Lecture 1: Introduction to Financial Economics

Renuka Sane

July 25, 2017

Participants in any economy

1. Individuals
2. Firms
3. State
Each grapple with the financial question of how to manage their cashflow
through time, and in possible future states.
An example of the questions

I As individuals we want to smooth consumption over our life.

I Is it worth it for me to take an education loan? How will I be able to repay
it later?
I I want to buy a car? How do I finance that purchase?
I How do I accumulate wealth to finance retirement?
I Firms require funding to do business
I Which project do I invest in? How much steel should I produce?
I How do I raise money to make this investment?
An example of the questions

I As individuals we want to smooth consumption over our life.

I Is it worth it for me to take an education loan? How will I be able to repay
it later?
I I want to buy a car? How do I finance that purchase?
I How do I accumulate wealth to finance retirement?
I Firms require funding to do business
I Which project do I invest in? How much steel should I produce?
I How do I raise money to make this investment?
I Finance makes this possible.
The problems finance solves

I A country generates savings.

Who should get these savings? What industries? What firms? For what
projects? This is the allocation problem.
I How do we transport money across time?
E.g. the pensions problem. E.g. borrow to build a bridge today and pay for
it in coming 30 years using toll revenues. This is the borrowing problem
I Risk is everywhere.
How to cut risk into separate little pieces, place each piece at the place
best suited for it, and overall obtain the best risk/reward?
An example

I A person comes up with a good idea for a project. Say, he wants to make
shoes in a factory in Madhya Pradesh. He thinks he wants to finance it
using Rs.50 crore of equity capital and Rs.25 crore of borrowing, thus
adding up to a project cost of Rs.75 crore.
I How is he going to get the money?
I What if he was very rich?
How does finance make this possible?

I Financial assets: contracts which are statecontingent claims.

I Financial markets and institutions that make trading these assets possible.
What is a financial asset?

I A legal contract between two parties

I The contract defines
I Expected cashflow: what amount and type of income
I Maturity: when will it be received
I Every asset can be described as a series of (Expected(cashflow), Maturity)
pairs.
Examples of financial assets

I Assets with fixed (deterministic) cashflows and fixed maturities: loans,

bonds
I Assets with fixed cashflows and uncertain maturities: insurance products
I Assets with uncertain cashflows and fixed maturities: derivatives
I Assets with uncertain cashflows and uncertain maturities: equity
What is essentially happening here?

I Some people want to transport money from today to tomorrow (savers)

I Some people want to transport money from tomorrow to today
(borrowers)
I They meet in the financial market (for example the bond market), where
a contract sold by the borrowers (for money today) to the savers (who will
receive the money tomorrow)
I This need not be a domestic market. Borrowers could connect with capital
outside of India.
I This market finds out the price at which supply equals demand the
interest rate.
The big questions

I Given an asset and its structure, what is the right price to pay for it?
I How is a financial asset valued?
I How should it be valued?
I Given my goals, how should I manage those goals?
I How much should I save/spend?
I What should I buy/sell? When?
I How should I finance my purchase?
Principal problem

Given an asset and its structure, what is the right price to pay for it?
I Step 1: Find out the factors that determine the price and
I Step 2: Value each factor and
I Step 3: Sum all factors.
What factors control pricing?

Ans: Everything!
From contract definition, to legal environment, to probable states in the future
relating in any way to the contract.

Pricing in finance is tough.

Factors That Make Finance Challenging

I Time
I Now is different from tomorrow
I There is a gap between when you pay for them and when you get the
benefits.
I There tends to be a lack of standardisation to count on.
I Risk
I How should we model the unknown?
 Part I

This course
Questions we focus on

I Financial markets: what is the role they play in pricing assets?

I Markets for pricing assets, markets for pricing risk.
I Market micro-structure: Different kinds of financial markets. Why do so
many exist, what are their pros and cons?
I Liquidity? What is the liquidity premium?
Questions we focus on

We focus on the following set of questions that arise in finance

I Types of financial assets and how they are different from each other.
I Principles of pricing the assets: theoretical and empirical models of pricing
assets
I How to calculate the risk of these assets.
I How to hedge the risk of these assets.
Questions we focus on

I Do markets always work in discovering prices?

I What is behavioural finance?
Questions we focus on

I What do markets in India look like?

I What kind of credit markets do we have?
I What kind of secondary markets do we have?
I What kind of a regulatory framework do we have?
Grading

Examination Marks
Class tests 30
Midterm exam 30
Final exam 40
Resources

I Investment Science by Luenberger

I Investments by Bodie, Kane and Marcus
I Quantitative Financial Economics: Stocks, Bonds and Foreign Exchange
by Keith Cuthbertson and Dirk Nitzsche