Introduction: Essentials of Finance

Dr. Prof. Hening Liu

Role of finance for growth and business cycles

I Long run: financial markets are important to facilitate entry

of new firms, development of new products, ..., i.e., 1) allows
firms to grow more quickly, and 2) allow more productive
firms to borrow more

I Short run: financial markets make recessions less painful —

smooth out the downturns — not constrained by current lack
of income or profits.

I However, in some cases financial markets may amplify

fluctuations
I Example: banks failures. Banks lose money on mortgages, cut
back lending across the board, this reduces investment and
output.
Stocks = Equities

I Owning a share −→ you become entitled to dividends, and

can sell your share for the price that people will agree to pay
I You own the firm, so you can participate in decision making.
Elect board, vote on dividends, etc.
I Stocks are risky.: no sure payment, you will get whatever
dividend the firm decides to pay, which depends on its
earnings, which are uncertain; the price at which you can sell
the share is uncertain too.
I Limited liability: the price is positive. (The firm cannot
demand more money from you.)
I Return on holding a stock: you buy at t, you sell at t + 1:
Pt+1 + Dt+1
Rt+1 =
Pt
Bonds

I Promise of a fixed payment: a bond pays you back a principal,

at a fixed date

I Plus payment of interest (coupon), usually every year or

half-year until the principal is paid back

I Corporate bond: you are a creditor (lender, priority over

stockholders) of a firm

I Governmental bonds: creditor of governments

I Risk of default: failure to pay interest or principal. If default,

you can obtain something through bankruptcy process
Bonds
I Difference in credit risk (default risk): US gov.t safe, some
local or foreign gov.t less safe, corporations less safe ...
I Credit ratings: S&P, Moody.s, Fitch: from AAA, AA, A to ...
C
I Bond gives you a sure payment, unless there is default, if you
wait until the end!
I If you sell the bond before the end, the price of the bond may
have changed (Why?)
I Hence, from one year to the next return is
(n−1) (n−1)
b Pt+1 + ct+1
Rt+1 = (n)
Pt

I n is the number of years until principal is repaid, c is coupon

I n is called the maturity of the bond
Stylized facts

I High average stock returns, high volatility of stock returns

I Low average return on T-Bills, low volatility of return on
T-Bills
I Slightly higher average return on long-term Treasuries, but
volatile return year-to-year
Key Questions

I Why is equity risk premium so high? — equity premium puzzle

Equity risk premium = E [RM − Rf ]

I Why is the stock market so volatile? — equity volatility puzzle

I Why do some stocks earn higher expected returns than

others? — factor pricing

I Information contents of prices of stocks and bonds:

information −→ expectation −→ prices
Example: EU Referendum

Stock index: FTSE100, Jan 2016 — now

Example: EU Referendum
Foreign currency: GBP/USD, Jan 2016 — now
Example: EU Referendum
Gold, June 2016 — now

On the Brexit day

Example: EU Referendum

S&P500 Volatility Index (VIX): gauges fear of uncertainty

Stock Market Comovement

Stock index: S&P500

China Stock Market

Shanghai composite index, Jan 2016—

China Stock Market

China A shares: meltdown on 3 Jan and 6 Jan, 2016

What is this course about?
I To be brief: models and data!

I How large is the return you expect an asset (stock or bond) to

provide? — Systematic risk factors

I Capital asset pricing model (CAPM)

I Arbitrage pricing theory (APT)
I Consumption-based asset pricing model (CCAPM)

I Prices, information efficiency, and rationality

I Efficient market hypothesis

I Rational valuation

I Bond pricing: theories on the term structure of interest rates

What is this course about?

Confront models to data

I Why CAPM fails? In what respects?

I What is Fama-French three-factor model?

I What is Shiller’s equity volatility puzzle?

I Why CCAPM fails?

What is this course about?

In short, asset pricing models can be summarized by

Equity premium = risk premium × quantity of risk

but with different stories about “risk premium” and “quantity of

risk”.

I Focus on concepts and intuitions without killing you with

boring algebra and impossible proofs.
Organization of the Course
I Email: Hening.Liu@manchester.ac.uk
I Weixin (WeChat): fminsearch
I Office: M38 Crawford House
I Lecture times: see syllabus
I Assessment: 100% unseen examination
I Teaching assistant: Miss. Weiping Qin,
Weiping.Qin@postgrad.mbs.ac.uk, Office hours: Friday
5pm-6pm Harold Hankins Building 10.08
I Another important issue: Students enrolled in each of the
MSc. programs must only attend their assigned lecture
session. If they miss or cannot make a session, which should
only be under acceptable extenuating circumstances, they still
cannot attend the other session.
Organization of the Course

I Important: Attending the lectures is compulsory. Lectures

will cover models and provide illustrative examples not
covered by the textbook

I Textbook: Elton, E., M., Gruber, S., Brown, and W.,

Goetzmann, Modern Portfolio Theory and Investment
Analysis, John Wiley & Sons; 9th Edition (July 2014)

I We will use the textbook in combination with lecture notes.

On some topics, we will rely on lecture notes intensively.

I It is strongly recommended you read the textbook and lecture

notes (on upcoming topics) before each class.
Organization of the Course
I Where is the “stuff”?
I Teaching materials, handouts, problem sets, etc. will be
available from the course Blackboard
I Additional announcements and discussion questions will be
also posted on the Blackboard

I Am I going to teach/review everything from the alphabet to

the numbers?
I No. It is assumed that you have a working understanding of
basic concepts in economics (e.g., utility functions),
introductory financial management (e.g., present values), and
statistics (e.g., variance)
I References to Introductory material in economics and statistics
will be provided for your own use
The Exam

I It will have a known format/structure

I Notice: format or structure 6= contents!

I “Known” alludes to the fact that we will give sample practice

questions every week to help with your preparation.

I The exam will be 2-hour long and UNSEEN

I Unseen: we are not assumed or even allowed to tell you in

advance what the questions will be

I Preparing the exam is not a hunt to understand what topics

will not be part of the test — The exam can be on
anything in the syllabus