Financial Economics

An Introduction

Objective
To Define Finance
The Value of Finance
Introduction to
the Players

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 Key concepts
1. Defining Finance.
2. What is the Financial System?
Financial Markets
Financial intermediaries
Financial Decisions of households.
Financial Decisions of firms.
3. Agency problem.
4. The Four Basic Principles of Finance.
5. The efficient market hypothesis 2
 1. Defining Finance
• Finance is the study of how people
allocate scarce resources over time.
– costs and benefits are distributed over
time
• Understanding finance helps you
evaluate these uncertain cash flows.

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 Defining Finance
• Financial theory consists of:
– The set of concepts that help to
organize one’s thinking about how to
allocate resources over time.

– The set of quantitative models used to

help evaluate alternatives, make
decisions, and implement them.

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 Defining Finance
• When implementing decisions,
people make use of the Financial
System defined as the set of
markets and other institutions used
for financial contracting and
exchange of assets and risks.

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2. What is the Financial
System?

• A Financial System is comprised of

markets, intermediaries, service firms
and other institutions.
They used to carry out the financial
decisions of households, business
firms, and governments.

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 2.1 Why Study Financial
System?
• To study financial markets.
• To study financial intermediaries.
• To study tools of finance or “securities”.
• To study financial decisions for
households.
• To study financial decisions for firms.

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 2.1.1:The Financial
Markets
• Forums where buyers and sellers of financial
assets and commodities meet.
• Financial markets can be classified by:
– The Type of Asset Traded
• Debt
• Equity
• Derivatives
– The Maturity of the Financial Asset
• Money market
• Capital market
– The Owner of the Financial Asset
• Primary market
• Secondary market
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 Financial Markets
classified by Type of
Assets
• Debt (Also called fixed income
securities, Bonds and Loans)
Fixed Income Instruments promising fixed future payments

• Equities (Common Stock/Shares)

Residual claim on assets.

• Derivatives (Options, Forwards,

Futures)
Securities that derive their value from other securities

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 Financial Markets
classified by Maturity
• Money Market
– Mostly debt instruments issued by
governments and secure large corporations
– Highly liquid: Quickly convertible to cash
– Short-term securities
• Capital Market
– Equities, and debt instruments with a life
greater than a year.
– Medium & long-term securities.

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Financial Markets classified
by owner of financial asset
• Primary Market
- Where securities are created.
- In this market firms sell new stocks and
bonds to the public for the first time.
• Secondary Market
- It is commonly referred to as the "stock market."
- Investors trade among themselves.
- Does not provide financing to the issuing
company.

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 Function of Financial
Markets
• Perform the essential function of channeling funds
from economic players that have saved surplus
funds to those that have a shortage of funds {see
the figure}
• Direct finance: borrowers borrow funds directly
from lenders in financial markets by selling them
securities (also called financial instruments)
• Indirect finance: borrowers borrow funds indirectly
from lenders through financial intermediaries (such
as banks)
➢ Securities are assets for the person who buys them
but liabilities (debts) for individual or firm that sells
(issues) them 12
 2.1.2 Financial
Intermediary
– A firm whose primary business is to
provide financial services and financial
products.
– Examples:
• Commercial banks (checking
accounts, loans, Certificate Deposits)
• Shadow Banks: financial
intermediaries (bank like activities)
outside the traditional banking system
and not subject to rules and
restrictions applied on it. (mutual
funds - insurance companies- pension
funds- financing companies) 13
 The Flow of Funds
– Funds may flow from the
surplus unit to the deficit unit:
• Through markets (directly)
• Through intermediaries
(indirectly)

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Flows of Funds Through the
Financial System

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 2 .2 Financial
instruments (Securities)
Common Preferred
stocks stocks

Types of
derivatives securities bonds

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 • Bonds
• Bonds are long term debt instruments, they usually
offered to the public and sold to many investors.
• The buyer of a newly issued bond is lending money
to the issuer, who in turn, agrees to pay interest on
this loan and repay the principal (par value) at the
maturity date.
• If you buy a newly issued government (or
corporation) bond, you are lending money to the
government (or corporation)
• Bonds are fixed-income securities because the
interest payments and the principal are specified at
the time the bond is issued and fixed for the life of
the bond.
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 • Common stocks
• The common shareholders are the
owners of corporation.
• Equity ownership involves risk
because holders of common stock
are not guaranteed a return and are
last in priority in a liquidation.

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 • Preferred stocks
• Preferred stock is a hybrid of
debt and equity.
• It has a fixed payments (like
bonds).
• But it is has no a maturity date,
and the buyer is an owner of
the firm (like common stocks).
They give ownership right to
their holders. 19