Introduction to finance D775

Seccion 1

How many financial ratios are there?

There are 5 Financial Ratios (Liquidity, leverage, efficiency, profitability, and market value ratio)

What is finance?

The management of money (investing, borrowing, lending, budgeting, saving, and forecasting)

What are the 3 types of finance?

Personal finance (individual), Public finance (country), Business finance (Company).

What are financial instruments?

Financial assets that can be traded in the open market and are used to raise capital in public and private markets (stocks, equity (securities))

Stocks

Are equity securities that represent the ownership interest held by investors in the company

Bonds or debt securities

Are financial instruments that represent money borrowed by an issuer from investors. In return, the issuer agrees to repay the principal (the amount borrowed) on a specified maturity date and usually makes periodic interest payments, known as coupon payments, throughout the life of the bond.

Investor or bondholder

The lender who buys the bond

Principal or (face value)

The amount borrowed

Interest rate (coupon rate)

The percentage paid to the bondholder for lending the money

Maturity Date

The date the principal must be repaid

Financial markets

A financial market is a marketplace where buyers and sellers come together to trade financial instruments, such as stocks, bonds, derivatives, and currencies. Financial markets play a vital role in the economy by providing liquidity (the ability to buy and sell assets easily), facilitating the flow of capital from investors to businesses and governments, and encouraging participation from a wide range of investors. These functions support economic growth, efficient resource allocation, and financial stability. Financial markets can be classified as public markets, which are open to participation by the general public, or private markets, which are restricted to institutional investors and qualified individuals.

Liquidity

How easily an asset can be bought or sold without greatly affecting its price.

Financial markets

allow investors to buy and sell financial assets (stocks, bonds), and they provide liquidity by easily buying and selling assets

Primary markets

sell new securities directly from issuers to investors/ where new financial assets are issued and sold for the first time (Initial Public Offering (IPO)

Secondary markets

Markets allow investors to (buy/Sell) trade existing securities

Dealer markets

Use market makers to facilitate trades (ready to buy and sell securities) (example: the Nasdaq stock market operates as a dealer market)

Auction market

Match buyers and sellers through competitive bidding/Buyers and sellers trade directly by competing with one another (NYSE)

Depository institutions

Accept deposits and provide loans (bank)

Investment Institutions

Collects money from many investors and invests money on behalf of investors (mutual funds, Exchange-traded funds-ETFs)

Insurance companies

Protects individuals and businesses against financial loss and invests in premiums (insurance)

Pension funds

They help workers save for retirement/ Invest retirement contributions to provide future retirement income

What is GDP?

(Gross Domestic Product) Monetary value of all final goods and services produced within a country’s borders during a specific period (year or quarter)

-It measures the size and health of a country’s economy

What is CPI?

Consumer price index is a measure of the average change in prices that consumers pay for a basket of goods and services over time

What is PPI?

The producer price index measures the average change over time in the prices that producers (manufacturers, farmers) receive for their goods and services before those products reach consumers.

What is considered when determining inflation?

Both the CPI and the PPI are considered when determining inflation

The unemployment rate

Is the percentage of those in the labor force who are jobless rising or falling after economic conditions

Agency problems

Occur when one person or group (the agent) is responsible for making decisions on behalf of another person or group, but the agent’s interests are different from the principal’s interests (managers not acting in accordance with shareholders’ interests)

What are the 4 financial statements?

Income statement, Balance sheet, Owners’ Equity, and Cash flows

Finance

Concerned with the management of assets and liabilities as well as the planning and strategizing for future growth and stability (investment analysis, risk management, capital raising, and budgeting)

What does Business finance focus on?

Focuses on the financial activities and strategies of companies. It involves capital investment decisions, financing methods, dividend policies, and risk management. The goal is to maximize shareholder value.

Companies rely on finance to

Support operations, expansion, and long-term strategic planning

What are the three roles of business finance?

1-Using financial ratios to manage the business

2-Applying skills with time value of money to determine which projects to invest in

3-Controlling the risk associated with projects by computing the cost of capital to determine how to fund the chosen projects.

Ratio analysis

Is a financial analysis technique that uses information from a company’s financial statements to evaluate its performance, profitability, efficiency, liquidity, and financial health/ understand how well a company is performing

Capital budgeting

Is the process a company uses to evaluate and select long-term investment projects that are expected to generate benefits in the future (decide if a major investment is worth the cost)

How do financial analysts use the cost of capital to evaluate investments (through debt or equity)?

The cost of capital represents the required rate of return that a company must earn on its investments to satisfy lenders and shareholders.

How many financial instruments are there?

There are 3 (stocks, bonds, and financial derivatives)

Stocks

Certificates (financial security) that represent ownership of an asset/ part-owner of the company. When you buy a stock, you become a shareholder (own a small portion of that company.

How many types of stock are there?

