FINA 3010: Financial Markets

Session 1: Introduction to the Course

Chanik Jo
Assistant Professor of Finance

Introduction and Overview 1/39

 Today’s lecture

Introduction of the course

Who am I? and Who are you?

Big picture of this course

Why do you have to study finance?

Why do financial markets exist?

What are di↵erent financial instruments?

Core of understanding financial markets: Risk-Return relationship

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 Course Outline

Learning objective:
Get knowledge on financial markets.
Learn data analysis tools to analyze finance (“basic” statistical tools).
Grow intuition for what’s happening in the world.
Develop critical ways of thinking
Basic knowledge for certificates: CFA, and CPA.
At the end of my course, you might be able to answer the following questions.
Why do financial markets exist?
How are stocks di↵erent from the bond?
What is an option?
What is the risk of investment?
What are the expected returns?
How do we construct a portfolio?
How to get richer?

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 Keys to Succeed in this course

READ finance news article (Bloomberg Markets and Finance, CNBC, CNN Business, etc).

ASK as many questions as possible. To yourself, friends, and me.

classes, office hours, etc.

COMMUNICATE with me.

ENJOY the course. It is going to be a lot of fun!

future careers in finance, investment idea, real finance issues
COLLABORATE with classmates.

Make a Big Picture.

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 Our Team

Instructor: Chanik Jo (ôö¸), Assistant Professor of Finance

E-mail: chanikjo@cuhk.edu.hk (Please write the course code in your subject - FINA3010E or
FINA3010F)
Office: 1252, Cheng Yu Tung Building (CYT)
Web: https://www.bschool.cuhk.edu.hk/sta↵/jo-chanik/
Ph.D. in Finance (2021) from Rotman School of Management, University of Toronto
Research areas: Asset Pricing and Household Finance
Personal story: Why did I want to be a finance professor?

TA: Fan Zhang ( A), Ph.D. Candidate in Finance

Email: fan.zhang@link.cuhk.edu.hk
Research areas: Financial Markets, Macroeconomic, Firm Behavior, and Capital Budgeting

You: ???

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 Grading

Assignment 1 (5%): Problem solving + data analysis

Midterm (35%): Closed-book exam, double-sided crib sheets A4, February 22, 6:00 - 8:00 pm,
LSK, LT7, Special required meetings for the bottom 5% students.
Assignment 2 (5%): Problem solving + data analysis
Final (55%): Formula will be given, closed-book exam, double-sided crib sheets A4, April 3, 6:00 -
8:00 pm, LSK, LT7
BTW, do you have another exam?

You may wonder

Oh teacher, what about a presentation? I want to do that.
What about participation score?
What about attendance?

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 Grading
It is about YOU!

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 Overview of the course

Session 1. Introduction of Financial Markets

Session 2, Bond Market
Session 3, 4 Stock Market
Session 5. Mutual/Hedge Funds and ETFs
Session 6. Midterm
Session 7. Portfolio Theory
Session 8. Capital Asset Pricing Model and Multi-factor models
Session 9. Option Market
Session 10. Market Efficiency
Session 11. Green Finance
Session 12. Final Exam

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 Overview of the course (Session 1 and 2)

Why do financial markets exist?

You have a million-dollar idea, but you don’t have $$ to start your business.
You go to a financial market and either sell the bond or stock to investors. (Session 1)
For investors, how much money do they have to pay to issue bonds or stock? :
Valuation
How to value an asset? The current value of an asset is the present value of future
cash flow that
PT theCFasset will generate.
P Theory = t=1 (1+r t
) t where CFt is cash flow at time t. r is the appropriate
discount rate.
Then, how to compute the present value of future cash flow? (Session 2).

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 Overview of the course (Session 2, 3, 4, 5, 6, and 7)
For investors,
PThowCFmuch money do they have to pay to buy bonds or stock? :
P Theory = t=1 (1+r t
)t where CFt is cash flow at time t. r is the appropriate
discount rate.
Bond market, value = Coupon Coupon
1+r1 + (1+r2 )2 + · · · +
Coupon+Principal
(1+rT )T
(still Session 2)
P1
Stock market, value = t=1 (1+rDt
(Session 3) ieden of
PRelued rae
ost
ofcaprtay
t
e) Banf rat
What determines r and re ? Risk! High risk implies high returns. (Session 4).
How do we invest in stocks and bonds through funds? (Session 5) Expeced
retuem ,

Midterm (Session 6)
Can we mix bonds and stocks and minimize risk? (Session 7)
E [Rp,t ] Rf ,t = Mp (E [Rm,t ] Rf ,t )
Investors should hold the market.

