F INANCE AND F INANCIAL M ANAGEMENT

L ECTURE O NE – T HE B ASICS

Dr Sofia Gueorgieva

Imperial College Business School

2024 - 2025
 TO START

• Office hours – 2:50 pm to 3:50 pm Thursdays

• Venue most days is Business School Meeting Room 294a - Level 2. Meet
just outside next to the Lecture Theatre. Please notify me in advance.

• Email: [email protected]

• (Optional) Textbook: Investments, 13th (or 12th) edition, by Bodie, Kane, and Marcus

3
 ASSESSMENT

• 4 quizzes, 2.5% each = 10% total.

At beginning of weeks 3, 5, 8 and 10. No retaking allowed.
• Coursework = 35%
Online or in-person trading game
Marked individually even if there is a group component
Groups determined by programme team
Writeup submitted online by 10 am on Wed 26 March
• Final exam = 55%
2 hours, late April – early May
4
 BY THE END OF THE MODULE

You should
• Be able to talk intelligently about financial markets
• Understand the mechanisms that move and determine prices
• Understand some of the risk that investors think about

You won’t have to

• Memorise or derive complicated mathematical formulate

5
 TO F INISH OFF H OUSEKEEPING

Lectures are recorded

You will have access to the slides before class
The slides are not a transcript of the lectures – need
to come to class and take notes

Questions Please don’t hesitate to ask them – if you have

questions, others have them too
If you lose the thread, it will be difficult to recover it
Don’t be afraid

6
 C OURSE O UTLINE - TOPIC O NE

B ASICS

• Finance versus Economics

• Types of Assets, Players
• Financial Intermediaries and Markets
• Key Securities
• Types of Transactions

Reading: Textbook Chapters 2 and 3

7
 C OURSE O UTLINE - TOPIC T WO

T IME VALUE OF M ONEY

• Discounting
• Present Value
• Zero-Coupon Bonds

8
 C OURSE O UTLINE - TOPIC T HREE

S ETTING UP THE CAPM

• Generalised Portfolio Theory

• Asset Allocation
• Return vs Variance vs Covariance
• Optimal Portfolio Choice

9
 C OURSE O UTLINE - TOPIC F OUR

CAPM PAYOFF

• Efficiency of the Market Portfolio

• Systemic vs Idiosyncratic Risk
• Testing the Model

10
 C OURSE O UTLINE - TOPIC F IVE

A RBITRAGE

• Examples: multiple securities or multiple markets

• FX Trades: what is and isn’t arbitrage
• Limits to Arbitrage: transaction costs and market microstructure

11
 C OURSE O UTLINE - TOPIC S IX

E QUITY VALUATION

• Market Value vs
• Intrinsic Value vs
• Book Value
• Discounted Cash Flow Models
• Valuation Ratios
• Dividend Growth and Multiples

12
 C OURSE O UTLINE - TOPIC S EVEN

F IXED I NCOME VALUATION

• Bond Prices
• Term Structure
• Duration
• Convexity
• Fixed Income Portfolio Management

13
 C OURSE O UTLINE - TOPIC E IGHT

O PTIONS

• Option types, contracts and strategies

• Black-Scholes and option valuation
• Implied probabilities and volatilities
• Hedging

And throughout the module – what is the relationship to

sustainability.

14
 C OURSE O UTLINE - TOPIC N INE

R EVISION

• Going over the material covered

• Filling in any gaps

15
 A N E XAMPLE
FROM THE P RESS

16
 A N E XAMPLE FROM Anatomy of the VIX Spike in August 2024
A CADEMIC R ESEARCH Karamfil Todorov & Grigory Vilkov
BIS Bulletin No 95, 29 October 2024

17
 1. F INANCE VERSUS E CONOMICS

• ECONOMICS – the social science studying how to satisfy people’s unlimited

wants subject to scarce resources (land, capital, labour)

• To achieve that, economics examines the production, distribution and consumption of

goods and services – how to maximise welfare
• It also investigates human behaviour leading to seemingly irrational decisions / actions
• Normative versus positive approach

• How does money change things?

