Financial Economics Lecture 1

Welcome to financial economics, EC4024. Today, we'll look at:

• The module outline, learning outcomes, asssessment details.
• A brief chat about my expectations for the module, and yours.

• Contact: stephen.kinsella@ul.ie, twitter.com/stephenkinsella, 061-233611 (leave a message), office hours Wednesdays 9-12, drop in then. No need to make an appointment.

• Contact: Dr Antoine Godin Antoine.Godin@ul.ie, Office hours Tuesdays 9-12 KB 342.

• Contact: Hamid Raza (TA), Hamid.Raza@ul.ie. Office hours TBA.

This module introduces students to:

1. the main models of financial economics and the tools of financial economists

2. The basics of valuation, contract theory and monitoring,

3. how to read a balance sheet, how leverage works, how ‘the market’ really works,

4. how to deal sensibly with financial and macroeconomic data, the ‘zombie’ models.

5. Some cool topics like algorithmic trading, finance and growth, Bitcoin. (Antoine Godin will take most of these)

• Illustrate the building blocks of modern financial economics, both in the context of full information market economies and non-market contractual relationships.
• Overview the main theoretical and empirical developments in finance, in order to analyse the way in which firms make financial decisions and how such decisions are likely to affect performance.
• Survey canonical models which analyse the behaviour of stock prices within auction and dealership markets, developing student awareness of the important issues in market microstructure.

• There is no textbook for this module.

• Go to www.stephenkinsella.net, look for EC4024_2015.

• All the readings and lecture notes will be there.

• We'll use SULIS to upload your assignments.

• Try to read these before lectures, you'll get a lot more out of them.

There are two assessment vehicles.

1. A data project, due Monday of Week 6 by 4.30PM through SULIS, worth 40%. You'll get a lot of feedback on this submission.

2. A final exam, worth 60%. The exam will have 2 sections. Section A will have 10 short questions, Section B will have 4 longer questions, of which you'll have to do 3.

• Let's talk for a bit about what your expecations are for this module.
• Then mine.

Dixit and Pindyck (1994): condense the essence of investment decisions to three key attributes:

1. the degree of irreversibility;
2. the risk over future revenue;
3. the flexibility in the timing of the decision.

Bolton et al (2013), in your reading list, add a fourth:

1. the funding cost of the investment.

Various answers to this question. How you answer determines a lot of your future direction in financial economics (or politics)

1.􏰝 transfer of savings to would-be investors, increasing economic growth. 􏰝2. Finance exists to distribute risk and reward 3. 􏰝 The markets collectively can master risk, that is, they can to some extent control the future path of their returns. 4. 􏰝 Finance exists to finance innovation/social change 5. 􏰝 Finance exists to maintain the social order. It is a tool of the government and other systems of social control. 6. 􏰝 Finance is a tool for speculation, fee generation on behalf of the market participants really only.

The problem of a rational economic order is determined precisely by the fact that the knowledge of the circumstances of which we must make use never exists in concentrated or integrated form, but solely as the dispersed bits of incomplete and frequently contradictory knowledge which all the separate individuals possess.

1. Intrinsic valuation, relates the value of an asset to the present value of expected future cashflows on that asset.
2. Relative valuation, estimates the value of an asset by looking at the pricing of 'comparable' assets relative to a common variable like earnings, cashflows, book value or sales.
3. Contingent claim valuation, uses option pricing models to measure the value of assets that share option characteristics.

In discounted cash flow valuation, value of an asset is the present value of the expected cash flows on the asset, so you'd price a bond, a house, or any asset really, as:

Present Value of asset \[ = \frac{E(CF)}{(1+r)}+\ldots+\frac{E(CF)}{(1+r)^{n}}. \]

Where \( CF \) is the cash flow and \( r \) is the interest rate/discount factor.

Another way to look at that:

\[ Price = \sum \frac{Coupon}{(1+r)^{t}} +\frac{face value}{(1+r)^{t}} \]

Or for a dividend:

\[ Price = \sum \frac{dividend}{(1+r)^{t}} \]

Fundamental object. Reconciles assets, liabiliies and equity.

• Assets: anything of value you control.
• Liabilities: Liabilities are debts you owe to others.
• Equity: portion of assets that you own free and clear.

\[ Assets = Liabilities + Equity. \]

• Current assets (short-term): items that are convertible into cash within one year
• Non-current assets (long-term): items of a more permanent nature

As total assets these will equal

• Current liabilities (short-term): obligations due within one year
• Non-current liabilities (long-term): obligations due beyond one year These total liabilities +
• Shareholder equity (permanent): shareholders investment and retained earnings

• One measure: Assets to equities ratio.

• For banks: assets to capital ratio.

See Demirguc-Kunt et al 2010 for examples of Bank Capital: Lessons from the Financial Crisis.

Idea: agents, acting as price-takers, exchange claims on consumption to maximize their respective utilities. Role of information is less important.

So far in your study of economics, you’ve seen that much of human behaviour is modeled according to two principles: either

1. optimisation: people try to choose the best patterns of consumption they can afford (Friedman’s life cycle consumption notion)
2. Equilibrium: prices adjust until the amount that people demand of something is equal to that supplied (Marshallian microeconomic supply and demand, Walrasian general equilibrium, Nash/Cournot game theory)

See Handout.

1. Welcome to the course. We're really excited to get started.
2. Now geMake sure to do the readings for next week.
3. Tutorials start in week 3.
4. t to work.