VILNIUS UNIVERSITY

FACULTY OF ECONOMICS
Phd student Graina Mikalinien
grazina.mikaliuniene@ef.vu.lt

The Financial Environment: Markets,

Institutions, and Interest
Risk and Rates of Return

A market is a venue where goods and services

are exchanged.
A financial market is a place where
individuals and organizations wanting to
borrow funds are brought together with
those having a surplus of funds.

Physical assets vs. Financial assets

Money vs. Capital
Primary vs. Secondary
Spot vs. Futures
Public vs. Private

Direct transfers
Investment banking
house
Financial
intermediaries

Commercial banks (SEB. Swedbank)

Savings and loan associations
Mutual savings banks (Finasta)
Credit unions (Vilniaus taupomoji kasa)
Pension funds (Swedbank, MP)
Life insurance companies (Aviva, Mandatum)
Mutual funds (DnB investicij valdymas)

Auction market vs.

Dealer market
NYSE vs. Nasdaq
Differences are
narrowing

The price, or cost, of debt capital is the

interest rate.
The price, or cost, of equity capital is the
required return. The required return investors
expect is composed of compensation in the
form of dividends and capital gains.

 The

amount charged, expressed as a

percentage of principal, by a lender to a
borrower for the use of assets.
Interest rates are typically noted on an
annual basis, known as the annual
percentage rate (APR).
The assets borrowed could include, cash,
consumer goods, large assets, such as a
vehicle or building.

 Using

the simple interest formula:

Simple Interest = P (principal) x I (annual

interest rate) x N (years)
Borrowing $1,000 at a 6% annual interest rate
for 8 months means that you would owe $40
in interest (1000 x 6% x 8/12).

Production
opportunities
Time preferences for
consumption
Risk
Expected inflation

 Investment

returns measure the financial

results of an investment

Returns

may be historical or prospective

Returns

can be expressed in:

Dollar

terms

Percentage

terms

The rate of return on an investment can be

calculated as follows:
Return =

(Amount received Amount invested)

________________________
Amount invested

For example, if $1,000 is invested and $1,100 is

returned after one year, the rate of return for this
investment is:
($1,100 - $1,000) / $1,000 = 10%.

Dollar return:
$ Received - $ Invested
$1,100
$1,000

= $100

Percentage return:
$ Return/$ Invested
$100/$1,000
= 0.10 = 10%

Two types of investment risk

Stand-alone

risk
Portfolio risk

Investment risk is related to the probability

of earning a low or negative actual return.
The greater the chance of lower than
expected or negative returns, the riskier
the investment.
http://www.investopedia.com/video/play/
risk-and-time-horizon/#axzz2DG4Xdkn8

A listing of all possible outcomes, and the

probability of each occurrence.
Can be shown graphically.

Firm X

Firm Y
-70

15

Expected Rate of Return

100

Rate of
Return (%)

type of security that signifies ownership in

a corporation and represents a claim on part
of the corporation's assets and earnings.
There are two main types of stock: common
and preferred.
Common stock usually entitles the owner to
vote at shareholders' meetings and to receive
dividends.
Preferred stock generally does not have
voting rights, but has a higher claim on
assets and earnings than the common shares.

 http://www.google.com/finance?q=NASDAQ%

3AGOOG&ei=BWayUIidLcj1wAPZVQ

debt investment in which an investor loans

money to an entity (corporate or
governmental) that borrows the funds for a
defined period of time at a fixed interest
rate.
Bonds are used by companies, municipalities,
states and U.S. and foreign governments to
finance a variety of projects and activities.
Bonds are commonly referred to as fixedincome securities and are one of the three
main asset classes, along with stocks and
cash equivalents.
http://www.investopedia.com/video/play/u
nderstanding-bonds/#axzz2DG4Xdkn8

short-term debt obligation backed by the

U.S. government with a maturity of less than
one year.
T-bills are sold in denominations of $1,000 up
to a maximum purchase of $5 million and
commonly have maturities of one month
(four weeks), three months (13 weeks) or six
months (26 weeks).
http://www.investopedia.com/video/play/tr
easury-bill/#axzz2DG4Xdkn8

Small-company stocks
Large-company stocks
Corporate bonds
6.1
Government bonds
U.S. Treasury bills

Average
Return
17.3%
12.7
5.7
3.9

Standard
Deviation
33.2%
20.2
8.6
9.4
3.2

Source: Based on Stocks, Bonds, Bills, and Inflation: (Valuation

Edition) 2002 Yearbook (Chicago: Ibbotson Associates, 2002), 28.

Future value
Present value
Annuities
Rates of return

http://www.investopedia.com/video/play/
understanding-time-value-of-money/

Compound interest:
http://www.investopedia.com/video/play/what-is-compoundinterest/

 The

value of an asset or cash at a specified

date in the future that is equivalent in value
to a specified sum today. There are two ways
to calculate FV:
For an asset with simple annual interest: =
Original Investment x (1+(interest
rate*number of years))
For an asset with interest compounded
annually: = Original Investment x ((1+interest
rate)^number of years)

 $1000

invested for 5 years with simple

annual interest of 10% would have a future
value of $1,500.00

$1000

invested for 5 years at 10%,

compounded annually has a future value of
$1,610.51

CF1

CF2

CF3

i%

CF0

Show the timing of cash flows.

Tick marks occur at the end of periods, so
Time 0 is today; Time 1 is the end of the
first period (year, month, etc.) or the
beginning of the second period.

$100 lump sum due in 2 years

0

i%

100

3 year $100 ordinary annuity

0

100

100

100

i%

Uneven cash flow stream

0

100

75

50

i%

-50

Finding the FV of a cash flow or series of

cash flows when compound interest is
applied is called compounding.
FV can be solved by using the arithmetic,
financial calculator, and spreadsheet
methods.

10%

100

FV = ?

 After

FV1 = PV ( 1 + i ) = $100 (1.10)

After

2 years:

3 years:

FV3 = PV ( 1 + i )3 = $100 (1.10)3 =$133.10

After

= $110.00

FV2 = PV ( 1 + i )2 = $100 (1.10)2 =$121.00

After

1 year:

n years (general case):

FVn = PV ( 1 + i )n

Solves the general FV equation.

Requires 4 inputs into calculator, and will
solve for the fifth. (Set to P/YR = 1 and
END mode.)

INPUTS
OUTPUT

10

-100

I/YR

PV

PMT

FV
133.10

 The

difference between the present value of

cash inflows and the present value of cash
outflows. NPV is used in capital budgeting to
analyze the profitability of an investment or
project.
NPV analysis is sensitive to the reliability of
future cash inflows that an investment or
project will yield.
Formula:

http://www.investopedia.com/video/play/what-is-netpresent-value/#axzz2DGTrzmQz

 Finding

the PV of a cash flow or series of

cash flows when compound interest is
applied is called discounting (the reverse of
compounding).
The PV shows the value of cash flows in
terms of todays purchasing power.
0

10%

PV = ?

100

 Solve

the general FV equation for PV:

PV = FVn / ( 1 + i )n

PV = FV3 / ( 1 + i )3
= $100 / ( 1.10 )3
= $75.13

Solves the general FV equation for PV.

Exactly like solving for FV, except we
have different input information and are
solving for a different variable.

INPUTS
OUTPUT

10

I/YR

PV
-75.13

100

PMT

FV