- Money is used as a medium of exchange + unit of account + store of value
18
 1. T HE E CONOMIC M ODEL

Labour Market

Product Market
Households Firms

Financial Market

Intermediaries

19
 1. F INANCE VERSUS E CONOMICS

• FINANCE – a subset of economics

• How to allocate resources over time and under uncertainty

• Resources (savings of households) are transferred over time through investment

opportunities that are expected to generate a return above what is invested

• These opportunities are most of the time subject to risk – because the future, by
definition, is uncertain

20
 1. M ORE ON F INANCE

• Risk juxtaposed to return à Modern Portfolio Theory (Harry Markowitz,

Portfolio Selection, Journal of Finance, 1952b) = mean-variance model

• 1960s – CAPM – what is the theoretically appropriate required return to an

asset when added to a well-diversified portfolio

• Deal with
- valuation (of assets, contracts) – positive and normative
- management – What? When? How?
- financial institutions - role and regulation
- ownership of assets - incentives for agents
21
 1. B RANCHES OF F INANCE

• Asset Pricing – valuing assets

• Corporate Finance - how firms get their funding and how they invest it
• Household Finance – saving / investment decisions by households
• Macrofinance – link between asset prices and economic fluctuations
• Market Microstructure – price formation in asset markets
• Mathematical Finance – novel methods and models to analyse financial problems
• Climate Finance – incentives to mitigate / adapt to climate change; carbon pricing
• Behavioural Finance – how psychological influences and biases affect financial
decisions
22
 1. T YPICAL A SSUMPTIONS IN F INANCE

• Selfish agents
• Higher returns are better than lower returns
• Lower risk is better than higher risk
• Better money now than same amount later
• “There ain’t no such thing as a free lunch.”
• Security prices make supply = demand
• Financial innovation focuses on risk sharing and reducing frictions
• It is normal for models to appear unrealistic.

23
 2. R EAL VERSUS F INANCIAL A SSETS

• Real Assets
- produce goods and services
- generate net income to the economy and determine its material wealth
• Financial Assets
- are claims on real assets and hence on the income the latter provide
- each financial asset gives rise to a financial liability è their sum is zero
- define the allocation of income / wealth among investors
è Net national wealth = sum total of REAL assets only

24
2. N ATIONAL B ALANCE S HEET

25
 2. F INANCE – THE S TAGE AND THE P LAYERS

Firm Banks &

Financial
Intermediaries
Borrows
Investors
Assets (Today) Raises Capital Markets
•Debt (Bonds)
• Equity (Stock)

Reinvests

Repays
Regulation
Output (Tomorrow) Pays Taxes
Consumers
26
 2. M AJOR P LAYERS (1)

• Non-financial firms – typically net borrowers

- issue securities to investors, use proceeds to invest in risky projects. The
investment funds can come out of profits (retained earnings) but also from:
- banks (esp. small businesses)
- private equity (PE), venture capital (VC), private capital (PC)
- stock market (must first become a public company)
- bond market (esp. large firms)
• Households – typically net savers, dependent on interest rates, wealth, income
- purchase securities from government & non-financial firms and / or deposit at
financial firms (banks, mutual funds)
27
 2. M AJOR P LAYERS (2)

• Government – usually a net borrower

– through issuing bonds (gilts) = when taxes fall short of spending
è Budget Deficit
– but sometimes saves (budget surplus)
• Financial Intermediaries
– issue their own securities to invest in financial assets
– act as clearing houses for financial assets and liabilities, bringing
together borrowers and savers
• Overseas Sector
– we borrow overseas when domestic savings < domestic investment
(through capital inflows) = capital account surplus
28
3. F INANCIAL I NTERMEDIARIES AND INSTITUTIONS

29
 3. F UNCTIONS OF F INANCIAL I NTERMEDIARIES

• Size transformation
- aggregation of small borrowers / lenders

• Maturity transformation
- by pooling short-term deposits they are able to lend at longer term
àThis does increase the risk of “credit crunch” and the need for regulation

• Risk transformation
- able to smooth risk of lending to risky ventures by pooling,
diversifying, monitoring and hedging
30
 3. F INANCIAL M ARKETS IN THE E CONOMY

• Information role – through setting security prices

- financial markets allocate capital between different uses, ideally to the
most efficient use
- separation of ownership and control (management)
- corporate governance and corporate ethics
• Timing of consumption across life
- financial assets allow you to shift consumption of real goods from
times when you earn a lot to times when you earn less
• Allocation of Risk
- financial markets allow risk to be traded between different parts of
the economy
31
 3. W HAT D O F INANCIAL I NSTITUTIONS A CHIEVE ?