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 Overview of the course (Session 8)

What should be the expected returns of an asset given the risk? Can we quantify the
expected returns? : Capital Asset Pricing Model (Markowitz, Miller, and Sharpe 1990
Nobel Prize) (Session 9)
PN
E [Ri,t ] Rf ,t = i (E [Rm,t ] Rf ,t ) where Rm,t = i=1 wi,t Ri,t , Rf ,t is the risk-free
Cov (Ri,t ,Rm,t )
asset, and i = Var (R m,t )

An asset that varies sensitively with market returns should have higher expected
returns.

Intuition: You hold a well-diversified portfolio (aggregate market). Then, if you invest
in an asset with high i , when the market crashes, the asset crashes at the same time
! No hedge ! high risk ! high returns.

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 Overview of the course (Session 9)
Can we think of a financial contract that derives its value from the performance of an
underlying - e.g., payo↵ = max(ST K , 0)?
How can we value them? Black-Sholes Option (Scholes and Merton, 1997 Nobel
Prize) (Session 10 and 11)

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 Overview of the course (Session 10)
Does the market reflect all relevant information? Market Efficiency (Eugene Fama,
2013 Nobel Prize) (Session 11)
Weak form: Stock price reflects all past information.
Semi-strong: Stock price reflects all public information.
Strong: Stock price reflects insider information.

Poteshman, 2006 Journal of Business: Unusual option trading activity for American
Airlines and United Airlines before 9/11 terror attack. The market detected the terror
Introduction andattack!
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 Overview of the course (Session 10)
21

18

Annual Return, Percent

15

12

0
Losers 2 3 4 5 6 7 8 9 Winners

Portfolios Sorted by Recent Performance

I’d be a bum on the street with a tin cup if the markets were efficient
–Warren Bu↵ett
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 Overview of the course (Session 11)

Green finance
What is climate risk?
Socially responsible investing
Risk-return relationship for green securities
Mispricing in green finance markets
How to hedge climate risk?
Green bonds and covenants

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 Why Is Studying Finance Important?
It’s going to help you find a job.
It gives you intuition about risk and returns.
It helps you assess risk and make a better decision under uncertainty.
Running your firm (or working for a firm)
Raising money
Investing money
Managing firm’s resources
Running your own life
Planning for retirement
Making smart (or at least not dumb) investment decisions
Understanding the world around us
Maintaining healthy relationships
Avoid being fooled by people who know finance ... as well as by those who think they
know finance. There is no free lunch.
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 Why Is Studying Finance Important? (cont’d)
In the US, 60.2% of households invest in the stock market either directly or indirectly
(Survey of Consumer Finances, 2016).
How do they make a decision?

Be Fearful When Households Are Greedy:

The Household Equity Share and Expected
Market Returns (Yang, American Finance
Association 2019)

HEShare: household equity share in

total financial assets.

After households heavily invest in the stock market, the stock market declines! How to
invest di↵erently?
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 Why Is Studying Finance Important? (underdiversification)

Florentsen, Nielsson, Raahauge, and Rangvid (2019, The Financial Review 54, pages 833 - 856)

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 Why Is Studying Finance Important? (underdiversification)

Florentsen, Nielsson, Raahauge, and Rangvid (2019, The Financial Review 54, pages 833 - 856)

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 Why Is Studying Finance Important? (Financial literacy)
How should risk and return be related?

For example, Tesla stock is somehow riskier than Apple stock.

E [RTesla ] > E [RApple ] or E [RTesla ] < E [RApple ] ?

Expected returns of equity = required rate of returns = discount rate = cost of equity

CAPM: E [Ri,t ] Rf ,t = i (E [Rm,t ] Rf ,t )

High risk ( i ) leads to high returns (E [Ri,t ] Rf ,t ).

Why is it called discount rate?

P1 Dt
Stock market, value = t=1 (1+re )t , where re = E [Ri,t ]

Is it how households believe?

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 Why Is Studying Finance Important? (Financial literacy)
US respondents (N = 2, 548)
0.4
Slope = -0.301
0.3

0.2

Expected Returns
0.1

-0.1

-0.2

-0.3
1 2 3 4 5
Risk Perception

Figure: Subjective Risk-Return Perception, Jo, Lin, and You (2022)

Research finding summary: click

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 Why Is Studying Finance Important? (Financial literacy)
I asked you guys what you believe.

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 Why Is Studying Finance Important? (Financial literacy)

The number of observations = 28, (respondent rate = 19%)

79% of respondents believe the high risk and high return relationship!

Is there any relationship between the belief in the risk-return tradeo↵ and the number of
education years/the number of finance courses taken?

