Why Study Finance?

L&W #1 PRINCIPLES OF FINANCE

What is Finance?
The art and science of managing money Finance is concerned with the process, institutions, markets, and instruments involved with the transfer of money among and b/w individuals, businesses and governments An understanding of finance benefits people by allowing them to make better personal financial decisions

Why Study Financial Markets and Institutions?

They are the cornerstones of the overall financial system in which financial managers operate Individuals use both for investing Corporations and governments use both for financing

Overview of Financial Markets

Markets in which funds are transferred from people who:
Have an excess of available funds to people who have a shortage Do not have a productive use for the funds to those who do Financial markets promote economic efficiency and high economic growth

Financial instruments
A real or virtual document representing a legal agreement involving some sort of monetary value Financial instruments can be classified generally as:
Equity based, representing ownership of the asset Debt based, representing a loan made by an investor to the owner of the asset Foreign exchange currency

Might be cash-based or derivative-based

Debt Markets and Interest Rates

Security = a claim on the issuers future income and assets Bond = debt security that promises to make payments periodically for a specified period of time Bond markets enable corporations and governments to borrow to finance their activities. They are where the interest rates are determined Interest rate is the cost of borrowing or the price paid for the rental of funds (expressed in % of the rental) Interest rates affect the willingness to spend and the investment decisions The concept of lumping interest rates together to the interest rate

Bond Market

Interest Rates on Selected Bonds, 1950-2003 (Source: Federal Reserve)

Stock Markets
Stock = a share of ownership in corporation Used by the corporations finance their activities Stock market = a place where the shares of stock are traded and their prices are determined Its the place where people can get rich or poor quickly Stock prices affect the wealth, the willingness to spend, and the investment

Stock Market

Stock Prices as Measured by the Dow Jones Industrial Average, 1950-2003 (Source: Dow Jones Indexes)

Foreign Exchange Markets

FX markets deal in trading one currency for another (e.g. dollar for yen) FX market = a place where the FX rate (the price of one countrys currency in terms of anothers) is determined The spot FX transaction involves the immediate exchange of currencies at the current exchange rate The forward FX transaction involves the exchange of currencies at a specified date in the future and at a specified exchange rate The FX rate affects imports and exports

Foreign Exchange Market

Exchange Rate of the US Dollar, 1970-2003 (Source: Federal Reserve)

Financial Institutions
They are what make financial markets work They perform the essential function of channeling funds from those with surplus funds to those with shortages of funds

The Financial System

The Central Bank is the most important financial institution
Manages the interest rates and the quantity of money Monetary policy affects interest rates, inflation and business cycle

Private sector financial institutions (financial intermediaries): banks, thrifts, insurance companies, securities firms and investment banks, finance companies, mutual funds, pension funds

Financial Innovation
A process of creative thinking on the part of financial institutions that can lead to higher profits, leading to:
The invention of new financial instruments and services The establishment of new markets New means of delivering financial services

Managing Risk
Interest rates fluctuated wildly Stock markets have crashed Speculative crises have occurred in the FX markets Did the financial institutions fail? How to cope with increased risk?

QUIZ (1)
1. Why are financial markets important to the health of the economy? 2. When interest rates rise, how might businesses and consumers change their economic behavior? 3. How can a change in interest rates affect the profitability of financial institutions? 4. What effect might a fall in stock prices have on business investment? 5. What effect might a rise in stock prices have on consumers decisions to spend?

6. How does a decline in the value of the pound sterling affect the British consumers? And the British imports and exports? 7. What is the basic activity of banks? 8. What are the other important financial intermediaries in the economy besides banks? 9. Can you think of any financial innovation that has affected you personally? 10. What types of risks do financial institutions face? 11. Why do managers of financial institutions care so much about the activities of the central bank?

QUIZ (2)