• So, financial markets and intermediaries

- achieve efficient allocation of resources.
Savers want the best return for their money. Efficient allocation means
that the pool of savings should go to the most productive investments.
- as a result, the financial sector generates savings and investments.
With money going to the most efficient projects, return on savings goes up
which increases total savings and total investment.
• Financial instruments (securities)
- are used to finance major sustainable development projects.
Hence they are key tools to fund and implement such projects.
- what is needed is coming up with sustainable projects
32
 3. S OME K EY F EATURES OF F INANCIAL M ARKETS

• Primary (initial floating of security) versus Secondary (trade of already

existing securities)

• Regulated exchanges / alternative trading systems such as ECN or

crossing networks that are more loosely regulated / over the counter
(OTC) (unregulated) / “internalisation” (outside of a trading venue)

• Trading mechanisms
- auction = order-driven – centralised, direct – Paris, Milan, Tokyo
- dealership = quote-driven – decentralised, intermediated -
NASDAQ
33
 3. K EY F EATURES (2)

• Liquidity – ability to trade a security quickly at a price close to its

fundamental value
- measured through the size of the spread between bid and ask
- bid = price at which the market maker is willing to buy
- ask = price at which the market maker is willing to sell

• Depth – the maximum order size that can be executed without affecting the
security price
à Related issue: price impact

34
 3. T RANSACTION E XECUTION

• Brokers
– find a counterparty for the buyer or seller
– earn a commission
– traditionally, exchanges operated with brokers. Investment banks broker
IPO deals or new bond issues.
• Dealers
– counterparties for both buyers or sellers
– earn the bid-ask spread
• Exchanges
– Today, exchanges are automated, so no brokers or dealers needed.
– Trades are executed based on order books matching buyers and sellers.
35
 3. E QUITY M ARKET – F LOW OF F UNDS

Assets
Individuals Corporates

Asset Managers
Pension funds, unit trusts, Risk transformation
insurance companies, products

Exchanges and Dealers Hedging Market

Secondary markets, electronic trading Equity derivative products, futures
– brokers and dealers

Investment Banks Risk transformation

IPOs, rights issues products

Liabilities
Corporates
36
3. D EBT / C REDIT M ARKET – F LOW OF F UNDS

37
 4. K EY T YPES OF S ECURITIES - B ONDS

• Bonds – instruments constituting a loan made by the buyer to the issuer

• Fixed-income – because it is known in advance what the cashflows will be
- the loan today = the purchase price
- the coupons = interest payments,
- the principal = the (face value) payment back at maturity

coupons Principal = face value

...
Loan today = purchase price

38
 4. K EY T YPES OF S ECURITIES – B ONDS (2)

Government bonds Corporate bonds

= Treasuries, Gilts, … - corporate paper < 1 year
- Treasury Bills (<1 year) - corporate bonds >1 year
- Treasury Notes (1 to 10 years) • Different repayment priorities (senior,
junior)
- Treasury Bonds (> 10 years)
• Higher yields than govt bonds (why?)
• Semi-annual coupons • Different types of risk:
• Normally considered safe (risk-free) - credit
• The interest rate depends on the - liquidity
maturity - counterparty

39
 4. T HE B OND M ARKET

40
Source: Fed Reserve Economic Data (FRED) Saint Louis, using also data from IMF (household debt),
US Office for Management and Budget (fed debt), Board of Governors of Fed Reserve System (business debt)
 4. T HE Y IELD C URVE – IN THE US
Yield in %

41
Source: home.treasury.gov
 4. K EY T YPES OF S ECURITIES - E QUITIES

• Stocks – ownership of a share in a business

• Stocks entitle shareholders to receive dividends
• Value of the stocks
- the expected present value (PV) of the future dividends and the
liquidation value
OR
- the expected present value (PV) of the future cash flows from business
projects after paying off any creditors

