Lecturer: Shaling Li Acc&Fin Dept, PBS University of Portsmouth 15 October, 2009.
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Transcript of Lecturer: Shaling Li Acc&Fin Dept, PBS University of Portsmouth 15 October, 2009.
Lecturer: Shaling LiAcc&Fin Dept, PBS
University of Portsmouth15 October, 2009
What is Finance?
Fin
an
ce
Investment
Corporate Finance
Financial Market
and Financial Institutio
ns
Real Investmen
t
Financial Investme
ntFinancin
g decision
Investment &
Dividend decisions
Global financial systems: banks,
equity/debt markets
Resources of money
Usage of money
2S Li, Acc&Fin, PBS, UoP
Why study Finance?Finance is important to economy
Economy allocates money to its highest valued use (e.g. stock market)
Good business get more money (e.g. bank lending & interests)
Finance is important to individualManage your money: borrow/debtDifferent needs for money in different life
stages: young, middle age, retired
3S Li, Acc&Fin, PBS, UoP
How to study finance?Finance as a subject in ScienceScience:
Science refers to a system of acquiring knowledge. This system uses observation and experimentation to describe and explain natural phenomena.
The purpose of science is to produce useful models of reality.
Scientific methods
4S Li, Acc&Fin, PBS, UoP
Theory and Practice
Theoretical world:
AssumptionsGeneral rules
Results
Real world: Full of myteries
ExpectedUnexpected
results
5S Li, Acc&Fin, PBS, UoP
The theoretical world in FinanceThe assumptions of the theoretical world of
Finance1. Rational self-interest2. Frictionless financial markets
No transactions costs. No public information costs
3. Financial markets are liquid4. Minimal role for government
Theoretical world:
Assumptions: IFGeneral
rules/models: THEN
Results: SO
6S Li, Acc&Fin, PBS, UoP
How realistic are the assumptions of the finance textbook world?UK London stock market
The FTSE 100 companies are the 100 biggest UK companies by market capitalisation
Checking the assumptions in the UK marketsAssumption1: Rational self-interest
Self-interest: only focus on and seek self benefits (egotism – altruism)
Rational: logic manner Professional investors: pension fund, insurance
company, investment companiesCheck: yes or no?
7S Li, Acc&Fin, PBS, UoP
How realistic are the assumptions of the finance textbook world?Checking the assumptions in the UK markets
Assumption 2: Frictionless financial markets No transaction cost: commission fee exists, 0.35%
of selling/buying No public information cost: internet, newspaper, TV
Check: yesAssumption 3: Financial markets are liquid
The total market capitalisation of all FTSE 100 stocks is well over £1,000 billion
The total daily trading volume runs into the millions of shares traded
Check: Yes
8S Li, Acc&Fin, PBS, UoP
How realistic are the assumptions of the finance textbook world?Checking the assumptions in the UK markets
Assumption 4: Minimal role for government Government: a ‘night watchman’. systems of internal controls: professional ethics, the
strict legal and regulatory framework Check: yes
9S Li, Acc&Fin, PBS, UoP
Theory and PracticeTheoretical
world:RationalityFrictionless
marketLiquidity
Government role+
Models, results
Real world:UK London exchange
What is that??
10S Li, Acc&Fin, PBS, UoP
Arguments on the assumptionsThe rationality assumption is the most
important assumption of our textbook world model
Three arguments challenging this assumptionArgument 1: the ‘blockheads’ argument: Question: Blockheads are many and not
rational Explanation: On average the blockheads
cancel each other out
11S Li, Acc&Fin, PBS, UoP
Arguments on the assumptionsArgument 2: the rational arbitrageurs argument:
Question: when blockheads are not even numbered at short time, mispricing exists
Explanation: rational arbitrageurs will enter the market, forcing stocks back to their fair value.
Argument 3: winner and loser argumentQuestion: Are there more blockheads than smart
guysExplanation: blockheads will tend to lose money
over time, and that smart investors will tend to make money
12S Li, Acc&Fin, PBS, UoP
Arguments on the assumptions
Conclusions: The existing of blockheads does not influence the market and the assumption of rationality.
13S Li, Acc&Fin, PBS, UoP
How closely does the real world resemble the world of theory?
Theoretical world:
RationalityFrictionless
marketLiquidity
Government role+
Models, results
Real world:UK London exchange
14S Li, Acc&Fin, PBS, UoP
How closely does the real world resemble the world of theory?Whatever is thought and found in the theory
world has two types of results if matched/applied to the practical world: Yes, largely
The model (rules) can be applied to the practice with expected results most of time
However, this does not mean everyone gains in the market
There are always exceptions in the real worldNo, basically
If it does not work, why? Proper assumptions, models? However, this also does not mean there is no random
gain.
15S Li, Acc&Fin, PBS, UoP
How closely does the real world resemble the world of theory?Example: US market & Successful investors
A mutual fund, the Vanguard S&P500 Tracker In the early 1970s in America John Bogle decided to
apply the textbook world finance theory that was developed by finance scholars during the 1960s
looking at the thirty-year record, the investment returns on the Vanguard S&P500 Tracker fund have beaten those of every other stock market mutual fund in the United States.
Mr. Buffett’s personal wealth is around $40 billion and the funds he manages are far larger
16S Li, Acc&Fin, PBS, UoP
How closely does the real world resemble the world of theory?Russian market in 1990s
Investment model & investment results US/UK model likely to lose or does not work
Checking the assumptionsInformation was expensive Reliable information hardly existed Trading had to stopped during some period
(liquidity)Have a well-developed legal and regulatory
framework on paper, the lack of an enforced legal and regulatory framework
17S Li, Acc&Fin, PBS, UoP
The approach to studying finance1. We always start off with a problem, or a
question.2. Next we give the theoretically correct
solution to the problem3. The next step is empirical research
18S Li, Acc&Fin, PBS, UoP
SummaryFinance and its key elementsThe theoretical world in Finance + four
assumptionsThe realistic degree of the assumptions of the
finance textbook worldHow closely does the real world resemble the
world of theory (yes or no examples)Approach to study finance
19S Li, Acc&Fin, PBS, UoP
Seminar for next weekPlease see the attached.
S Li, Acc&Fin, PBS, UoP 20