Financial Markets Explained

CHAPTER 2:
FINANCIAL MARKETS
Lecturer: Truong Thi Thuy Trang

Email: truongthithuytrang.cs2@ftu.edu.vn
1
Content
• Financial Markets
• Functions of Financial Markets
• Structure of Financial Markets
• Internationalization of Financial Markets
• Characteristics of a Well-Run Financial Market
2
Financial Markets
• Financial markets are markets in which funds are
moved from people who have an excess of
available funds (and lack of investment
opportunities) to people who have investment
opportunities (and lack of funds).
• Financial markets (such as bond and stock
markets) are markets in which securities are
traded.
3
Figure 1. Flows of Funds Through the
Financial System
4
Function of Financial Markets
• Performs the essential function of channeling
funds from economic players that have saved
surplus funds to those that have a shortage of
funds
• Direct finance: borrowers borrow funds directly
from lenders in financial markets by selling them
securities
5
Function of Financial Markets
• Promotes economic efficiency by producing an
efficient allocation of capital, which increases
production
• Financial markets provide liquidity
• Financial markets also improve the wealth of
individual participants by providing investment
returns to lender-savers and profit and/or use
opportunities to borrower-spenders
6
Structure of Financial Markets
• Debt and Equity Markets
• Primary and Secondary Markets
• Stock Exchanges and Over-the-Counter (OTC)
Markets
• Money and Capital Markets
7
Debt and Equity Markets
• Debt instruments (contractual agreement)
– Maturity: the remaining time until the expiration date
• Equities (claims to net income and assets)
– Dividends: periodic payment to shareholders
– Residual claimant
8
Debt and Equity Markets
• A bond (a debt instrument) is a contractual agreement by
the borrower to pay the holder of the instrument fixed
dollar amounts at regular intervals (interest and principal
payments) until a specified date (the maturity date), when
a final payment is made.
– Maturity: Short-term; Intermediate-term; Long-term
• Equities are claims to share in the net income (income

after expenses and taxes) and the assets of a business.
Equity often make periodic payments (dividends) to their
holders and are considered long-term securities because
they have no maturity date.
9
Primary and Secondary Markets
• Primary markets are financial markets in which
new issues of a security are sold to initial buyers
by the corporation or government agency
borrowing the funds.
– Underwriting, initial public offering
• Secondary markets are markets in which existing

securities are traded among investors
– Role of secondary market
10
Primary and Secondary Markets
• The primary markets are not well known to the

public.
– Investment banks underwrite securities in primary
markets.
• The previously issued securities will be sold in

the secondary market
– Brokers and dealers work in secondary markets.
11
Exchanges and Over-the-Counter (OTC)
Markets
• Exchanges are markets where buyers and sellers
of securities (or their agents or brokers) meet in
one central location to conduct trades
– Examples: NYSE, Chicago Board of Trade
• Over-the-counter (OTC) markets are markets, in
which dealers at different locations who have an
inventory of securities stand ready to buy and sell
securities “over the counter” to anyone who
comes to them and is willing to accept their prices
– Examples: Foreign exchange, Federal funds
12
Money and Capital Markets
• Money markets deal in short-term debt
instruments
– Short terms to maturity, least price fluctuations and

least risky investment
• Capital markets deal in longer-term debt and

equity instruments
– With maturities more than one year
13
The Money Markets
• The securities in the money market are short term
with high liquidity; therefore, they are close to
being “money”.
• Money market securities are usually sold in large
denominations ($1,000,000 or more).
• They have low default risk.
• They mature in one year or less from their issue
date, although most mature in less
than 120 days.
14
Why do we need money markets?
• Investors in Money Market: Provides a place for
warehousing surplus funds for short periods of
time.
• Borrowers from money market provide low-cost
source of temporary funds.
15
Principal Money Market Instruments
Amount ($ billions, end of year)

Type of Instrument 1990 2000 2010 2016
U.S. Treasury bills 527 647 1,767 1,816
Negotiable bank certificates of deposit 547 1,053 1,923 1,727
(large denominations)
Commercial paper 558 1,602 1,058 885
Federal funds and security repurchase 372 1,197 3,598 3,778
agreements
Source: Federal Reserve Flow of Funds Accounts; http://www.federalreserve.gov
16
Money Market Instruments
• U.S. Treasury Bills
• Negotiable Bank Certificates of Deposits
• Commercial Papers
• Banker’s Acceptances
• Repurchase Agreements
• Fed Funds
17
Treasury Bills
• Short-term debt instruments of the US
government (1-,3- or 6- month maturities)
• No interest payments but they are sold at a
discounted price (lower price than the set amount
paid at maturity)
• The most liquid instruments
18
Negotiable Bank Certificates of Deposits
• A debt instrument sold by a bank to depositors
that pays annual interest of a given amount and at
maturity pays back the original purchase price.
• Sold in secondary markets.
• Important source of funds for commercial banks
from corporations, money market mutual funds,
charitable institutions, and government agencies.
19
Commercial Papers
• Issued by large banks and well-known corporations
• There are 2 major types of commercial paper:
– Direct paper is issued mainly by large finance
companies and bank holding companies directly to the
investor.
– Dealer paper, or industrial paper, is issued by
security dealers on behalf of their corporate customers
(mainly nonfinancial companies and smaller financial
companies).
20
Banker’s Acceptances
• An order to pay a specified amount to the bearer
on a given date if specified conditions have been
met, usually delivery of promised goods.
• These are often used when buyers/sellers of
expensive goods live in different countries.
21
Repurchase Agreements
• With very short maturities
• Treasury bills serve as collateral (an asset that the
lender will receive if the borrower defaults)
• A firm sells Treasury securities, but agrees to buy
them back at a certain date (usually 3–14 days
later) for a certain price.
22
Fed Funds
• Short-term funds transferred (loaned or borrowed)
between financial institutions, usually for a period
of one day.
• Borrowing and lending of bank reserves on
deposit with the Federal Reserve.
• Used by banks to meet short-term needs, to meet
reserve requirements.
23
Capital Market Instruments
• Capital market instruments are debt and equity
instruments with maturities of greater than one
year.
24
Principal Capital Market Instruments
Amount ($ billions, end of year)

