„ Market Finance – Financial Theory“

Course at ESC Dijon

Prof. Dr. Franke-Viebach 1

Chapter 1: Investments: Background and Issues

Chapter 2: Asset Classes and Financial Instruments

Chapter 3: Securities Markets

Chapter 4: The Market for Foreign Exchange

Chapter 5:The Efficient Market Hypothesis

Bibliography: Bodie, Z. / Kane, A. / Marcus, A. J. (2013): Essentials of Investments. 9 th ed., New York.

 Chapter 1: Investments: Background and Issues

1.1 Real Assets versus Financial Assets

1.2 Financial Assets

1.3 Financial Markets and the Economy

1.4 The Investment Process

1.5 Markets Are Competitive

1.6 The Players

Bibliography: Bodie, Z. / Kane, A. / Marcus, A. J. (2013): Essentials of Investments. 9 th ed., New York, chapter 1.

Prof. Dr. Franke-Viebach 2

Investment = current commitment of resources in the expectation of reaping future benefits

1.1 Real Assets versus Financial Assets

(1) Real Assets

= assets used to produce goods and services → they generate income and thus wealth (remember: wealth = PV of income) examples: property, plants and equipment, human capital, etc.

(2) Financial assets

= claims on real assets or claims on real-asset income

→ they distribute income or wealth

examples: Toyota share, French government bond

Prof. Dr. Franke-Viebach3

Exercise: Are the following assets real or financial?

a. Patentsb. Lease obligationsc. Customer goodwilld. College educatione. U.S. treasury bill

Exercise: For each transaction, identify the real and/or financial assets that trade hands. Are any financial assets created or destroyed in the transaction?

a. Toyota takes out a bank loan to finance the construction of a new factory.b. Toyota pays off its loan.c. Toyota uses $ 10 million of cash on hand to purchase additional inventory of spare auto parts.

Prof. Dr. Franke-Viebach 4

Exercise: Lanni Products is a start-up computer software development firm. It currently owns computer equipment worth $30,000 and has cash on hand of $ 20,000 contributed by Lanni‘s owners. For each of the following transactions, identify the real and/or financial assets that trade hands. Are any financial assets created or destroyed in the transactions?

a. Lanni takes out a bank loan. It receives $ 50,000 in cash and signs a note promising to pay back the loan over three years.

b. Lanni uses the cash from the bank plus $ 20,000 of its own funds to finance the development of new financial planning software.

c. Lanni sells the software product to Microsoft, which will market it to the public under the Microsoft name. Lanni accepts payment in the form of 5,000 shares of Microsoft stock.

d. Lanni sells the shares of stock for $ 25 per share and uses part of the proceeds to pay off the bank loan.

Prof. Dr. Franke-Viebach 5

(3) Saving – investment, financial and real

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- saving = that part of disposable income which is not used for present consumption but laid back („saved“) for future consumption

- shift consumption to the future by a shift of purchasing power

- do so by a financial investment: buy a financial asset! example: buy a Toyota share

- Toyota will then use the saver‘s purchasing power to make an investment in real assets

Remember: investment = current commitment of resources in the expectation of reaping future benefits → hope to get back purchasing power in the future …!

(4) Individual/sectoral wealth versus aggregate/ national wealth

(a) Household sector

- assets: real assets, financial assets

- liabilities (b) National wealth (neglecting international relations)

- consists of real assets only

- reason: all financial assets (owner of the claim) are offset by a financial liability (issuer of the claim) → when all balance sheets are aggregated, only real assets remain

(c ) Example: USA 2011

7Prof. Dr. Franke-Viebach

Table 1.1 Balance Sheet, U.S. Households, 2011Assets $ Billion % Total

Liabilities and Net Worth $ Billion % Total

Real assets Real estate 18,117 25.2% Mortgages 10,215 14.2% Consumer durables 4,665 6.5% Consumer credit 2,404 3.3%

Other 303 0.4% Bank and other loans 384 0.5% Total real assets 23,085 32.1% Security credit 316 0.4%

Other 556 0.8% Total liabilities 13,875 19.3%

Financial assets Deposits 8,038 11.2% Life insurance reserves 1,298 1.8% Pension reserves 13,419 18.7% Corporate equity 8,792 12.2% Equity in noncorp. business 6,585 9.2%

Mutual fund shares 5,050 7.0%

Debt securities 4,129 5.7% Other 1,536 2.1% Total financial assets 48,847 67.9% Net worth 58,058 80.7% TOTAL 71,932 100.0% 71,932 100.0%

Note: Column sums may differ from total because of rounding error. SOURCE: Flow of Funds Accounts of the United States, Board of Governors of the Federal Reserve System, June 2011.

Table 1.2 Domestic Net Worth, 2011

Assets $ Billion Commercial real estate 14,248

Residential real estate 18,117 Equipment and software 4,413 Inventories 1,974

Consumer durables 4,665 TOTAL 43,417

Note: Column sums may differ from total because of rounding error.

SOURCE: Flow of Funds Accounts of the United States, Board of Governors of the Federal Reserve System, June 2011.

Exercise: In a wave of pessimism, housing prices fall by 10% across the entire economy.

a. Has the stock of real assets of the economy changed?

b. Are individuals less wealthy?

c. Can you reconcile your answers to a. and b.?

10Prof. Dr. Franke-Viebach

 

11Prof. Dr. Franke-Viebach

1.2 Financial Assets

(1) Debt securities

(a) General feature:

pay a stream of income that is determined according to a specified formula

(b) Classification by maturity

- money-market debt securities: short-term

examples:

- capital-market debt securities: long-term

examples:

- in any case: a limited lifetime → the holder is entitled to get his money (the „face value“ of the debt security) back at maturity: this is part of his claim because the holder is a creditor!