FINANCIAL ECONOMICS

CHAPTER 1

Financial Instruments and Markets

Bibliography: “Essentials of Investments”, Ch. 2

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1. Introduction and Basic Concepts

Defining our topic of study:

“Financial Economics is the study of how to best allocate and deploy resources
(by individuals or firms) across time in an uncertain environment (across
states of nature) and the role of economic organizations in facilitating these
allocations”

Key elements: Time and uncertainty

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WHY this desire to “move resources around”?

• CONSUMERS
- Shift purchasing power (consumption) across time and future states
of nature.
* Student: no resources today, a lot in the future: borrow!
* Mid-career: resources today, no resources when old: save!
* Potential bad future state: house fire. Avoid it by purchasing
insurance
• FIRMS
- Moving capital from those who have it to those who can use it
productively
* No resources today, but great investment opportunities: borrow!
* Risk management:
- I export to US, want to protect myself against dollar depreciation vs
€, buy € forward!

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• Agents achieve their optimal allocation of resources across time and states of
nature through financial assets:

- A financial asset or financial instrument is a contract that gives to

the contracting parties rights and obligations defined in terms of
payments or cash-flows

• If financial assets can be exchanged among investors, we call them securities

• Investors need to know the value of the financial assets they buy and sell

• Issuers of assets need to know the value of the resources they can raise

ASSET PRICING

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Financial
Markets
Financial
Asset
Deficit Units:
Firms Surplus Units:
Government Families
Families

Primary FA Secondary FA
AS

Financial Bank
Intermediaries
Saving
2. Financial Assets

A financial asset is a CONTRACT that confers financial RIGHTS and OBLIGATIONS

Financial Assets

Basic FA Derivatives

Fixed Income Equities

Futures
Options Swaps
Forwards

Money Bank Bonds Calls Puts

Market Accounts Common and
Preferred Stocks 6
Fixed Income

“Fixed Income assets give their owner the right to payments computed
according to a predetermined rule on future dates”

There are two sides to a bond contract: the debtor = borrower, issues a bond in
exchange for an agreed-upon amount called the bond price, paid by the creditor
= lender

• The amount of money that the asset will pay in the future is called nominal
value, face value, par value, or principal

• Very often, especially with long-term bonds (maturity exceeds one year), the
debtor will make periodic payments to the creditor during the life of the bond.
These payments are a predetermined percentage of the nominal (principal) value
of the bond and are called coupons.

•We distinguish between Money Market Instruments and Bonds

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Fixed Income: Money Market Instruments

•In the money market, financial assets maturing in the short term are
exchanged. They are characterized by their great liquidity and little risk.

1) Treasury Bills: These are securities issued at discount. They do not

pay coupon, that is, an explicit interest, but they are sold below the
nominal

Ex. One year Treasury bill with a nominal value of € 1,000 and a price of
€ 950 interest: € 50; r = 50/950 = 5.26%

2) Certificates of deposit: Term deposit in a bank.

3) Commercial paper: Short-term corporate debt

4) Sales with a repurchase commitment (REPOS): State debt sales with a

repurchase obligation in the very short term at a higher price.
https://www.investopedia.com/terms/r/repurchaseagreement.asp
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Fixed Income: Bonds

• They mature in the medium or the long term

• Pure discount bonds (zero-coupon bonds): the initial price is equal to the
discounted nominal value; they pay no coupons during the life of the bond

• Coupon bonds: Very often, especially with long-term bonds (maturity exceeds
one year), the debtor will make periodic payments to the creditor during the life
of the bond
- These payments are a predetermined percentage of the nominal
(principal) value of the bond and are called coupons.
- In fact, a coupon bond is equivalent to a collection, or a basket, of
pure discount bonds with nominal values equal to the coupons

• If the price at which the bond is sold is exactly the same as the nominal value,
we say that the bond sells at par; if it is higher the bond sells above par; if it is
lower the bond sells below par (zero-coupon bonds always sell below par)
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 Example of 5-year coupon bond

- Price + N·ic + N·ic + N·ic + N·ic + N· (1+ ic )

t=0 t=1 t=2 t=3 t=4 t=5

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Do bonds really guarantee a fixed payment?? No! Risk of trading bonds

• The debtor might fail to meet the payment obligation embedded in the bond
(credit or default risk)

• Even if the amount to be paid in the future is fixed, it is in general impossible to

predict the amount of goods which that sum will be able to buy (inflation risk);
there are bonds that guarantee a payment that depends on the inflation level
(inflation-index bonds)

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Another important risk arises when the creditor needs money before maturity
(interest rate risk) and tries to sell the bond
- If there is no risk of default, the creditor knows with certainty that
the nominal value will be paid at maturity
- However, there is no price guarantee before maturity: The creditor
can in general sell the bond, but the price that the bond will reach
before maturity depends on factors (interest rates) that cannot be
predicted
- Bond prices change as consequence of movements in interest rates;
therefore, if we want to sell our bond before maturity, the bond will be
trading at a price which may represent a gain or a loss to the investor
- Bond prices fluctuate as the price of any other security: However, the
degree of fluctuation of bond prices (volatility) tends to be lower than
other risky assets like stocks

One can lose money investing in bonds

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https://www.marketplace.org/2023/03/16/duration-risk-got-silicon-
valley-bank-into-trouble/

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Stocks (Equity)

“Security that gives its owner the ownership of a firm and the right to a fraction
of any profits that might be distributed by the firm that issues the stock and to the
corresponding part of the firm in case it closes down and liquidates”

• These distributions are called dividends and are in general random; they will
depend on the firm’s profit, as well as on the firm’s policy

• In principle (if it does not go out of business), the stock will not expire

• The potential risky gains (losses) of the stock include capital gains (losses) and
the dividend yield (relation between the dividend and the price of the stock)

• Overall stocks will be more risky than bonds, although with respect to inflation
uncertainty, stocks can behave better than bonds:
- general price increases mean than corporations are charging more for
their sales and might be able to increase their revenues and profits (it
does not apply to bonds)

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- Ordinary or common shares: Shareholders have the right to vote and
receive dividends

- Preferred shares: Shareholders do NOT have the right to vote, in

exchange they receive a fixed amount of dividends, provided that the
company has benefits

- Indexes of shares: A value that allows to study the evolution in the price
of a basket of shares. They may be:

* Weighted average of prices (DJIA)

* Average of returns weighted by market capitalization (SP500)
* Equal-weighted average of returns

Investors don’t buy indexes directly but through mutual funds or ETFs

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Derivatives

“Financial instruments whose payoff depends on the value of another financial

variable (price of a stock, price of a bond, exchange rate, and so on), called
underlying”

• As in the case with bonds, derivatives are not related to physical assets or
business opportunities:

• Two parties get together and set a rule by which one of the two parties will
receive payment from the other depending on the value of some financial variable
- The profit of one party will be the loss of the other party; this is what
is called a zero-sum game

• Futures and forwards; options; swaps; mortgage-backed securities; callable

bonds…………..

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3 Short-selling

Two investors might have different expectations (based on their own judgment of
the available information) about future dividends and prices

An optimistic investor might decide to buy the stock (long position)

A pessimistic might prefer to sell; however, suppose that this investor does not
own the stock

This investor still can bet on his beliefs by short-selling the stock

It consists in borrowing the stock from someone who owns it and selling it

The short-seller hopes that the price of the stock will drop; when that happens, he
will buy the stock at that lower price and return it to the original owner

The investor has a short position in the stock

The act of buying back the stock and returning it to the original owner is called
covering the short position 21
Successful Short-Selling: An investor thinks the stock of Downhill, Inc. is
overvalued. It sells at 45€

The investor goes on-line, signs into her Internet brokerage account, and places an
order to sell short 1,000 shares of Downhill

By doing so she receives 45,000€

After patiently waiting four weeks, she sees that the stock price has indeed
plunged to 22€

She buys 1,000 shares at a cost of 22,000€ to cover his short position

She thereby makes a profit of 23,000€

- We ignore transaction fees, required margin amounts, and inflation/interest rate

issues
- If the stock pays any dividends, the short seller will have to pay them to to the
share lender
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https://www.youtube.com/watch?v=Uwtn1FbQIcU
https://www.ft.com/content/851d118c-0516-11e4-b098-00144feab7de
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4. Organization of Financial Markets

Some securities and financial contracts can be exchanged in markets with a

physical location and a set of rules.

Those markets are called exchanges (New York Stock Exchange, American
Exchange, Euronext (both cash and derivative markets in Belgium, France, The
Netherlands, Portugal, and the UK (derivatives)), The Spanish Continuous Stock
Exchange Market (Bolsa)), etc

However, some securities and contracts are sold through bilaterally between buyers
and sellers

We say that those financial instruments are traded over the counter or on an OTC
market

For example, currencies and some derivatives are traded on OTC markets. Also,
stocks can be traded in alternative platforms known as dark pools

Both types of markets have advantages and disadvantages

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 Appendix: Mathematics of interest rates

• Simple interest loan: interest is paid on a periodic basis

• Compound interest loan: No interest is paid until the end of the

loan.

• Accrued interest is added to capital and generates interest.

• Consider a loan with a principal C0, rate r, and n years.

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 Int.
Accrued Paym Debt Amortiz. Debt at the end of the year
Year Debt at the Interest ent
start of the
year
1 C0 C0 · r 0 0 C0 + C0 · r
= C0 (1 + r)
2 C0 (1 + r) C0 (1 + r) · r 0 0 C0 (1 + r) + C0 (1 + r) · r
= C0 (1 + r)2
3 C0 (1 + r)2 C0 (1 + r)2 · 0 0 C0 (1 + r)2+C0 (1 + r)2 · r
r = C0 (1 + r)3

… … … … … …

n C0 (1 + r)n-1 C0 (1 + r)n-1 · 0 C0 (1 + r)n 0

r
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FUTURE VALUE of X euros is the final capital to be
paid in a compound interest loan of X euros, with
annual rate r, after n years.

FV(X,r,n) = X (1+r) n

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PRESENT VALUE of Y euros is the amount of money
that must be lent in a compound interest loan at rate r,
in order to receive Y euros at the end of n years.

PV(Y,r,n) = Y (1+r) – n

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How much capital will I have in three years if I invest
5000 euros at the beginning of each year if r=3%?

5000(1+0.03)³ + 5000(1+0.03)² + 5000(1+0.03) = 15918

How much should I invest now in order to receive 1000

euros at the end of each year for the next 5 years if
r=2%?