Type of Instrument 1990 2000 2010 2016
Corporate stocks (market value) 3,530 17,628 23,567 38,685
Residential mortgages 2,676 5,205 10,446 10,283
Corporate bonds 1,703 4,991 10,337 12,008
U.S. government securities (marketable 2,340 3,171 7,405 12,064
long-term)
U.S. government agency securities 1,446 4,345 7,598 8,531
State and local government bonds 957 1,139 2,961 3,030
Bank commercial loans 818 1,497 2,001 3,360
Consumer loans 811 1,728 2,647 3,765
Commercial and farm mortgages 838 1,276 2,450 2,850
Source: Federal Reserve Flow of Funds Accounts; http://www.federalreserve.gov
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Bonds
• A bond is a promise to make periodic coupon
payments and to repay principal at maturity;
breech of this promise is an event of default.
• Carry original maturities greater than one year so
bonds are instruments of the capital markets.
• Issuers are corporations and government units.
26
Treasury Bonds
• T-notes and T-bonds issued by the U.S. treasury to finance
the national debt and other federal government
expenditures
• Backed by the full faith and credit of the U.S. government
and are default risk free
• Pay relatively low rates of interest (yields to maturity)
• Given their longer maturity, not entirely risk free due to
interest rate fluctuations
• Coupon securities: Pay coupon interest (semiannually),
notes have maturities from 1-10 years, bonds 10-30 years
27
Municipal Bonds
• Securities issued by state and local governments
to fund either temporary imbalances between
operating expenditures and receipts or to finance
long-term capital outlays for activities such as
school construction, public utility construction or
transportation systems
• Tax receipts or revenues generated are the source
of repayment
• Attractive to household investors because interest
(but not capital gains) are tax exempt
28
Corporate Bonds
• All long-term bonds issued by corporations
• Minimum denominations publicly traded corporate
bonds is $1,000
• Generally pay interest semiannually
29
Bond Ratings
• Bonds are rated by the issuer’s default risk
• Large bond investors, traders and managers
evaluate default risk by analyzing the issuer’s
financial ratios and security prices
• Three major bond rating agencies are Fitch,
Moody’s and Standard & Poor’s (S&P)
• Bonds assigned a letter grade based on perceived
probability of issuer default
30
31
32
Stocks
• Two types of corporate stock exist
– Common stock
§ The fundamental ownership claim in a public
corporation
– Preferred stock
§ A hybrid security that has characteristics of both
bonds and common stock
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Mortgages
• Mortgages are loans to individuals or businesses
to purchase a home, land, or other real property
• Many mortgages are securitized
– securities are packaged and sold as assets backing a
publicly traded or privately held debt instrument
• Four basic categories of mortgages issued: home,

multifamily dwelling, commercial, and farm
34
Derivative markets
• Derivative markets are the markets where
investors trade derivative instruments like futures
and options
• Derivatives (or contingent claims) are securities
whose value depends on the value of some other
underlying security.
• Derivatives include forwards, futures, options and
swaps.
35
Derivative markets
• A call option is the right to buy—“call away”—a given
quantity of an underlying asset at a predetermined price,
called the strike price (or exercise price), on or before a
specific date.
• There is a seller, called an option writer, and a buyer,
called an option holder.
• A put option gives the holder the right but not the
obligation to sell the underlying asset at a predetermined
price on or before a fixed date. The holder can “put” the
asset in the hands of the option writer.
36
Internationalization of Financial Markets
• Foreign Bonds: sold in a foreign country and denominated in
that country’s currency
• Eurobond: bond denominated in a currency other than that of

the country in which it is sold
• Eurocurrencies: foreign currencies deposited in banks outside

the home country
– Eurodollars: U.S. dollars deposited in foreign banks outside

the United States or in foreign branches of U.S. banks
• World Stock Markets:
– help finance corporations in the United States and the U.S.

federal government 37
Characteristics of a Well-Run Financial Market
• Must be designed to keep transaction costs low.

• Information the market pools and communicates
must be accurate and widely available.
• Borrowers promises to pay lenders must be
credible.
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CHAPTER 3:
FINANCIAL INSTITUTIONS

1
Content
• Some facts about the financial structure through
out the world
• Functions of Financial Institutions
• Asymmetric Information
• The Structure of Financial Institutions
– Depository Institutions: Commercial Banks
– Non-depository Institutions: Insurance Companies;
Pension Funds, Securities firms, Mutual Funds,
Investment Banks, Finance Companies and Venture
Capital Funds
• Regulation of the Financial System 2
Figure 1. Flows of Funds Through Financial Institutions
3
Flows of Funds Through the Financial System
• In addition to the lenders and the borrowers, the

financial system has three components:
1. financial markets, where transactions take place;
2. financial intermediaries, who facilitate the transactions;
3. regulators of financial activities, who try to make sure
that everyone is playing fair.
• In this chapter, we look at each of the financial

institutions and the motivation for their existence.
4
Basic Facts about Financial Structure
Throughout the World
• The bar chart in Figure 2 shows how American businesses
financed their activities using external funds (those
obtained from outside the business itself) in the period
1970–2000 and compares U.S. data to those of Germany,
Japan, and Canada.
5
Figure 2. Sources of External Funds for Nonfinancial Businesses: A
Comparison of the United States with Germany, Japan, and Canada
Source: Andreas Hackethal and Reinhard H. Schmidt, “Financing Patterns: Measurement Concepts and Empirical Results,” Johann
Wolfgang Goethe-Universitat Working Paper No. 125, January 2004. The data are from 1970–2000 and are gross flows as
percentage of the total, not including trade and other credit data, which are not available.
6
The Relative Importance of Financing Channels
(Averages for 1990–2013)
7
Role of Financial Intermediaries
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Pooling savings
• The most straightforward economic function of a
financial intermediary is to pool the resources of many
small savers.
• To succeed in this endeavor the intermediary must
attract substantial numbers of savers. This is the
essence of indirect finance, and it means convincing
potential depositors of the soundness of the institution.
• Banks rely on their reputations and government
guarantees like deposit insurance to make sure
customers feel that their funds will be safe.
9
Pooling savings
Financial
intermediaries
pool the funds of
many small
savers and lend
them to one
large borrower.
10
Safekeeping and accounting
• Today, banks are the places where we put things for
safekeeping; we deposit our paychecks and entrust our
savings to a bank or other financial institution because we
believe it will keep our resources safe until we need them.
• Banks also provide other services, like ATMs, checkbooks,
and monthly statements, giving people access to the
payments system.
• Financial intermediaries also reduce the cost of
transactions and so promote specialization and trade,
helping the economy to function more efficiently.
11
Safekeeping and accounting
• The bookkeeping and accounting services that financial
intermediaries provide help us to manage our finances.
• Providing safekeeping and accounting services as well as
access to the payments system forces financial
intermediaries to write legal contracts, which are
standardized.
• Much of what financial intermediaries do takes advantage
of economies of scale, which means that the average
cost of producing a good or service falls as the quantity
produced increases. Information is also subject to
economies of scale.
12
Transaction Costs
• Search costs include expenses to advertise one’s
intention to sell or purchase a financial instrument
and the value of time spent in locating a
counterparty - that is, a buyer for a seller or a
seller for a buyer to the transaction.
• Information costs are costs associated with
assessing a financial instrument’s investment
attributes
13
Transaction Costs
• Financial intermediaries have evolved to reduce
transaction costs.
– Economies of scale
– Expertise
14
Economies of scale & Expertise
• Think about what would happen if commercial
banks did not exist in a financial system?
– the lenders’/depositors’ maturity is typically short term
– the maturity of borrowers may be considerably long
term.
15
• In this scenario, borrowers would have to either
– borrow for a shorter term in order to match the length
of time lenders are willing to loan funds; or
– locate lenders that are willing to invest for the length of
the loan sought.
16
• Solution to the problem of high transaction costs is
to bundle the savings of many depositors together
so that they can take advantage of economies of
scale.
• Bundling depositors' funds together reduces
transaction costs for each individual depositor.
• There are economies of scale that financial
intermediaries realize in contracting and
processing information about financial assets
because of the amount of funds that they manage.
17
Providing liquidity
• Liquidity is a measure of the ease and cost with
which an asset can be turned into a means of
payment.
• Financial intermediaries offer us the ability to
transform assets into money at relatively low cost
(ATMs are an example).
• By collecting funds from a large number of small
investors, a bank can reduce the cost of their
combined investment, offering the individual investor
both liquidity and high rates of return.
18
Diversifying risk
• Financial intermediaries enable us to diversify our
investments and reduce risk.
• Banks mitigate risk by taking deposits from a large
number of individuals and make thousands of
loans with them, thus giving each depositor a
small stake in each of the loans.
• Providing a low-cost way for individuals to
diversify their investments is a function all financial
intermediaries perform
19
Collecting and processing information service
• One of the biggest problems individual savers face is