There are 2 main types of stock (common and preferred stock)

Common stock

The most common type of stock represents ownership in a corporation, and it’s recorded on the balance sheet (people who own common stock are called common shareholders). They have a claim on the company’s profits and assets after all debts and obligations have been paid

Common stockholders

Are primary owners of a company, who have voting rights allowing them to influence major corporate decisions (selecting the board of directors) shareholders benefit from potential capital appreciation and dividends

Dividends

A portion of a company’s earnings distributed to shareholders, usually in the form of cash or additional stock

Market capitalization

The total market value of a company’s outstanding shares of stock is calculated by multiplying the current stock price by the total number of outstanding shares.

Capital appreciation

Is the increase in the value of an investment over time/ Its when a stock is bought at a lower price than what it is sold (subtracting the lower purchase price from the higher sales price is the appreciation.

What is the primary difference between common stock and preferred stock?

Common stock represents ownership with voting rights and variable dividends; preferred stockholders receive fixed dividends and have priority over common stockholders in asset claims but usually do not have voting rights.

Preferred stock

It can be called hybrid security (characteristics of both common stock and bonds). It represents ownership in the firm and usually includes dividends, which are cash payments per share. Recorded under the owner equity portion of the balance sheet

Who is getting paid first, common stockholders or preferred stockholders?

Firms have to pay their preferred dividends first; they are not allowed to pay common dividends until the preferred dividends are paid, and if a firm really wants to pay its common dividends or their stock price takes a big hit.

Who has more claim on assets common stockholders or preferred stockholders?

Preferred stockholders have a higher claim on assets and earnings than common stockholders because they receive fixed dividends and have priority for dividend payments (safe choice)

Who could potentially have higher returns?

Common stocks offer the potential for higher returns and voting rights but come with greater risk due to their lower priority in claims on assets

Preferred stocks

They provide more stability with fixed dividends and higher priority in asset claims but usually have no voting rights

Bonds

They are loans that businesses, governments, or individuals issue or sell to raise capital

Bond investors

Buy bonds because they are lending their money to the issuing entity, and the issuer or creditor must make payments as agreed under the terms of the bond offering

Coupon rate

Is the annual interest rate paid by a bond issuer on the bond’s face value (percentage)

Bond maturity

is the date on which the principal amount of a bond or other debt instrument is to be paid in full when a bond reaches maturity, or a specific date when the last coupon is due, along with the original face value of the bond, then the debt is paid in full.

Why do entities issue bonds?

To secure long-term investing funding without diluting ownership, unlike stock, which gives investors part ownership of the company

Why do investors buy bonds?

Predictable income lower risk compared to stocks and portfolio diversification. Bonds provide a fixed income stream through interest payments and the return of principal at maturity (retirees usually buy bonds)

Junk bonds

Are high-yield, high-risk bonds issued by the companies with lower credit ratings to attract investors they offer a higher return rate

How many bonds are there?

There are 2 (Corporate and public)

Corporate Bonds

are issued by firms to finance operations, expansions, and business activities. They offer high yields due to their higher risk compared to public bonds (not paying back the debt)

What is the difference between bond and stock investors?

Is that bond, investors can force a firm into bankruptcy for failure to pay back the loan, whereas shareholders have no ability to force a firm into bankruptcy

Public bonds

Are issued by government groups, there are 2 types of public loans (Municipal and treasuries)

Municipal Bonds (MUNIS)

Are issued by states or local governments, and they fund public projects (infrastructure, public roads, parks, and fire departments). Usually, the income from investments in MUNI bonds is exempt from federal and state taxes

Treasuries

Are short-term, non-risky investments for the cash (treasury bonds) are considered among the safest investments due to their backing by the full faith and credit of the U.S government

Treasuries and Bonds

They are digitally issued by the U.S federal government and are considered very low risk (as long as the government collects taxes, it can collect back the loan)

Deficit spending or the federal deficit

This means the U.S government spends more than it makes. The difference is often made when the government issues bonds and collects money, taking on additional debt to fund the deficit

What investment is considered the most stable in the world?

U.S treasuries

What is a municipal bond, and how does it differ from a corporate loan?

A municipal bond is issued by local governments to finance public projects and often has tax advantages

A corporate bond is issued by a company to raise funds and typically carries higher yields due to higher risk

How do companies raise capital through debt and equity financing?

Companies can issue bonds (debt financing), which must be repaid with interest, or sell stock (equity financing), which gives ownership to investors but does not require repayment.

Financial derivatives

Another financial instrument they derive their value from the performance of underlying assets, indexes, or rates/ Are contracts whose value is derived from an underlying asset, rate, index, or event

What are the two main types of financial derivatives?

Options and futures

options

Are financial contracts that give the buyer the right but not the obligation to buy or sell an asset at a predetermined price (known as strike price) before a specified date.

Futures

Are Standardized contracts obligating the buyer to purchase or the seller to sell an asset at a predetermined price on a specific future date

What are corn futures?

