set of real or financial assets (usually of a corporation) usually coupled with corporate control.

4. Derivatives
payoff is dependant on the value of some other (usually financial) asset.

5. Combinations of the above
Example: Callable Bond
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Foundations of Finance: Overview

C. Illustration: Debt vs. Equity.
Suppose XYZ Co s assets pay off a random amount of Cash Flow (CF) in 1 year s time and XYZ has issued debt with a promised payment of $100 in 1 year s time, and equity. The value of the Debt, Equity, and Firm Assets will depend on the realization of CF.

CF

100

120

140

160

180

Debt

CF

60

80

100

100

100

100

100

100

min{CF,100}

Equity

0

0

0

0

CF-100

20

40

60

80

max{0,CF-100}

Firm

CF

60

80

100

CF

120

140

160

180

CF

Equity = 0, means that the Debtholders take over what’s left of the assets. Example: The retailer Kmart Corp was not generating enough CF. In May 2003, after a period of reorganization under bankruptcy (so called chapter 11 reorganization), the Equity (also referred to as “shares,” “stocks”) of Kmart lost all their value, and ownership of the company was transferred to its creditors.

D. Example: IBM Corporation.
1. Real Assets:
plant used to build computers.
2. Claims to the income generated by Real Assets:
a) Equity: IBM stock.
b) Debt: IBM bonds.
3. Derivatives:
Claims on IBM stock.
A call option on IBM stock gives the holder the right (but not the obligation) to buy the stock at a given exercise price.
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Foundations of Finance: Overview

Insert IBM Data on pages 5-8

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Foundations of Finance: Overview

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Foundations of Finance: Overview

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Foundations of Finance: Overview

III. Characteristics of an Asset
A. Divisibility:
extent to which fractional amounts of an asset can be sold/bought. 1. Physical assets are often indivisible (cars) but not always (gas). 2. Financial assets often are divisible (equity of a corporation). In this course we will treat all financial assets as divisible.

B. Liquidity:
refers to the speed (and price impact) with which the asset can be sold. 1. Money is the most liquid asset.
2. Large firm equity tends to be more liquid than small firm equity. In this course we will treat all assets as equally liquid.

C. Standardization:
extent to which units of the asset are the same.
1. New cars are...
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