figuring out which potential borrowers are trustworthy
and which are not.
• There is an information asymmetry because the
borrower knows whether or not he or she is
trustworthy, but the lender faces substantial costs to
obtain the same information.
• Financial intermediaries reduce the problems created
by information asymmetries by collecting and
processing standardized information.
20
Asymmetric Information
• Asymmetric information is a situation that arises
when one party’s insufficient knowledge about the
other party involved in a transaction makes it
impossible for the first party to make accurate
decisions when conducting the transaction.
• Asymmetric information is a serious hindrance to
the operation of financial markets, and solving this
problem is one key to making our financial system
work as well as it does.
21
Asymmetric
information
Adverse Moral Hazard

selection
Lemon Principal-
problems Agent Problem
22
Asymmetric Information: Adverse Selection
and Moral Hazard
• Asymmetric information poses two obstacles to
the smooth flow of funds from savers to investors:
– Adverse selection, which involves being able to
distinguish good credit risks from bad before the
transaction; and
– Moral hazard, which arises after the transaction and
involves finding out whether borrowers will use the
proceeds of a loan as they claim they will.
• Agency theory analyses how asymmetric

information problems affect economic behavior.
23
Adverse Selection: The Lemons Problem
• If quality cannot be assessed, the buyer is willing to
pay at most a price that reflects the average quality.
• Sellers of good quality items will not want to sell at

the price for average quality.
• The buyer will decide not to buy at all because all

that is left in the market is poor quality items.
• This problem explains fact 2 and partially explains

fact 1.
24
Adverse Selection: The Lemons Problem
• Owner of lemon is more than happy to sell it; few

people want to buy a lemon, there will be few
sales.
• Owner of peach knows that the car is
undervalued; he may not want to sell it.
• The used-car market will function poorly, if at all.
25
The Lemons Problem: How Adverse Selection
Influences Financial Structure
• If high and low quality stocks are difficult to
distinguish, potential buyers will be willing to pay
the average price.
• Owners who know their profit potential is high and
their risk is low will not offer their stock.
• Owners with low profit horizon and high risk will be
happy to sell.
• Overabundance of lemons in the stock market will
discourage lenders to enter the market.
26
The Lemons Problem: How Adverse Selection
Influences Financial Structure
• Adverse selection is a problem in bond markets
when default risk is significant.
• A firm may know that its true default risk is higher
or lower than the public thinks. If it is higher, then
issuing bonds is a good deal, because the firm
pays an interest rate below what it should pay
given the true risk.
• Once again, low-quality securities can flood the
market, causing it to break down.
27
Tools to Help Solve Adverse Selection
Problems
• Private production and sale of information
– Free-rider problem
• Government regulation to increase information

– Not always works to solve the adverse selection
problem, explains Fact 5
• Financial intermediation
– Explains facts 3, 4, & 6
• Collateral and net worth

– Explains fact 7
28
Private Production and Sale of Information
• Providing the information to the buyers
• If purchasers of securities can distinguish good
firms from bad, they will pay the full value of
securities issued by good firms, and good firms
will sell their securities in the market.
• Private firms might collect and sell the needed
information.
– Ex: Standard&Poor's, Moody's, and Fitch
• Free-rider problem would cut into their earnings

and sub-optimal information would be generated. 29
Free rider problem
• The free-rider problem occurs when people who
do not pay for information, take advantage of the
information that other people have paid for.
• The free-rider problem suggests that the private
sale of information will be only a partial solution to
the lemons problem.
30
Government regulation to increase information
• Government would regulate the market and

require firms to supply information. This solves
the public good problem and the political problem
of having to reveal harmful data.
31
Financial intermediation
• Financial intermediaries collect information about
firms and loan them the funds provided by their
depositors. Because the loan process is private
and loans are not traded, there is no free-rider
problem.
• The role of banks: The less information available
about firms, the more prominent banks will be in
the financial system.
32
Collateral and net worth
• Collateral , property promised to the lender if the borrower
defaults, reduces the consequences of adverse selection
because it reduces the lender's losses in the event of a
default.
• The presence of adverse selection in credit markets thus
provides an explanation for why collateral is an important
feature of debt con tracts. It reduces the risk from lack of
knowledge for the lender.
• A firm with high net worth (assets – liabilities) will be able
to pay the loan even if the business goes sour.
33
Moral Hazard
• Moral hazard is the asymmetric information
problem that occurs after the financial transaction
takes place, when the seller of a security may
have incentives to hide information and engage in
activities that are undesirable for the purchaser of
the security.
34
Moral Hazard
• Example:
– An insurance policy changes the behavior of the
person who is insured.
– People who invest in a company by buying its stock do
not know that the funds will be invested in their best
interests.
35
How Moral Hazard Affects the Choice Between Debt
and Equity Contracts
• Called the Principal-Agent Problem:

– Principal: less information (stockholder)
– Agent: more information (manager)
• Separation of ownership and control of the firm

– Managers pursue personal benefits and power rather
than the profitability of the firm.
36
Principal-Agent Problem
• Equity contracts, such as common stock, are
claims to a share in the profits and assets of a
business.
• Equity contracts are subject to a particular type of
moral hazard called the principal–agent problem.
37
Principal-Agent Problem
• When managers own only a small fraction of the
firm they work for, the stockholders who own
most of the firm's equity (called the principals) are
not the same people as the managers of the firm,
who are the agents of the owners.
• The principal-agent problem, which is an example
of moral hazard, arises only because a manager
has more information about his activities than the
stockholder does-that is, there is asymmetric
information.
38
Tools to Help Solve the Principal-Agent
Problem
• Monitoring (Costly State Verification)
– Free-rider problem
– Fact 1
• Government regulation to increase information

– Fact 5
• Financial Intermediation
– Fact 3
• Debt Contracts
– Fact 1
39
Monitoring (Costly State Verification)
• One way for stockholders to reduce this moral hazard
problem is for them to engage in a particular type of
information production: monitoring the firm’s activities by
auditing the firm frequently and checking on what the
management is doing.
• The problem is that the monitoring process can be
expensive in terms of time and money, as reflected in the
name economists give it: costly state verification.
• Costly state verification makes the equity contract less
desirable and explains in part why equity is not a more
important element in our financial structure.
40
Government regulation to increase information
• Governments everywhere have laws to force firms

to adhere to standard accounting principles that
make profit verification easier.
• They also pass laws to impose stiff criminal
penalties on people who commit the fraud of
hiding and stealing profits.
41
Financial Intermediation
• Financial intermediaries have the ability to avoid
the free-rider problem in the face of moral hazard.
• One financial intermediary that helps reduce the
moral hazard arising from the principal–agent
problem is the venture capital firm.
42
Debt Contracts
• The debt contract is a contractual agreement by the
borrower to pay the lender fixed dollar amounts at periodic
intervals.
• The less frequent need to monitor the firm, and thus the
lower cost of state verification, helps explain why debt
contracts are used more frequently than equity contracts to
raise capital.
• Debt contracts are still subject to moral hazard because a
debt contract requires the borrowers to pay out a fixed
amount and lets them keep any profits above this amount,
the borrowers have an incentive to take on investment
projects that are riskier than the lenders would like.
43
How Moral Hazard Influences Financial
Structure in Debt Markets
• Borrowers have incentives to take on projects that
are riskier than the lenders would like.
– This prevents the borrower from paying back the loan.
44
Tools to Help Solve Moral Hazard in Debt Contracts
• Net worth and collateral