I ran a regression: Yi = ↵ + 1 Yeari + 2 Coursesi + ✏i ,

where Yi is 1 for a student i who says a positive risk-return tradeo↵, otherwise zero. Yeari is the
number of year at university (e.g., Yeari = 2 if you are a second year student.) Coursesi is the
number of finance courses taken.

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 Why Is Studying Finance Important? (Financial literacy)

Table: Regression result

Coefficient Std. err. t P>t

Year -0.060 0.115753 -0.52 0.611
Courses -0.100 0.079546 -1.26 0.221
↵ 1.136 0.297964 3.81 0.001
Adj. R-squared = 0.0415

Negative relationship for both the number of years and the number of courses.
If you spend one more academic year, you are 6% less likely to believe the positive risk-return
tradeo↵.
If you take one more finance course, you are 10% less likely to believe the positive risk-return
tradeo↵.
But, they are not statistically significant, meaning that they are not very reliable.

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 Why Is Studying Finance Important? (Financial Advice)

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 Why Is Studying Finance Important? (Financial Advice)

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 Why Is Studying Finance Important? (Financial Advice)

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 Why Is Studying Finance Important? (Financial Advice)

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 Why Is Studying Finance Important? (Financial Advice)

?????

Introduction and Overview Source: Hartley and Olson (2018) 26/39

 Why Is Studying Finance Important? (Financial Advice)

Never listen to financial advisors recommending individual stocks! unless stock picking
is your hobby.
If you take my course, you would buy ETFs, not individual stocks.

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 Why Is Studying Finance Important? (Financial Advice)

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 Why do Financial Markets Exist?

A Youtube Video

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 Why do Financial Markets Exist?

First corporation: the Dutch East India Company (Verenigde Oost-Indische

Compagnie)

- Established on 20 March 1602 to trade

spice with India and Indonesia to compete
with English and Portuguese.

This business involved a high risk due to a high chance that ships do not return. Why?

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 Why do Financial Markets Exist?

Battle or rogue ocean waves, rebellion, etc.

Solution: Issues stocks to individuals to share risks.
Intuition: You own a fraction of a company, a single loss of a ship doesn’t harm much.

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 Why do Financial Markets Exist?
Reduced risk ! VOC actively engaged in risky voyages ! acquire exotic goods,
establish colonies, and create military ! financial stability ! lower finance costs
(interest rate) ! more active business.
At its peak, its valuation is $7.9 trillion (inflation-adjusted) (2018 Japan GDP is $5.2
trillion)

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 Financial Instruments
Debt vs. Equity Securities

Major financing tools are debt and equity. Then, what are the di↵erences?

Conditions Debt Equity

Description Obligation to repay Ownership stakes
Management None. Common stockholders have voting rights.
Repayment Debt has a maturity Equity doesn’t have a maturity
Obligation Payment of interest and Principal A firm isn’t legally liable to pay dividends
Tax benefits Interest is tax deductible Dividends are not tax deductible.
Example Ford Company corporate bond Starbucks stock

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 Financial Instruments
Debt vs. Equity Securities

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 Financial Instruments
Debt vs. Equity Securities

Merton (1974). On the pricing of corporate debt: the risk structure of interest rates.
Journal of Finance 29: 449-470
Equity value = Max(VT -K,0), debt value = Max(K,VT )
where VT is the asset value at T (debt maturity) and K is the debt claim.

Equity payoff
Debt payoff

m Fihed xam
Payoffs

Asset value at maturity

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 Financial Instruments
Marketable vs. Non-marketable Securities

Marketable securities are traded among market participants (e.g., Apple stock).

Non-marketable securities are funds that are available on demand and not traded (e.g.,
savings account).

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 Classification of Financial Markets
By type of issue (‘new’ vs. ‘old’)
Primary market
Refers to the original sale of securities (e.g., initial public o↵erings, new debt issues)
Issuing entity receives funds
Secondary markets
Involve the sale of already-issued (‘old’) securities from one investor to another
Securities may be exchange-traded or traded over-the-counter
By type of security traded
Equity markets
Fixed-income markets
Money market: short-term debt instruments
Debt market: intermediate and long-term debt instruments
Derivatives markets
Foreign exchange markets

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 Two Broad Fields of Finance

1 Asset Pricing (aka Investments)

How should we value financial assets?
What portfolios should we optimally hold? Focus of
Are financial markets efficient? this course

2 Corporate Finance
Capital budgeting
Corporate financing
Working capital management

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 Summary

Why is it important to study finance?

Why do financial markets exist?
What are the two main financial instruments? and how do they di↵er?
Two areas of finance are:
Asset pricing: how do we value financial assets, what portfolios of financial assets we should
hold
Corporate finance: what investment projects we should take, where to get money to finance
them, how to manage working capital
There is a large number of financial instruments traded in various markets.
For next class: Bond markets

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