Introduction to Finance

Defining Finance: Finance is the study of how people allocate scarce resources over time. The two features of Financial Decision are that the costs & benefits are 1) Spread over time & 2) Are not know with certainty in advance.

Benefits of Studying Finance:

• To manage your personal resources.
• To deal with the world of business.
• To pursue interesting & rewarding career opportunities.
• To make informed public choices as a citizen (how financial system works)
  
• To expand your mind (how the real world works)

Financial Decisions for Households: Most households are families & face four basic type of financial decisions

• Consumption & Saving decisions
• Investing decisions
• Financing decisions
  
• Risk-Management decisions (how to reduce financial uncertainties)

Financial Decisions for Firms: Firms are entities whose primary function is to produce goods & services

• Capital Budgeting (deciding on acquiring long lived assets to operate business function)
  
• Capital Structure (feasible financing plan for the firm)
  
• Working Capital management (managing firms operating cash flows)

Financial Markets:

Specific Contracts	Securities Market
Non Transferable Non Negotiable	Capital Market (a: Stock Market b: Bond Market) Money Market Derivatives

A different classification is by the maturity of the claims being traded. The market for short term debt (less than one year) is called Money Market and the one for long-term debt & equity securities is called Capital Market

Money Market: Money market instruments are mostly interest earning securities issued by Government (T-bills, Repo) & large Corporations

Capital Market: In capital markets the total capital (bond & equity) are sold & purchased
Types: a) Stock Market ...b) Bond Market

Derivatives: Derivatives are financial instruments that drive their value from the prices of one or more other assets such as quity securities, foreign currencies or commodities. Their function is to serve as tools for managing exposures to the risk associated with the underlying assets.
Types: a) Forward Contracts ...b) Futures ...c) Options

Calculation:

Rate of Return in Other Currency:

Data: Time Period = 1 year, Japanese Govt. Bond Rate = 3%, U.K Govt. Bond Rate = 9%, Exchange Rate is currently 150 yen to the pound, Suppose exchange rate after one year is 140 & you invest £ 100 in U.K Govt. Bonds.

Yen Rate of Return: Interest Earned x Future price of ¥ - Investment
Investment

£ 109 x ¥140 - ¥15000
¥15000

= .017333 or 1.733%

Thus, your realized yen rate of return will be 1.733%, which is less than the 3% risk free yen interest rate you could have earned on one-year Japanese Bonds.

Rate of Return in Stock Equity:
Data: Time Period = 1 year, Price of Share $ 100/-, One day later $ 101/-.

Rate of Return: Ending price - Beginning price
...........................Beginning price

$ 101 - $ 100
$ 100

= .01 or 1.0%

Thus, your rate of return for the day is 1% & capital gain is of $ 1/-

Suppose you hold the stock for a year & at the end stock pays a dividend of $ 5/- and the price is $ 105/-

Rate of Return: Ending price - Beginning price + Cash Dividend
...........................Beginning price

$ 105 - $ 100 + $ 5
$ 105
= .10 or 10.0%

Inflation & Real Interest Rate:
To correct the effects of inflation, economists distinguish between

• Nominal Price: Prices in terms of some currency
• Real Prices: Prices in terms of purchasing power over goods & services

Data: Rate of Interest = 8%, Inflation = 5%

Real Rate: Nominal Interest Rate - Rate of Inflation
.................1 + Rate of Inflation

0.08 - 0.05
1.05
= 0.02857 or 2.857%

Stock Market Index:

Dow Jones Industrial Index (DJI) is the most cited stock index which is the index of prices of 30 stocks of major U.S Industrial Corporations but it has two major problems.

1. It is not diversified enough to accurately reflect the wide spectrum in the U.S.
2. It corresponds to a portfolio strategy that is not suitable as a performance benchmark

Therefore, most professional investors prefer to use other indexes like the Standard & Poor's 500 (S & P 500)

Illustration

Company	Base Year	Now	No. of Shares	Market Value
				Base Year	Now
IBM DEC	$ 100 $ 50	$ 50 $ 110	200 million 100 million	$ 20 billion $ 5 billion	$ 10 billion $ 11 billion
			Total	$ 25 billion	$21 billion
			Weight	20 / 25 = 0.8 5 / 25 = 0.2	Decline of 25-21 25 = 0.16 or 16%

DJI - Type Index = Avg. of Current Stock Price x 100

............................Avg. of Base year Stock Prices

........................($ 50 + $ 100) / 2 x 100
................($ 100 + $ 50) / 2

= 106.67 or increase of 6.67%

S & P - Type Index = (Weight of IBM x Current Price of IBM

.................................................................Base year Stock Prices
.......+.....Weight of IBM x Current Price of DEC
..................................................Avg. of Base year Stock Prices) x100
(0.8 x 0.5 + 0.2 x 2.2) x 100
.............L..........
= 0.84 or 84%, a decrease of 16%

Thus, the index shows a 16% decline, which accurately reflects the total market value of the all Stocks