– Incentive compatible
• Monitoring and enforcement of restrictive
covenants
– Discourage undesirable behavior
– Encourage desirable behavior
– Keep collateral valuable
– Provide information
• Financial intermediation
– Facts 3 & 4
45
Net worth and collateral
• When borrowers have more at stake because their net
worth is high or the collateral they have pledged to the
lender is valuable, the risk of moral hazard - the
temptation to act in a manner that lenders find
objectionable - is greatly reduced because the
borrowers themselves have a lot to lose.
• In other words, if borrowers have more “skin in the
game” because they have higher net worth or pledge
collateral, they are likely to take less risk at the
lender’s expense.
46
Monitoring and enforcement of
restrictive covenants
• Covenants to discourage undesirable behavior
• Covenants to encourage desirable behavior
• Covenants to keep collateral valuable
• Covenants to provide information
47
Financial intermediation
• Financial intermediaries - particularly banks - can
avoid the free-rider problem by primarily making
private loans.
• Private loans are not traded, so no one else can
free-ride on the intermediary’s monitoring and
enforcement of the restrictive covenants.
• The intermediary making private loans thus
receives the full benefits of monitoring and
enforcement and will work to shrink the moral
hazard problem inherent in debt contracts.
48
Summary Table 1 Asymmetric Information Problems and
Tools to Solve Them
49
The Structure of the Financial Industry
Intermediaries can be divided into two broad
categories:
• Depository institutions
– Take deposits and make loans
– What most people think of as banks
• Non-depository institutions.
– Include insurance companies, securities firms, asset
management firms that operate mutual funds and
exchange-traded funds, hedge funds, private equity or
venture capital firms, finance companies, and pension
funds 50
Depository institutions
• Depository institutions take deposits and make
loans
• Depository institutions include commercial banks
and thrifts.
• Thrifts include savings and loan associations,
savings banks, and credit unions.
51
Commercial Banks
• Commercial banks are the largest type of
depository institution
• A commercial bank is a financial institution that is
owned by shareholders, and engages in accepting
deposits and lending for a profit.
• A bank may be owned by a bank holding company
(BHC), which is a company that owns one or more
banks.
52
Top 7 Bank Holding Companies in the US in 2012
53
Commercial Banks
• Banks are highly leveraged financial institutions,
meaning that most of their funds come from
borrowing.
• One form of borrowing includes deposits.
• There are four types of deposit accounts issued
by banks:
– demand deposits,
– savings deposits,
– time deposits and
– money market demand accounts. 54
Insurance Companies
• Insurance companies accept premiums, which
they invest, in return for promising compensation
to policy holders under certain events.
• Insurance companies offer two types of insurance:
– Life insurance.
– Property and casualty insurance.
• While a single company may provide both kinds of

insurance, the two businesses operate very
differently.
55
Insurance Companies
• Life insurance comes in two basic forms.
– Term life insurance provides a payment to the policy
holder’s beneficiaries in the event of the insured’s
death at any time during the policy’s term.
§ Generally renewable every year as long as the
policyholder is less than 65 years old.
– Whole life insurance is a combination of term life
insurance and a savings account.
§ The policyholder pays a fixed premium over his/her
lifetime in return for a fixed benefit when the
policyholder dies
56
57
58
59
Insurance Companies
• Car insurance is an example of property and
casualty insurance. It is a combination of:
– Property insurance on the car itself, and
– Casualty insurance on the driver, who is protected
against liability for harm or injury to other people or
their property.
• Holders of property and casualty insurance pay

premiums in exchange for protection during the
term of the policy.
60
Insurance Companies
• Adverse selection and moral hazard create
significant problems in the insurance market.
• A person with terminal cancer has an incentive to
buy life insurance for the largest amount possible
- that’s adverse selection.
• Without fire insurance, people would have more
fire extinguishers in their houses - that’s moral
hazard.
61
Insurance Companies
• Insurance companies work hard to reduce both
adverse selection and moral hazard.
– A person that wants to buy life insurance needs a
physical exam.
– People who want auto insurance must provide their
driving records.
• Policies also include restrictive covenants that

require the insured to engage or not to engage in
certain activities.
62
Insurance Companies
• Insurance companies might also require
deductibles.
– These require the insured to pay the initial cost of
repairing accidental damage, up to some maximum
amount.
• Or they may require coinsurance.

– This is where the insurance company shoulders a
percentage of the claim, usually 80 or 90 percent and
the insured assumes the rest.
63
Pension Funds
• Pension funds invest individual and company contributions
in stocks, bonds, and real estate in order to provide
payments to retired workers
• A pension fund offers people the ability to make premium
payments today in exchange for promised payments
under certain future circumstances.
• They provide an easy way to make sure that a worker
saves and has sufficient resources in old age.
• They help savers to diversify their risk.
• By pooling the savings of many small investors, pension
funds spread the risk.
64
Pension Funds
• People can use a variety of methods to save for
retirement, including employer sponsored plans
and individual savings plans.
• Many employer-sponsored plans require a person
work for a certain number of years before
qualifying for benefits, a process called vesting.
65
Securities firms
• Securities firms include brokers, investment
banks, underwriters, and mutual fund companies.
– Brokers and investment banks issue stocks and bonds
to corporate customers, trade them, and advise
customers.
– Mutual-fund companies pool the resources of
individuals and companies and invest them in
portfolios.
– Hedge funds do the same for small groups of wealthy
investors.
66
Brokerage Firms
• Brokers provide loans to customers who wish to
purchase stock on margin.
• They provide liquidity, both by offering check-
writing privileges with their investment accounts
and by allowing investors to sell assets quickly.
67
Investment Banks
• Investment banking activities include:
– Raising funds through public offerings and private
placement of securities.
– Trading of securities.
– Mergers, acquisitions, and financial restructuring
advising.
– Merchant banking.
– Securities finance and prime brokerage services.
68
Mutual Funds
• These financial intermediaries acquire funds by
selling shares to many individuals and use the
proceeds to purchase diversified portfolios of
stocks and bonds.
• Mutual funds allow shareholders to pool their
resources so that they can take advantage of
lower transaction costs when buying large blocks
of stocks or bonds.
69
Mutual Funds
• Provide an important service for individuals who
wish to invest funds and diversify
• Offer liquidity if they are willing to repurchase an
investor’s shares upon request.
• Offer various different services, such as transfers
between funds and check-writing privileges.
70
Mutual Funds
• Open-end funds:
– Are open to investment from investors at any time
– Allow investors to purchase or redeem shares at any
time the number of fund shares is not fixed.
– The total number of shares in the fund increases if
more investments than withdrawals are made during
the day, and vice versa.
71
Mutual Funds
• Closed-end funds:
– do not issue additional shares or redeem shares.
– the number of fund shares is fixed at the number sold
at issuance (i.e., at the time of the initial public
offering).
– investors who want to sell their shares or investors
who want to buy shares must do so in the secondary
market where the shares are traded (either on an
exchange or in the over-the-counter market).
72
Mutual Funds
• Money market mutual funds:
– Are portfolios of money market instruments constructed
and managed by investment companies
– Allow investors to participate for as little as $1,000
– Usually allow check-writing privileges
• Other funds include venture capital funds, real