Corn futures are contracts where buyers agree to take delivery on future date of a fixed amount of corn at a given time since the underlying price of corn fluctuates the value of the contract also fluctuates throughout its life span the original price paid for the contract and the ultimate price that will be paid for the corn itself are fixed in the contract moves allow buyers and sellers to lock in future price for corn

What are the financial instruments?

Common stock, preferred stock, corporate bonds, public bonds (Munis and treasuries) and financial derivatives (options and futures)

When taking out bonds, where are they recorded?

They are recorded under liabilities on the balance sheet and if things go wrong and the firm did not make the investment payments, the creditors (owners of the bonds) can drive the firm into bankruptcy

Investment funds

Collect money from multiple investors and pool it together to invest in diversified portfolio of assets such as stocks, bonds or other securities (are managed by professionals and make investing decisions on behalf of the investors) and benefit to diversification

Both investment funds and financial instruments

They are similar because they both are used to grow capital

Types of investment funds

Mutual funds, exchange-traded funds (ETFs), hedge funds and pension funds

Mutual funds

Investment vehicles that pool funds from multiple investors to buy a diversified portfolio of securities are managed by professional fund managers (they are usually open-end investment companies that issue shares to the public and are priced daily based on their net asset value (NAV)

Open end investment

A type of mutual fund that does not have restrictions on the amount of shares the fund can issue, allowing for continuous buying and selling of shares

Net asset value (NAV)

The per-share value of a mutual fund or ETF calculated by dividing the total value of the fund’s assets by the number of outstanding shares

Exchange-traded funds (ETFS)

Trade on stock exchanges like individual stocks and can be bough and sold throughout the trading day

Hedge funds

Are private investment partnerships for accredited investors that employ diverse strategies to generate high returns often with higher risk

Pension funds

Are large pools of capital collected from employees for retirement savings, managed to ensure the growth and sustainability of the fund

How do Financial derivatives like options and futures help businesses manage risk?

Options give the right to buy or sell an asset at a fixed price, while futures require buying or selling at a predetermined price. Businesses use them to hedge against price fluctuations in commodities, stocks or currencies

Financial market

A marketplace where buyers and sellers trade financial assets, such as stocks, bonds, currencies, and derivatives, facilitating the allocation of resources and risk (platforms to buy and sell securities), plays a role in the flow of capital from savers to borrowers

Ways to separate avenues for firms to raise capital

Public markets and private markets

Public Markets

Involves the buying and selling of securities such as stocks and bonds and ETFs on organized exchanges where the general public can participate (liquidity, Access)

Private markets

Involve transactions of equity, debt, or other securities that are not publicly traded (private equity firms). Companies in private firms are not subject to the same level of regulatory oversight as their public counterparts, allowing them greater flexibility and privacy in their operations (more risk due to less transparency and reduced liquidity)

The NYSE

Prominent exchanges NYSE, Is known for its strictest listing requirements and auction-based trading

NASDAQ

Is recognized for its electronic trading platform and focus on technology stocks

Who are the regulators of the Exchange market?

In the United States, the SEC regulates securities markets, enforcing laws to protect investors and maintain orderly functioning

The Commodity Futures Trading Commission (CFTC)

Oversees futures and options markets, ensuring they operate free from fraud and manipulation

Primary markets

Where new securities (financial instruments that represent an ownership position or rights to ownership) such as stocks, bonds, and options are issued and sold for the first time, companies, governments, or others need to raise capital by using stocks, bonds, or other financial instruments directly to investors

Underwrite

Is the process in which an investment bank or financial institution analyzes and takes the risk of a new securities issuance

What is an initial public offering (IPO) and why do companies use it?

The process by which a private company offers its shares to the public for the first time, allowing it to raise capital from a broad base of investors, they do it to expand operations and increase their market presence

Secondary markets

Is where existing securities are traded among investors. This market provides liquidity, enabling investors to buy and sell securities without the need for the issuing firm’s involvement

What is an example of secondary markets?

Stock market exchanges like the NYSE and NASDAQ are examples of secondary markets. The prices of securities in the secondary market are determined by supply and demand dynamics

What is the difference between primary and secondary financial markets?

The primary market is where companies issue new securities to raise capital (IPOS). The secondary market is where investors trade existing securities (NYSE)

Dealer markets

Financial markets can also be classified based on their trading mechanism as in dealer markets and auction markets. Transactions are facilitated by market makers or dealers Market participants who buy and sell securities for their own accounts, providing liquidity to the market) - think of a dealer in a dealer market as being similar to a used car lot owner the owner of the lot must purchase each vehicle from the prior owner hold the vehicle on the lot and then hope someone will buy that vehicle for a price higher than the owner paid for it the owner carries the risk of the inventory a dealer in a dealer market must sell securities for more than the dealer paid for them carrying the risk the risk if the securities are sold at a lower cost. 

Auction Markets

They operate through a centralized mechanism where all buy and sell orders for a security are aggregated, and the price is determined by the highest price buyer is willing to pay and the lowest price a seller is willing to accept