Lecture 4 - chapters 15-16

Lecture Information

  • Subject: IND500 Investment Analysis

  • Institution: University of Stavanger

  • Date: September 18, 2024

Class Outline

  • Feedback reminder on early evaluation

  • Practicalities:

    • New MA deadline: October 15

    • Final exam: December 17 at 9 AM

  • Reading Assignments: Vernimmen Chapters 15, 16 (to be continued in Lecture 5)

  • Next class: October 2, 2024

  • Topics for today:

    • Financial systems

    • Functions of a financial system

    • Market efficiency

    • Investor behavior

    • Net present value

Financial Markets Overview

  • Source: P. Vernimmen, P. Quiry, Y. LeFur, Corporate Finance, Theory and Practice

The Financial System

  • Connects economic agents with surplus resources (investors) and those with financial needs (borrowers).

  • Functions:

    • Financial intermediation: Brokers manage transactions between excess funds and financing needs.

Direct Finance

  • Examples:

    • Bond Markets:

      • Direct issuance of bonds by entities (companies/governments) to investors.

      • E.g., U.S. Treasury bonds finance federal spending.

      • Issues of default from Argentina (2001 and 2020).

    • Equity Markets:

      • Companies issue shares directly; investors gain ownership rights.

      • Example: Tesla's IPO in June 2010 with an initial price of $17/share.

    • Crowdfunding:

      • Utilizing online platforms like Kickstarter, individuals raise funds bypassing traditional financiers.

Indirect Finance

  • Examples:

    • Banks:

      • Accept deposits and lend out funds (e.g., mortgages, personal loans).

    • Mutual Funds:

      • Pool investor funds for diversified investments managed by professionals. E.g., Vanguard 500 Index Fund.

    • Pension Funds:

      • Collect worker contributions to invest in various assets ensuring future retiree benefits.

Intermediary Structure

  • Intermediaries (like banks) maintain balance sheets managing the flow of surplus and deficit funds.

  • Functionality includes managing revenues, costs, and profit from lending and collecting.

Capital Market Types

  • Bank-Based Economy:

    • Less developed capital markets, reliance on banks for corporate financing.

  • Market-Based Economy:

    • Corporations primarily use direct issuance of financial securities.

    • Increased individual and SME access to finance.

Primary and Secondary Markets

  • Primary Market:

    • New securities issuance.

    • Institutions obtain resources.

  • Secondary Market:

    • Trading of existing securities.

    • Provides liquidity; market equilibrium becomes essential.

Market Interaction

  • Poor performance in the secondary market can adversely affect primary market quality.

  • Financial instruments create interrelationships between both markets.

Derivative Markets

  • Options:

    • Right to buy/sell an asset at a set price within a set timeframe.

  • Futures:

    • Obligation to buy/sell an asset at a future date for a predetermined price.

Functions of a Financial System

  1. Payment facilitation (e.g., electronic transfers).

  2. Pooling funds for large projects (shares, bonds).

  3. Resource distribution across sectors.

  4. Risk management (mutual funds, insurance).

  5. Low-cost information dissemination.

  6. Conflict resolution between contracting parties.

Market Efficiency

  • Definition: Prices reflect all available relevant information quickly.

  • Tests of Efficiency:

    1. Predictability of prices

    2. Market response to events

    3. Insider information impact

Types of Market Efficiency

  1. Weak Form:

    • Prices reflect all past trading information.

  2. Semi-Strong Form:

    • Prices reflect all publicly available information.

  3. Strong Form:

    • Prices reflect all information, including insider.

Anomalies in Market Behavior

  • Existence of predictable patterns contrary to market efficiency.

  • Notable anomalies:

    • Small company performance

    • Value vs. growth returns

    • Calendar anomalies (e.g., January effect)

Investor Behavior

  • Types:

  1. Hedger: Minimizes risk exposure.

  2. Speculator: Takes on risk for potential gain.

  3. Arbitrageur: Profits from market discrepancies without risk.

  • Contribution to market liquidity enhances price accuracy.

Time Value of Money

  • Importance of discounting; future value needs to be assessed using present metrics.

  • Key Terms:

    • Discount rate

    • Present value (PV)

    • Future value (FV)

    • Net present value (NPV)

Calculating Future Value

  • Example: Calculation of future value of a deposit with interest.

  • Understanding compounding effects on cash flow.

Differences in Interest Rates

  • Nominal Rates: Pre-inflation adjusted rates set by central banks.

  • Real Rates: Adjusted for inflation; indicates practical borrowing costs.

Next Topics

  • Reliance on nominal vs. real calculations, NPV calculations, and understanding annuities and perpetuities.