estate investment trust…
73
74
Finance Companies
• Finance companies raise funds directly in the financial
markets by issuing commercial paper and securities and
then use them to make loans to individuals and firms.
– Finance companies tend to specialize in particular types of loans,
such as mortgage, automobile, or business equipment.
• They borrow in large amounts but often lend in small

amounts—a process quite different from that of banking
institutions, which collect deposits in small amounts and
then often make large loans
75
Finance Companies
• Finance companies are particularly good at:
– Screening potential borrowers’ creditworthiness,
– Monitoring their performance during the term of the
loan, and
– Seizing collateral in the event of a default.
76
Finance Companies
• Most finance companies specialize in one of three
loan types:
– Consumer loans,
– Business loans, and
– Sales loans.
• Some also provide commercial and home

mortgages.
77
Finance Companies
• Consumer finance firms provide small installment
loans to individual consumers.
• Business finance companies provide loans to
businesses.
– Business finance companies also provide both
inventory loans and accounts receivable loans.
• Sales finance companies specialize in larger loans

for major purchases, such as automobiles.
78
Private Equity and Venture Capital Funds
• Private equity fund makes long-term investments in
companies that are not traded in public markets.
• In a private equity fund, investors who are limited
partners (e.g., high-wealth individuals, pension funds,
financial institutions, and college endowments) place
their money with the managing (general) partners
who make the private equity investments.
79
Private Equity and Venture Capital Funds
• Private equity funds are of two types:
– Venture capital funds make investments in new start-up
businesses, often in the technology industry
– Capital buyout funds make investments in established
businesses, and in many cases, buy publicly traded
firms through a so-called leveraged buyout (LBO), in
which the publicly traded firm is taken private by
buying all of its shares, while financing the purchase
by increasing the leverage (debt) of the firm.
80
81
82
Regulation of the Financial System
• To ensure the soundness of financial
intermediaries:
– Restrictions on entry (chartering process).
– Disclosure of information.
– Restrictions on assets and activities (control holding of
risky assets).
– Deposit Insurance (avoid bank runs).
– Limits on competition (mostly in the past):
§ Branching
§ Restrictions on interest rates 83
Principal Regulatory Agencies of the
U.S. Financial System
Regulatory Agency Subject of Regulation Nature of Regulations
Securities and Exchange Organized exchanges and Requires disclosure of information;

Commission (SEC) financial markets restricts insider trading
Commodities Futures Trading Futures market exchanges Regulates procedures for trading in
Commission (CFTC) futures markets
Office of the Comptroller of the Federally-chartered commercial Charters and examines the books of
Currency banks and thrift institutions federally chartered commercial banks
and thrift institutions; imposes
restrictions on assets they can hold
National Credit Union Administration Federally-chartered credit unions Charters and examines the books of
(NCUA) federally chartered credit unions and
imposes restrictions on assets they
can hold
84
Principal Regulatory Agencies of the
U.S. Financial System
Regulatory Agency Subject of Regulation Nature of Regulations
State banking and insurance State-chartered depository Charter and examine the books of state-
commissions institutions and insurance chartered banks and insurance companies,
companies impose restrictions on assets they
can hold, and impose restrictions on
branching
Federal Deposit Insurance Commercial banks, mutual Provides insurance of up to $250,000 for
Corporation (FDIC) savings banks, savings each depositor at a bank, examines the
and loan associations books of insured banks, and imposes
restrictions on assets they can hold
Federal Reserve System All depository institutions Examines the books of commercial banks
and systemically important financial
institutions; sets reserve requirements for all
banks
85
CHAPTER 4:
TIME VALUE OF MONEY

1
Content
• Interest Rates: Interpretation
• The Future Value of a Single Cash Flow
• The Present Value of a Single Cash Flow
• The Future Value of a Series of Cash Flows
• The Present Value of a Series of Cash Flows
• Application of time value of money in bond valuation
• Application of time value of money in stock valuation
2
Content
• Investment Decision Criteria
– Net Present Value (NPV)
– Internal Rate of Return (IRR)
3
Financial Decisions
• Costs and benefits being spread out over time
• The values of sums of money at different dates
• The same amounts of money at different dates
have different values.
• Every decision involves time and uncertainty
4
Interest Rates: Interpretation
• An interest rate, denoted r, is a rate of return that
reflects the relationship between differently dated
cash flows.
• Interest rates can be thought of in three ways.
– First, they can be considered required rates of return -
that is, the minimum rate of return an investor must
receive in order to accept the investment.
– Second, interest rates can be considered discount rates.
– Third, interest rates can be considered opportunity costs.
5
• Economics tells us that interest rates are set in the
marketplace by the forces of supply and demand,
• Taking the perspective of investors in analyzing
market-determined interest rates, we can view an
interest rate as being composed of a real risk-free
interest rate plus a set of four premiums that are
required returns or compensation for bearing
distinct types of risk.
6
Interest rate = Real risk-free interest rate
+ Inflation premium
+ Default risk premium
+ Liquidity premium
+ Maturity premium
7
• The real risk-free interest rate is the single-
period interest rate for a completely risk-free
security if no inflation were expected.
• The inflation premium compensates investors for
expected inflation and reflects the average
inflation rate expected over the maturity of the
debt.
8
• The default risk premium compensates investors
for the possibility that the borrower will fail to make
a promised payment at the contracted time and in
the contracted amount.
• The liquidity premium compensates investors for
the risk of loss relative to an investment’s fair
value if the investment needs to be converted to
cash quickly.
9
• The maturity premium compensates investors
for the increased sensitivity of the market value of
debt to a change in market interest rates as
maturity is extended, in general (holding all else
equal).
10
The Three Rules of Time Travel
• It is only possible to compare or combine values
at the same point in time.
• To move a cash flow forward in time, you must
compound it.
• To move a cash flow back in time, we must
discount it.
11
Moving money through time
Compounding
Present Future
Value Value
Discounting
12
The Future Value of a Single Cash Flow
• Suppose you invest $100 in an interest-bearing
bank account paying 5 percent annually.
• How much will you have at the end of the 1st year?
• How much will you have at the end of the 2nd year?
• How much will you have at the end of the 3rd year?
13
FV = PV (1+i)n
Where:
PV : present value of the investment
FVn : future value of the investment n periods from
today
i: interest rate per period
14
15
• Simple interest
• Compound interest
16
Compound Interest
• Interest is compound interest if interest is paid on
both the principal—the amount borrowed—and
any accumulated interest.
• For instance, if you borrow $1,000 today for two
years and the interest is 5% compound interest, at
the end of two years you must repay the $1,000,
plus interest on the $1,000 for two years and
interest on interest.
17
Compound Interest
In the case of compound interest, the amount
repaid has three components:
1. The amount borrowed (= the principal)
2. The interest on the amount borrowed
3. The interest on interest
18
19
Example: You are 20 years old and are considering
putting $100 into an account paying 8% per year for
45 years. How much will you have in the account at
age 65? If you could find an account paying 9% per
year, how much more would you have at age 65?
20
Example: Fifty years after graduation, you get a
letter from your college notifying you that they have
just discovered that you failed to pay your last
student activities fee of $100. Because it was your
college’s oversight, it has decided to charge you an
interest rate of only 6% per year. As a loyal alumnis,
you feel obiliged to pay. How much do you have to
pay?
21
Example: You are the lucky winner of your state’s
lottery of $5 million after taxes. You invest your
winnings in a five-year certificate of deposit (CD) at
a local financial institution. The CD promises to pay
7 percent per year compounded annually. This
institution also lets you reinvest the interest at that
rate for the duration of the CD. How much will you
have at the end of five years if your money remains
invested at 7 percent for five years with no
withdrawals?
22
Example: An institution offers you the following
terms for a contract: For an investment of
¥2,500,000, the institution promises to pay you a
lump sum six years from now at an 8 percent
annual interest rate. What future amount can you
expect?
23
The Present Value of a Single Cash Flow
• PV = FV/(1+i)n
24
The Present Value of a Single Cash Flow
Example: Suppose you own a liquid financial asset
that will pay you $100,000 in 10 years from today.
You plan to study MBA four years from today, and
you want to know what the asset’s present value will
be at that time. Given an 8 percent discount rate,
what will the asset be worth four years from today?
25
Example: Bob estimates that he will inherit $10
million five years from now. He plans to invest this
amount of money on some financial assets. The
rate of return on those assets has been estimated
at 9 percent per year. What will the value of this
investment at t = 15? At t = 0?
26
Example: The rate of return on Bob’s investment
will be 10% instead of 9% as stated in the above
example. What will the value of his investment at t =
15? At t = 0?
27
• We can add amounts of money only if they are
indexed at the same point in time.
• For a given interest rate, the future value increases
with the number of periods.
• For a given number of periods, the future value
increases with the interest rate.
28
• To calculate interest rate
• To calculate number of periods
29
The Frequency of Compounding
• Rather than quote the periodic monthly interest
rate, financial institutions often quote an annual
interest rate that we refer to as the stated annual
interest rate or quoted interest rate.
– For instance, your bank might state that a particular CD
pays 8 percent compounded monthly. The stated
annual interest rate equals the monthly interest rate
multiplied by 12. In this example, the monthly interest
rate is 0.08/12 = 0.0067 or 0.67 percent.
30
With more than one compounding period per year:
Where in is stated annual interest rate, m is the