42
 4. D EBT VERSUS E QUITY
Debt Equity
- not an ownership interest - ownership interest
- creditors do not have voting - common stockholders vote for
rights the board of directors and other issues
- interest is considered cost of - dividends are not considered a
doing business and is tax deductible cost of doing business and are not tax
- creditors have legal recourse deductible
if interest or principal payments are - dividends are not a liability of
missed the firm and stockholders have no legal
- excess debt can lead to recourse if dividends are not paid
financial distress, bankruptcy & - an all-equity firm cannot go
agency problems of debt bankrupt
- future cashflows are often - future cashflows are stochastic
known
43
 4. E QUITY I NDICES

Equity performance often reported in aggregate indices

• Dow Jones Industrial Average
- price-weighted index
- 30 firms
• Standard & Poors Composite 500 Index
- value-weighted index
- 500 firms
• FTSE 100 Index
- value-weighted index
- 100 firms
44
 4. T HE E QUITY M ARKET
Annual Return in %

Source of raw data: website of Aswath Damodaran – January 2025

45
 4. K EY S ECURITIES - D ERIVATIVES

• Futures: a contractual agreement to exchange a security for a specified cash

amount on a particular future date
• Swaps: a contractual agreement to exchange two sets of cash flows over a
specified time period
• Forwards: non-standardized contracts to exchange a security for a specified
amount on an agreed future date
• Convertibles: debt instruments that convert into company equity under
certain conditions
• Options: instruments that give one party the right to buy or sell the
underlying security
• Asset-Backed Securities: instruments collateralised by an underlying pool
of assets such as mortgages, receivables, loans, life insurance policies

46
 4. VIX
Implied volatility of the S&P 500 Index
Calculated by Chicago Board Options Exchange (CBOE)

Source: https://www.tradingview.com/symbols/TVC-VIX/ accessed on 14 January 2024 47

 4. VIX – T HE S URGE IN A UGUST 2024

Implied volatility of the S&P 500 Index for last 6 months

Calculated by Chicago Board Options Exchange (CBOE)

Source: https://www.tradingview.com/symbols/TVC-VIX/ accessed on 14 January 2024 48

 5. T YPES OF T RANSACTIONS

• Cash funded
• Margin funded (bull)
• Short selling (bear)
Buying on margin
• The borrowing is regulated by Federal Securities Law:
- initial cash contribution (initial margin) at least 50%
- maintenance margin at least 30%

!"#$%& ()*#+ ,- .+/#0$%& 12,)3

𝑀𝑎𝑟𝑔𝑖𝑛 = ()*#+ ,- .+/#0$%& = ()*#+ ,- .+/#0$%&

49
 5. B UYING ON M ARGIN – E XERCISE 1

• You are bullish about MSFT and have $10,000

• Your broker can lend you $10,000 at 10%
• With that you can invest $20,000 in MSFT
• What will your return be if the stock goes up by 25% or falls by 25% during
the next year?

50
 5. S ELLING S HORT

Investor Broker

Now Borrow and sell stock Lend stock

Meantime Pay any margin calls Check maintenance margin

Later Buy back and return stock Receive stock, dividend fee

Payoff P0 – P1 – fee – dividends Fee

51
 TAKEAWAYS

• Finance has real (i.e. economic) implications

• There are three key types of securities: debt, equity, derivatives
• Asset prices carry information
• Buying on margin indicates confidence

52
 D EFINITIONS
• Efficiency – a situation of minimal waste given same inputs
• Pareto efficiency (optimality) - a situation where nobody can get better
off without someone getting worse off
• Risk and return – variance and expected return of an outcome
• Security – a financial instrument giving the right to cashflows
• Debt – borrowed money that has to be repaid
• Equity – ownership interest in a business
• Derivative – a security which value depends on other securities
• Bull market – investors expect security prices to rise
• Bear market – investor expect security prices to fall

53
 S OLUTION TO E XERCISE 1

MSFT up 25% MSFT down 25%

Value of stock position $25,000 $15,000

Loan repayment $11,000 $11,000
Net value of account $14,000 $4,000
Net return +40% -60%

54