Finance & Investment (lecture 1)

What is the Financial

Sector For?
Dr. Simon Hayley
The Financial Sector

• Banks
• Consumer finance (credit cards)
• Insurance Companies
• Financial Markets (stockbrokers)
• Investment Funds
• … and many more
What was all this for?
Individuals need to borrow and lend:
• Investing in education
• Buying a home
• Saving for a pension

Successful firms need to borrow in order to grow

Without the finance sector, borrowing and lending

would at best be a slow and laborious processes.
People would often be unable to find a suitable
counterparty.
 Financial
Sector

Households Firms
What About Financial Markets?

Which would you rather hold?

• A loan which pays 5% annual interest, repaid in
5 years’ time.
• A loan which pays 4.5% annual interest, repaid in
5 years’ time, but where you can claim your
money back at any time.
Liquidity
• Markets provide the opportunity to trade securities
quickly and easily.
• Liquidity (the ability to turn an asset into cash
quickly and cheaply) is very valuable to investors.
• Investors will accept lower returns for holding
liquid assets.
• This means that companies can obtain funding
more cheaply by issuing securities in forms which
have active secondary markets.
 Primary Market Transactions
• Primary Markets allow the issue of new securities.
Examples:
• An investment bank arranges an Initial Public
Offering (IPO) of shares in a growing
company.
• The government issues bonds to finance its
revenue deficit.
Secondary Market Transactions
• Secondary Markets allow financial instruments
issued in the primary markets to be traded (bought
or resold).
• This provides liquidity to investors.
• The original issuer of the security is not usually
involved in these trades.
Examples of markets:
• London Stock Exchange (LSE)
• New York Stock Exchange (NYSE)
• National Association of Securities Dealers
Automated Quotation (NASDAQ)
Instruments traded in the markets:
• Stocks
• Bonds
• Many others...
 Financial Markets: Overview
• A key function of financial institutions and markets
is to transfer funds from those who have a surplus
(e.g. private investors, institutional investors, etc.)
to those who have a deficit (e.g. corporations,
companies, home-buyers etc.).
• Without financial institutions, borrowing and
lending would be a slow and laborious processes.
• Financial markets provide liquidity. This is very
valuable to investors and so helps borrowers to
obtain finance more cheaply.

12
Finance & Investment (lecture 1)

Discounting
Dr. Simon Hayley
14
 Discounting
• One pound now is not the same as one pound at
some other date.
• There will be a rate r at which you are indifferent
between £1 today and £(1+r) in one year. This is
your one year discount rate.
• You can use this to calculate the present value
(PV) of a future cash amount: the sum that you
would regard as equivalent now.
• If my discount rate is 10% per annum then the PV of
£1000 next year is £1000/(1.1) = £909
• If I lend £100 for two years at 10% per annum, with the
interest paid at the end, then I will be repaid
£100x1.1x1.1 = £121.
• We have a similar compounding effect when we
discount. Thus the PV of £100 received two years in
the future is: 100/1.12 = £82.64
• However, in practice discount rates, just like interest
rates, need not be the same for all years in the future:
PV=100/(1+r1)(1+r2)
• Your discount rate may well be the same as the
interest rates that are available to you. The
discount rate can be regarded as reflecting the
opportunity cost of capital.
• For example, I am indifferent between £100 now
and £110 in one year (my discount rate is 10%)
because I know that if you give me £100 now I
can lend it so that I receive £110 next year.
• We are likely to increase our discount rates if
there is significant risk or illiquidity.
 Finance & Investment (lecture 1)

Using Discounting to
Choose Investments
Dr. Simon Hayley
• Net Present Value (NPV)
• Factors affecting our discount rate:
– Risk premium
– Liquidity premium
• NPV vs Payback period

19
The Risk Premium
• We are likely to increase our discount rate if there is
significant risk involved.
• For example, if I thought that you might pay me
£200 next year, or might pay nothing (both equally
likely), then I would discount the expected value
(£100) by a larger factor to reflect the uncertainty:
PV=£100/(1+10%+2%) = £89.29
• The extra 2% is an additional risk premium that I
include because I value an uncertain expected value
of £100 less than a certain £100.
Liquidity
• Liquidity (the ability to turn an asset into cash quickly and
cheaply) is very valuable to investors. Investors prefer to
hold liquid assets.
• Investors are likely to apply a higher discount rate to
illiquid assets.
• This increase in the discount rate to compensate for
illiquidity is known as the “liquidity premium”.
• Although it would be more logical to call it “illiquidity
premium”.
Components of Discount Rates
• Risk-free rate.
• Risk premium: the additional yield that lenders
require to compensate them for risks (especially
default risk) inherent in a particular type of lending.
• Investors may also demand a liquidity premium to
compensate them for holding illiquid assets.
• Tax effects can sometimes also be a factor for some
types of lending (eg. US municipal bonds have the
advantage of being tax free).

22
Components of Discount Rates

Liquidity premium

Risk premium

Risk-free rate

23
Net Present Value
• NPV is widely used as a decision-making
criterion. If the NPV of the future cashflows of a
project (discounted at an appropriate rate) is
positive, then this indicates that the project is
likely to add value to the firm.
• We will see later that popular methods used to
value equities and bonds are very similar.

24
 Payback Period
• The Payback Period is also sometimes used. This
calculates how long it takes (in years) for the
positive cashflows generated by a project to equal
the initial negative cashflows required.
• This is a very simple technique, but it is clearly not
as good as calculating the NPV, since:
– (i) it ignores the opportunity cost of capital
(effectively treating future cashflows as equally
valuable as cash today);
– (ii) It ignores cashflows after the cut-off date.

25
Finance & Investment (lecture 1)

About This Module

Dr. Simon Hayley
Structure of This Module
• Lecture 1 (Week 1). What is the Financial Sector For?
Discounting and NPVs
• Lecture 2 (Week 2). Money Markets/ Annuities and Perpetuities
• Lecture 3 (Week 3). Bonds 1: Structure/Economic Factors
• Lecture 4 (Week 4). Bonds 2: Duration/ Yield Curves
• Lecture 5 (Week 6). Equities 1: Firms, Shareholders & Managers/
Institutional Issues/ Equity Markets
• Lecture 6 (Week 7). Equities 2: Equity Valuation/ CAPM
• Lecture 7 (Week 8. Market Efficiency/Ethics
• Lecture 8 (Week 9). Derivatives: Forwards and Futures/Options
• Lecture 9 (Week 10). Foreign Exchange/ Behavioural Finance
• Lecture 10 (Week 11). Securitisation and ESG investing
Structuring Your Week
1. Work through the coming week’s material on the Moodle page:
videos, lecture notes, exercises and suggested readings.
2. Your weekly tutorial is in a small group, making it more
interactive. This lets you work through exercises and ask
questions, consolidating your learning before we move onto
new material the following week.
Reading for this module
• Brealey, Myers, Allen and Edmans “Principles of
Corporate Finance” is the main source in early weeks. It
is excellent on the principles of discounting. This week,
read Ch 1 and 2.1 (my references are to the 13th global
edition).
• BMA is not so good on financial markets. There are many
called “Financial Markets and Institutions” (or equivalent),
e.g. Madura, Mishkin & Eakins, Cornett & Saunders,
Fabozzi et al. Each week I will give specific chapter
suggestions for Madura, but if you want to use one of the
others, that’s fine: they are very similar. All tend to give
detail on US institutions, but please focus on
understanding the underlying principles involved.

29
• You don’t need to get the latest edition of these books,
since the main principles of finance haven’t changed. But
the examples and case studies used in older editions
might feel a bit dated.
• You need to do a substantial amount of self-study to
get an adequate understanding of the material
covered in this module. Studying the lecture
materials is not enough. This is probably the single
main reason why some students fail this module and
(if they fail the re-sit) end up leaving the university.

30
• Finally, ‘fun’ reading which will not help directly, but will
give you a better feel for how people act and think in the
financial sector. I recommend ‘New Market Wizards’ by
Jack Schwager. But bear in mind: (i) some of the
strategies described are horribly risky; (ii) others (as
interviewees admit) would not work anymore; (iii) this
book is a biased sample, since it looks at traders who
followed high risk strategies which worked –others who
followed similar strategies, but were unlucky will not have
been interviewed!
• Similarly, films: Wall Street (1987), Margin Call (2011),
The Big Short (2015).

31
• Assessment of this module has two components:
– Two coursework tests later this term.
– Exam in January.

• The two tests this term are designed to test your

understanding and give you rapid feedback on whether
you are on track to get through the exam.

32
Week 1: Summary
• Purpose of the financial sector
• Discounting and NPV
• Components of discount rates:
• Risk-free rate
• Risk premium
• liquidity (illiquidity) premium

33
I will sometimes use PollEverywhere to ask questions, so please
bookmark this link. Your answers will not be for credit, so do not
register… just hit “skip for now”
PollEv.com/simonhayley957

34