number of compounding periods per year, and n
now stands for the number of years.
31
Example: Suppose your bank offers you a CD with
a two- year maturity, a stated annual interest rate of
8 percent compounded quarterly, and a feature
allowing reinvestment of the interest at the same
interest rate. You decide to invest $10,000. What
will the CD be worth at maturity?
32
Example: An Australian bank offers to pay you 6
percent compounded monthly. You decide to invest
A$1 million for one year. What is the future value of
your investment if interest payments are reinvested
at 6 percent?
33
Continuous Compounding
If the number of compounding periods per year
becomes infinite, then interest is said to compound
continuously.
FVn= PV ein
Where:
i is stated annual interest rate
n is the number of years
e ≈ 2.7182818
34
Continuous Compounding
Example: Suppose a $10,000 investment will earn
8 percent compounded continuously for two years.
What is the future value of this investment?
35
The Effect of Compounding Frequency
on Future Value
Example: Suppose that you invest $1 with stated
annual interest rate of 8%/year. What is the future
value of your investment after one year if interest
payments are compounded:
§ Annually
§ Semiannually
§ Quarterly
§ Monthly
§ Daily
§ Continuously
36
Stated and Effective Rates
• Effective annual rate (EAR)
m is the number of compounding periods per year
• With continuous compounding, we can solve for

the effective annual rate as follows:
EAR = ei -1
37
Stated and Effective Rates
Example: You have check on the Internet and
come up with the following three rates:
Bank A: 15 percent compounded daily Bank B: 15.5
percent compounded quarterly Bank C: 16 percent
compounded annually
Which of these is the best if you are thinking of
opening a savings account? Which of these is best
if they represent loan rates?
38
The Future Value of a Series of Cash Flows
• Uneven cash flow
• Annuity
– Ordinary Annuity
– Annuity Due
• Perpetuity
39
The Future Value of a Series of Cash Flows
• An annuity is a finite set of level sequential cash flows.
• An ordinary annuity has a first cash flow that occurs one
period from now (indexed at t = 1).
• An annuity due has a first cash flow that occurs
immediately (indexed at t = 0).
• A perpetuity is a perpetual annuity, or a set of level never-
ending sequential cash flows, with the first cash flow
occurring one period from now.
40
41
The Future Value of an uneven cash flow
Example: An investor signs a 6-year contract that is
expected to return $8.25 million in the first year,
$7.75 million in the second year, $3.25 million in the
third year, $4.75 million in the fourth year, $5.25
million in the fifth year, and $6.25 million in the final
year. If 12 percent is the appropriate interest rate,
what is the total return of this investor at the end of
the contract?
42
Cash Flow signs
Investing $ today Borrowing $ today
• Invest (Expense) $ today • Borrow (Inflow) $ today

in present to earn in present to use now,
greater return in the then repay with interest
future. in the future.
• Earn interest (revenue), • Pay interest (expense),
plus principal. plus principal.
• PV = (-) • PV = +
• FV = + • FV = (-)
43
Future value of an Ordinary Annuity
Example:
Suppose that you decide to deposit $1000 at the
end of every year for the next five years. If you can
earn 5% on the account, what is the value of the
account at the end of the fifth year? Assume that
the first deposit will be one year from now.
44
45
FVA = CF(1+i)0 + CF(1+i)1 + CF(1+i)2 + CF(1+i)3 + …+ CF(1+i)n-2 + CF(1+i)n-1
FVA = CF + CF(1 + i) + CF(1 + i)2 + CF(1 + i)3 + …+ CF(1 + i)n - 2 + CF(1+i)n-1 (1)
FVA CF ! " #$!
= + CF + CF 1 + i + CF 1 + i + CF 1 + i + ⋯ + CF 1 + i
1+i 1+i
(1) – (2):
FVA CF #$% #$%
CF
FVA − = − + CF 1 + i = CF 1 + i −
1+i 1+i 1+i
1 #$%
1
FVA 1 − = CF 1 + i −
1+i 1+i
1+i 1 1+i # 1
FVA − = CF −
1+i 1+i 1+i 1+i
i 1+i #−1
FVA = CF
1+i 1+i
𝟏'𝒊
Multiply both sides by
𝒊
1+i #−1
FVA = CF
i
46
§ FVA: Future value of ordinary annuity

§ CF: Cash flow
47
Future value of an Annuity Due
Example:
Suppose that you decide to deposit $1000 at the
beginning of every year for the next five years. If
you can earn 5% on the account, what is the value
of the account at the end of the fifth year? The first
deposit is made at the beginning of the first year.
48
49
FVAD = CF(1+i)n + CF (1+i)n-1+…+CF(1+i)1
• Future value of annuity due
§ FVAD: Future value of annuity due

