Finance I

SUBJECT OUTLINE
Semester II 2011 Dr Les Coleman

Some Thoughts on This Course

We Cover Nuts and Bolts of ALL Finance

Course is introductory Material is broad ranging Just as no-one can take a shower for you, no-one can learn for you (Amos Tversky)

Copyright The University of Melbourne Department of Finance 2008

Copyright The University of Melbourne Department of Finance 2008

Some gratuitous advice

Feedback from QOTs

Extensive resources are available to assist

Tutors: tutes, pitstops, OLT Lecturers: during/after lectures, consultations Teaching & Learning Unit

1. Police noise in theatre

Zero-tolerance policy

You will almost certainly pass the exam if you

Attend lectures Participate in tutorials Submit both assignments on time Do a past exam

2. Promote more interaction during lectures

Introduced breaks for two-way questions

If you want to do well

Read the textbook and some business journals Use FinanceNow! In the exam:
Answer the questions Present your work neatly
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3. Provide earlier feedback on tutorials

Separated into Parts A & B
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Feedback II

4. Provide more real-world examples

Talk regularly about relevance

5 Expand on materials in textbook 5.

Added more sections to notes

6. Highlight critical points 7. Talk slower

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QUESTIONS ????

Lecture Schedule

Les Coleman

Week 1 2 3 4 5 6 7 8 9 10 11 12

Date of Lecture July 26 and 28 August 2 and 4 August 9 and 11 August 16 and 18 August 23 and 25 August 30 and September 1 September 6 and 9 September 13 and 16 October 4 and 6 October 11 and 13 October 18 and 20 October 25 and 27

Topic Welcome and Administration Introduction to the Financial System Fundamentals of Financial Mathematics The Payment System Deposit-Taking Institutions Deposit-Taking Institutions (cont) Introduction to Markets Introduction to Markets (cont) The Money Market The Bond Market Equity The Share Market Currency The FX Market Offshore Capital Markets Interest Rate Risk Management Interest Rate Risk Management (cont) Summary and recap

Hunt & Terry chapters 1 3 2 3 4 5 5 7 8 9 10 11 11 12 12

Academic Qualifications
Bachelor of Engineering Melbourne Uni Bachelor of Science (Economics) London Uni Master of Economics Sydney Uni PhD (Management) Melbourne University (2004)

Previous Work Experience p

Mining Engineer, Zambia Mobil Oil (ExxonMobil) operations, planning, finance

Current Positions
Senior Lecturer in Finance, University of Melbourne Investment Policy Committee, IOOF Ltd Director, Australian Ethical Investments Limited

Copyright The University of Melbourne Department of Finance 2008

Copyright The University of Melbourne Department of Finance 2008

This topics Big Question

Faculty of Business & Economics Department of Finance

Finance 1 (333-101)

Introduction to the Financial System

Dr Les Coleman

The role of a security

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Overview of the Financial System

Functions of the Financial System (1.1)

Finance Financial decision making

under conditions of uncertainty; allocates resources over time

The financial system

The set of financial institutions, markets and securities that manage financial contracting and the exchange of financial assets and risks Arranged by financial institutions (acting as principals) and financial markets (where institutions act as agents) Financial systems are constantly innovating

Corporate finance
Financial decision making by firms
This course is concerned with the study of the financial system

Developed financial systems perform five functions: Settle commercial transactions (domestically and internationally) Arrange the flow of funds (that is, financing) Transfer and manage risk Generate information to assist decision making Deal with incentive problems in contracting
Supervision is required!
Copyright The University of Melbourne Department of Finance 2008

Copyright The University of Melbourne Department of Finance 2008

Financial Contracts

Settlement of Transactions (1.1.1)

Security: financial contract that can be traded in a financial market

Asset involved: commodity (eg. gold), hard asset (eg. property), financial asset (eg. shares) Quantity and unit: thousand shares, ounce of gold Price Date Payment/settlement terms

Transaction: arrangement between a buyer and a seller to exchange an asset or service for payment
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Transaction and settlement can be different (example: payment by cheque) Settlement is when value (=purchasing power) and title transfer Organised network of connections: the payment system Supervised by the Reserve Bank

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The Flow of Funds (1.1.2)

Preferences of Surplus and Deficit Units

The financing system organises the flow of funds:

from surplus units (investors or depositors) to deficit units (such as borrowers)

Feature Return on funds Length of contract Risk exposure Amount of funds

Surplus units High as possible Flexible and short Varies, but many are risk averse Usually small

Deficit units Low as possible Inflexible and long Risk taker Usually large size mismatch maturity mismatch

Funds can flow via intermediaries, or through financial markets

Intermediaries and markets overcome differences in preferences to optimise the flow of funds
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Risks in Finance

Risk Management Alternatives

Risk is the chance that expected outcome is not achieved Credit risk: possibility that borrower will not meet scheduled repayments Default on loan obligations Market risk: possibility of unexpected movement in the market interest rates, exchange rates, security prices Operational risk failure of process or controls
e.g. credit card fraud ~0.06% of payments

Avoidance (opportunity cost: return foregone by passing up best choice) Elimination (costs of risk prevention) Acceptance/management (eg. a lender can reduce credit risk by requiring a mortgage over property) Insurance (payout to cover loss) Transfer

Shocks
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Risk Transfer (1.1.3)

The Relationship between Risk and Return

Risk transfer mechanisms: Match the risk appetites of participants in the financial system Example: Derivatives establish a future price Unbundle a financial contract so that risk and flow of funds are separated Example: Mortgage covers risk

Deficit units pay a return to compensate surplus units for deferring their use of the funds; and the risk they face Example: p default risk borrowers do not make loan repayments as agreed
Expected return

Risk premium Risk-free return

Risk
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We assume investors are risk averse meaning they have to be compensated to accept risk

Return in Finance

Intermediaries

Return in finance is interest or similar ANZ Bank interest rates

Type of facility
Borrowing Home loan Personal overdraft Credit card (cash advance) Deposit accounts ($50K) Less than one month 12 months 5+ years

July 2009
5.8 % 13.2 % 20.0 % 0.8 % 4.0 % 6.0 %

July 2011
7.1 % 12.7 % 21.7 % 0.8 % 6.0 % 6.2 %

Flow of funds through institutions Performed by authorised-deposit-taking institutions (ADIs) such as banks raise funds from deposits (pay interest) ADI deposit accounts give surplus units a low risk, , low return, , highly g y liquid q investment as well as access to payment services use these funds to make loans (earn interest) ADI loans are at relatively low interest rates, and can be for long periods and large amounts
ADI earns an interest rate spread Charges service fees

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Copyright The University of Melbourne Department of Finance 2008

Markets

Primary and Secondary Markets

Deficit units sell securities to investors Securities are contracts that can be traded in a financial market Major domestic markets:
Money market Bond market Share market

Other financial markets

Foreign exchange Commodities Housing

The primary market arranges for issue of new securities (issuers hire investment banks to sell the securities) Subsequent trading in existing securities occurs in the secondary market (institutions provide trading services) Secondary markets assist primary markets:
provide liquidity

(investors are more likely to buy new securities if they can be subsequently sold in liquid (active) secondary markets)
perform price discovery develop the supply of investment funds
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Copyright The University of Melbourne Department of Finance 2008

Forms of Finance

Differences between Debt and Equity

Debt (or credit) Borrowed funds with agreed interest cost and repayment date loans from intermediaries or bonds and money-market securities Debt payments have priority over equity payments Repayment default is the source of credit risk

Equity Funds that acquire part ownership of a business supplied through issue of ordinary shares, and retention of profits Riskier than the returns to debt holders

Debt Return (cost) Term Ranking Risk to supplier of funds Governance Agreed interest rate Finite Ahead of equity Default and lower interest rates Covenants and security
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Equity Varies (dividend + capital gain) No terminal date Behind creditors Residual claim, so higher risk Appoints management

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BHPs Financing

$US Billion ASSETS Inventories, Fixed Assets, etc LIABILITIES Payables, other Debt EQUITY Share capital Retained earnings

76

24 13 2 37

What is the worlds most successful invention?

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Copyright The University of Melbourne Department of Finance 2008

Resolving Incentive Problems

Moral hazard

Information asymmetry
parties do not have equal access to information (borrower knows more about capacity to repay and intended use of the borrowed funds than the lender) can result in adverse selection when one party contracts on the wrong basis

Arises when a contract changes incentives so one party may not act responsibly
Examples:
Insurance Bank loan approvals Governments

Dont worry son. you can have a new car if you smash this one

To reduce this risk

Apply credit standards Provide investors with relevant information Rely on market forces

The Economist (21 May 2005): Tax deductibility of interest expense encourages taxpayers to take bigger risks than they would if left to their own devices

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Copyright The University of Melbourne Department of Finance 2008

Agency Problems

Lets Review the Key Points

Arise when an agent acts in own interests, rather than those of the principal(s) Ap potential p problem when:
shareholders hire managers to run a business investors use brokers issuers employ investment banks
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1. Financial system functions 2. Securities 3. Transaction 4 Settlement 4. 5. Surplus and deficit units 6. Debt and equity 7. Incentive problems

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Some Good Data Sources

Reserve Bank of Australia Chart Pack www.rba.gov.au/ChartPack/ Commonwealth Parliament Monthly Economic and Social Indicators www.aph.gov.au/library/pubs/MSB/ Westpac Australian Economic Reports http://www.westpac.com.au/internet/publish.nsf/c ontent/wimcer%20australian%20economic%20re ports CommSec Broker Research https://www.comsec.com.au/ Yahoo! Australian Stock Research http://au.finance.yahoo.com/?u
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QUESTIONS ????