§ CF: Cash flow
50
Example: Chau graduated and started working on
January 2, 2020. At the end of each year, she
deposits 30 million VND into the bank at the interest
rate of 7%/year, compounded annually. As of
31/12/2027, how much will she have saved?
Assume that she will not make any withdrawal
during this period.
51
Example: Chau graduated and started working on
January 2, 2020. At the beginning of each year, she
deposits 30 million VND into the bank at the interest
rate of 7%/year, compounded annually. Her first
deposit was sent to the bank on 02/01/2020. As of
31/12/2027, how much will she have saved?
Assume that she will not make any withdrawal
during this period.
52
Example: Ellen is 35 years old, and she has
decided it is time to plan seriously for her
retirement. At the end of each year until she is 65,
she will save $10,000 in a retirement account. If the
account earns 10% per year, how much will Ellen
have saved at age 65?
53
Example: Green and Red put $1,500 into a college
fund every year for their son, Eric, on his birthday,
with the first deposit one year from his birth (at his
very first birthday). The college fund has a
guaranteed annual growth or interest rate of 7%. At
his eighteenth birthday, they will pay the last $1,500
into the fund. How much will be in the college fund
for Eric immediately following this last payment?
54
Example: Your biotech firm plans to buy a new
DNA sequencer for $500,000. The seller requires
that you pay 20% of the purchase price as a down
payment, but is willing to finance the remainder by
offering a 48-month loan with equal monthly
payments and an interest rate of 0.5% per month.
The first payment is one month after the down
payment. What is the monthly loan payment?
55
Present value of a Series of Cash Flows
• Uneven cash flow
• Annuity
– Ordinary Annuity
– Annuity Due
• Perpetuity
– Growing Perpetuity
– Growing Annuity
56
Present value of an uneven cash flow
Example: You have just graduated and need money
to buy a new car. Your rich Uncle Henry will lend you
the money so long as you agree to pay him back
within four years, and you offer to pay him the rate of
interest that he would otherwise get by putting his
money in a savings account. Based on your earnings
and living expenses, you think you will be able to pay
him $5000 in one year, and then $8000 each year for
the next three years. If Uncle Henry would otherwise
earn 6% per year on his savings, how much can you
borrow from him? 57
Present value of an Ordinary Annuity
58
• Present value of ordinary annuity
59
CF CF CF CF
PVA = !
+ "
+ #
+ ⋯+ $
1+i 1+i 1+i 1+i
1 1 CF CF CF CF
PVA = !+ "+ # + ⋯+ $
1+i 1+i 1+i 1+i 1+i 1+i
1 CF CF CF CF CF
PVA = "
+ #
+ %
+ ⋯+ $
+
1+i 1+i 1+i 1+i 1+i 1 + i $&!
(1) – (2):
1 CF CF
PVA − PVA = !
−
1+i 1+i 1 + i $&!
1 CF 1
PVA 1 − = 1− $
1+i 1+i 1+i
i CF 1
PVA = 1− $
1+i 1+i 1+i
CF 1
PVA = 1− $
i 1+i 60
Example: Suppose you are considering purchasing
a financial asset that promises to pay €1,000 per
year for five years, with the first payment one year
from now. The required rate of return is 12 percent
per year. How much should you pay for this asset?
61
Example:
• You have decided to buy a house and need to
borrow $100.000. One bank offers you a
mortgage loan to be repaid over 30 years in 360
monthly payment. If the interest rate is 12% per
year, what is the amount of the monthly payment?
• Another bank offer you a 15-year mortgage loan
with a monthly payment of $1,100. Which loan is
the better deal?
62
Present value of an Annuity Due
63
• Present value of Annuity Due
64
Example: You are retiring today and must choose
to take your retirement benefits either as a lump
sum or as an annuity. Your company’s benefits
officer presents you with two alternatives: an
immediate lump sum of $2 million or an annuity with
20 payments of $200,000 a year with the first
payment starting today. The interest rate at your
bank is 7 percent per year compounded annually.
Which option has the greater present value? (Ignore
any tax differences between the two options.)
65
Present Value of an Annuity Due
Example: You are the lucky winner of the $30
million state lottery. You can take your prize money
either as (a) 30 payments of $1 million per year
(starting today), or (b) $15 million paid today. If the
interest rate is 8%, which option should you take?
66
The Present Value of a Perpetuity
CF ⎡ 1 ⎤ CF
PVP = ⎢1− ∞⎥
=
i ⎣ (1+ i) ⎦ i
67
CF CF CF
PVP = + + +⋯
(1 + i)! (1 + i)" (1 + i)#
1 1 1
PVP = CF !
+ + +⋯
1+i (1 + i)" (1 + i)#
* *
#
1 1
PVP = CF × / # = CF × /
1+i 1+i
#)% #)%
As a geometric progression:
Where Z is a positive constant that is less than 1, and X is the sum of the
geometric progression:
The present value of the perpetuity can then be written as:
68
Example: For example, an investment offers a
perpetual cash flow of $500 every year. The return
you require on such an investment is 8 percent.
What is the value of this investment?
69
Example: You want to endow an annual MBA
graduation party at your alma mater. You want the
event to be a memorable one, so you budget
$30,000 per year forever for the party. If the
university earns 8% per year on its investments,
and if the first party is in one year’s time, what’s the
present value of your donation?
70
The Present Value of a Growing Perpetuity
• A growing perpetuity is a stream of cash flows
that occur at regular intervals and grow at a
constant rate forever.
71
• Present Value of a Growing Perpetuity
72
Example: You want to endow an annual MBA
graduation party at your alma mater. You want the
event to be a memorable one, so you budget
$30,000 per year forever for the party. Every year
thereafter, the payment will grow by 5 percent. If the
university earns 8% per year on its investments,
and if the first party is in one year’s time, what’s the
present value of your donation?
73
The Present Value of a Growing Annuity
74
The Present Value of a Growing Annuity
Example: Ellen is 35 years old and considers
saving $10,000 per year for her retirement.
Although $10,000 is the most she can save in the
first year, she expects her salary to increase each
year so that she will be able to increase her savings
by 5% per year. With this plan, if she earns 10% per
year on her savings, how much will Ellen have
saved at age 65?
75
Application of time value of money in
bond valuation
• Coupon: the stated interest payment made on a
bond.
• Face value: the principal amount of a bond that is
repaid at the end of the term. Also called par
value.
• Coupon rate: annual coupon divided by the face
value of a bond.
• Maturity: the specified date on which the principal
amount of a bond is paid.
76
bond valuation
• Yield to maturity (YTM) is the interest rate that
equates the present value of cash flow payments
received from a debt instrument with its value
today
• Yield to maturity is the rate required in the market
on a bond.
77
bond valuation
• Coupon bond
• Zero-coupon bond
• Perpetuity
78
bond valuation – Coupon bond
Example: The Xanth bond has an annual coupon of
$80. Similar bonds have a yield to maturity of 8
percent. The Xanth bond will pay $80 per year for
the next 10 years in coupon interest. In 10 years,
Xanth will pay $1,000 to the owner of the bond.
What would this bond sell for?
79
• Step 1: Lay out the timing and amount of the
future cash flows
• Step 2: To determine the appropriate discount
rate for this cash flow. Use the yield to maturity as
discount rate
• Step 3: Find the present value of the cash flow
• Step 4: Add the two present value amounts to get
the price or value of the bond
80
What if the YTM of the Xanth bond is
• 7% ?
• 9% ?
81
Example: A bond has a coupon rate of 14 percent,
then the owner will get a total of $140 per year, but
this $140 will come in two payments of $70 each.
The yield to maturity is quoted at 16 percent. What
would this bond sell for?
82
bond valuation – Zero-coupon bond
• A zero-coupon bond – a bond that paid zero
coupon.
83
bond valuation – Zero-coupon bond
Example: What is the current price of a one-year,
$1,000 Treasury bill with yield to maturity of 11.1%?
84
bond valuation – Consol bond
Example: The British government once issued a
type of security called a consol bond, which
promised to pay a level cash flow indefinitely. If a
consol bond paid £100 per year in perpetuity, what
would it be worth today if the required rate of return
were 5 percent?
85
stock valuation
• Prefered stock
• Common stock
86
stock valuation – Preferred stock
• Preferred stock (or preference stock) is an
important example of a perpetuity.
• When a corporation sells preferred stock, the
buyer is promised a fixed cash dividend every
period (usually every quarter) forever.
• This dividend must be paid before any dividend
can be paid to regular stockholders - hence the
term preferred.
87
stock valuation – Preferred stock
Example: Suppose the Fellini Co. wants to sell
preferred stock at $100 per share. A similar issue of
preferred stock already outstanding has a price of
$40 per share and offers a dividend of $1 every
quarter. What dividend will Fellini have to offer if the
preferred stock is going to sell?
88
stock valuation – Common stock
• Current price of the stock can be written as the
present value of the dividends beginning in one
period and extending out forever:
89
• Zero Growth: D1 = D2 = D3 = D = constant
• Because the dividend is always the same, the
stock can be viewed as a perpetuity with a cash
flow equal to D every period. The per-share value
is thus given by:
Where R is the required rate of return

90
Example: Suppose the Paradise Prototyping
Company has a policy of paying a $10 per share
dividend every year. If this policy is to be continued
indefinitely, what is the value of a share of stock if
the required rate of return is 20 percent?
91
• Constant Growth: If the dividend for a company
always grows at a steady rate. Call this growth
rate g. If we let D0 be the dividend just paid, then
the next dividend, D1, is:
• The dividend in two periods is:
• Dividend t periods into the future, Dt, is

92
• If we take D0 to be the dividend just paid and g to
be the constant growth rate, the value of a share
of stock can be written as:
• The present value of this series of cash flows can

be written simply as:
93
Example: The next dividend for the Gordon Growth
Company will be $4 per share. Investors require a
16 percent return on companies such as Gordon.
Gordon’s dividend increases by 6 percent every
year. Based on the dividend growth model, what is
the value of Gordon’s stock today? What is the
value in four years?
94
Investment decision criteria
• Net present value (NPV)
• Internal rate of return (IRR)
• Payback period
• Discounted payback period
• Average accounting rate of return (AAR)
• Profitability index (PI)
95
Net Present Value (NPV)
Net present value (NPV) is the difference between
the present value of cash inflows and the present
value of cash outflows over a period of time.
96
Example: Assume that GE Corporation is
considering an investment of €50 million in a capital
project that will return after-tax cash flows of €16
million per year for the next four years plus another
€20 million in Year 5. The required rate of return is
10 percent. What is NPV of GE?
97
• As long as the NPV is positive, the decision
increases the value of the firm and is a good
decision regardless of your current cash needs or
preferences regarding when to spend the money.
• When making an investment decision, take the
alternative with the highest NPV.
98
Internal Rate of Return (IRR)
IRR is the discount rate that makes the present
value of the future after-tax cash flows equal that
investment outlay. IRR can be defined as the
discount rate that makes the present values of all
cash flows sum to zero:
99
The decision rule for the IRR is to invest if the IRR
exceeds the required rate of return for a project:
• Invest if IRR > r
• Do not invest if IRR < r
The required rate of return (r) is often termed the
hurdle rate, the rate that a project’s IRR must
exceed for the project to be accepted.
100
• In the GE Corporation example, we want to find a
discount rate that makes the total present value of
all cash flows, the NPV, equal zero. In equation
form, the IRR is the discount rate that solves this
equation:
101
• In the GE Corporation example, we want to find a
discount rate that makes the total present value of
all cash flows, the NPV, equal zero. In equation
form, the IRR is the discount rate that solves this
equation:
IRR = 19.52%
102
Ranking Conflicts between NPV and IRR
• Ranking Conflict Due to Differing Cash Flow
Patterns
• Ranking Conflicts due to Differing Project Scale
103
Ranking Conflict Due to Differing Cash
Flow Patterns
Projects A and B have similar outlays but different
patterns of future cash flows. For both projects, the
required rate of return is 10 percent.
104
Flow Patterns
105
Flow Patterns
106
Ranking Conflicts due to Differing
Project Scale
Project A has a much smaller outlay than Project B,
although they have similar future cash flow patterns.
107
Project Scale
108
Project Scale
109

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Financial Markets Explained

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CHAPTER 2:

Lecturer: Truong Thi Thuy Trang

– Maturity: the remaining time until the expiration date

• Equities (claims to net income and assets)

– Dividends: periodic payment to shareholders

• Equities are claims to share in the net income (income

• Secondary markets are markets in which existing

• The primary markets are not well known to the

• The previously issued securities will be sold in

– Short terms to maturity, least price fluctuations and

• Capital markets deal in longer-term debt and

Amount ($ billions, end of year)

• Negotiable Bank Certificates of Deposits

Amount ($ billions, end of year)

• Four basic categories of mortgages issued: home,

• Eurobond: bond denominated in a currency other than that of

• Eurocurrencies: foreign currencies deposited in banks outside

– Eurodollars: U.S. dollars deposited in foreign banks outside

• World Stock Markets:

– help finance corporations in the United States and the U.S.

• Must be designed to keep transaction costs low.

Lecturer: Truong Thi Thuy Trang

• In addition to the lenders and the borrowers, the

• In this chapter, we look at each of the financial

• One of the biggest problems individual savers face is

Adverse Moral Hazard

• Agency theory analyses how asymmetric

• Sellers of good quality items will not want to sell at

• The buyer will decide not to buy at all because all

• This problem explains fact 2 and partially explains

• Owner of lemon is more than happy to sell it; few

• Government regulation to increase information

• Collateral and net worth

• Free-rider problem would cut into their earnings

• Government would regulate the market and

• Called the Principal-Agent Problem:

• Separation of ownership and control of the firm

• Government regulation to increase information

• Governments everywhere have laws to force firms

• Net worth and collateral

• While a single company may provide both kinds of

• Holders of property and casualty insurance pay

• Policies also include restrictive covenants that

• Or they may require coinsurance.

• Other funds include venture capital funds, real

• They borrow in large amounts but often lend in small

• Some also provide commercial and home

• Sales finance companies specialize in larger loans

Regulatory Agency Subject of Regulation Nature of Regulations

Securities and Exchange Organized exchanges and Requires disclosure of information;

Regulatory Agency Subject of Regulation Nature of Regulations

Lecturer: Truong Thi Thuy Trang

• To calculate number of periods

Where in is stated annual interest rate, m is the

m is the number of compounding periods per year

• With continuous compounding, we can solve for

• Invest (Expense) $ today • Borrow (Inflow) $ today

§ FVA: Future value of ordinary annuity

• Future value of annuity due

§ FVAD: Future value of annuity due

• Present value of Annuity Due

The present value of the perpetuity can then be written as: