Basics for market microstructure Stock market is a

Basics for market microstructure Stock market is a slough of fear and greed untethered to corporate realities – Warren Buffet 26 октября 2002 Стратегии

What is finance? n Capital markets – Portfolio management – Asset pricing • Time and cross dimensions – Risk management – Financial engineering – Performance evaluation – Market microstructure MM 2006/7 NES 2

What is finance? n Corporate finance – Capital budgeting • Project valuation – Capital structure – Mergers and acquisitions • Company valuation – Going private / public (IPO) – Corporate governance MM 2006/7 NES 3

Potential employer / job function n Investment bank – – – n Corporate finance: help companies to raise capital M&A: value companies, structure deals, negotiate Trading equity, FI, FX, derivatives Structured finance: create new instruments Analyst / research Commercial bank – Loans to individuals and companies – Mortgage – Private banking NES MM 2006/7 4

Potential employer / job function n Money management: mutual / pension / hedge funds – Portfolio manager: select investments – Investment advisor – Analyst Corporate finance dept in a company n Audit company n NES MM 2006/7 5

Market microstructure Financial markets n Financial instruments n Financial intermediaries n NES MM 2006/7 6

Financial markets Primary vs secondary n Exchanges vs OTC n Dealership vs (batch / continuous) auction n Listing/Depositary receipts n NES MM 2006/7 7

Financial markets n Objective: facilitate trading to allow – Money transfer over time – Risk sharing – Price discovery n Issues: transaction costs – Info asymmetry – Liquidity – Informational efficiency NES MM 2006/7 8

Financial instruments Basic: stocks and bonds n Derivatives: forwards, futures, options, swaps, etc. n Indices n NES MM 2006/7 9

Financial instruments n Objectives – Marketable – Give specific payoff in a given state of the nature n Issues – Specifics vs liquidity/ simplicity – Counterparty risk – Bad incentives NES MM 2006/7 10

Financial intermediaries Brokers / dealers n Commercial banks n Investment banks n Mutual / pension / hedge funds n Wealth management n NES MM 2006/7 11

Financial intermediaries n Objectives – Minimize transaction costs • Economies of scale – Solve information problems – Brokerage vs qualitative asset transformation n Issues – Agency problem – Coordination – Conflict of interest NES MM 2006/7 12

Jargon n n n n Short sales Spread Insider Market-maker Listing Liquidity Securitization Market efficiency Arbitrage NES MM 2006/7 13

Books Description Library Бригхем, Гапенски. Финансовый менеджмент x Sharpe, Alexander, Baily. Investments x Grinblatt, Titman. Financial Markets and Corporate Strategy x Megginson. Corporate Finance Theory x Haugen. Modern Investment Theory x Hull. Options, Futures, and Other Derivatives x Scanned x x Малюгин. Рынок ценных бумаг: Количественные методы анализа Энциклопедия финансового риск-менеджмента. Под ред. Лобанова и Чугунова Jorion Financial Risk Manager Handbook x x MM 2006/7 CFA study notes NES 14 x

Further courses Investment theory n Corporate finance n Econometrics of financial markets n Risk management n NES MM 2006/7 15

Lecture 2: plan n Prices and returns n Why is the discount rate positive? n Index models and CAPM n Specifics of corporation n Stocks vs bonds n Financial statements and coefficients NES MM 2006/7 16

Prices and returns -Why do prices rise? - Because there are more buyers than sellers! 26 октября 2002 Стратегии

Prices and returns n How to define returns? – for stocks / bonds Why usually employ returns in models? n Why need stochastics? n How to account for transaction costs? n NES MM 2006/7 18

Discount rate Time preference n Inflation n Risk n NES MM 2006/7 19

Models The one investment certainty is that we are all frequently wrong 26 октября 2002 Стратегии

Index models n Market model: Ri, t = αi + βi. RM, t + εi, t, – where E(εi, t)=0, cov(RM, εi)=0 n n Risk management: ΔRi ≈ βiΔRM Separation of total risk on systematic and idiosyncratic: var(Ri)=βi 2σ2 M+σ2(ε)i – Systematic risk depends on factor exposures (betas): βi 2σ2 M – Idiosyncratic risk can be reduced by diversification n Covariance matrix: – Assuming E(εiεj)=0 for i≠j cov(Ri, Rj) = βiβjσ2 M NES MM 2006/7 21

CAPM n More restrictive model: βi. E[RM, t-RF, t] E[Ri, t-RF, t] = – where E(εi, t)=0, cov(RM, εi)=0 n The expected excess return of each asset is proportional to its beta – Investors require higher expected returns on assets with higher systematic risk n In the equilibrium, everybody invests in the market portfolio (of risky assets) and risk-free rate MM 2006/7 NES 22

Specifics of corporation The most investor can lose is everything? 26 октября 2002 Стратегии

Forms of Business Organization Sole proprietorship n Partnership n Corporation Evaluate by n The life of the entity n The ability to raise capital n The owners' liability n MM 2006/7 NES 25

Modern Corporation n. Advantages – Limited liability • 1811: general act of incorporation in NY – Easy transfer of ownership – Unlimited life – Ability to raise large amounts of money NES MM 2006/7 26

Modern Corporation n. Disadvantages – Start-up can be costly – Earnings subject to double taxation – The agency problem • Separation of control and ownership • The leverage effect of debt NES MM 2006/7 27

Equity vs Debt n Shareholders – – n Control rights (e. g. , elect directors) Limited liability Residual claim on assets (after paying up liabilities) Dividends (fully taxable) Debtholders – – – Fixed contractual claim against the corporation No voting power unless the debt is not paid Interest on debt is tax-deductible MM 2006/7 NES 28

Basic Financial Statements 1. 2. 3. Balance Sheet Income Statement of Cash Flows Objectives: n current status and past performance information n set performance targets and impose restrictions on the managers n template for financial planning NES

The Balance Sheet Assets ≡ Liabilities + Shareholder’s Equity n n Tabulates a company’s assets and liabilities at a specific point in time Sorting – Assets by liquidity – Liabilities by maturity n Assets and liabilities are represented by historical costs – The original cost adjusted for improvements and aging = Book Value – Avoid using market value, since is too volatile and easily manipulated NES MM 2006/7 30

U. S. COMPOSITE CORPORATION Balance Sheet 20 X 2 and 20 X 1 (in $ millions) Assets Current assets: Cash and equivalents Accounts receivable Inventories Other Total current assets 20 X 2 $140 294 269 58 $761 20 X 1 $107 270 280 50 $707 Fixed assets: Property, plant, and equipment $1, 423 $1, 274 Less accumulated depreciation -550 -460 Net property, plant, and equipment 873 814 Intangible assets and other 245 221 Total fixed assets $1, 118 $1, 035 Total assets $1, 879 $1, 742 Liabilities (Debt) and Stockholder's Equity Current Liabilities: Accounts payable Notes payable Accrued expenses Total current liabilities Long-term liabilities: Deferred taxes Long-term debt Total long-term liabilities 20 X 2 20 X 1 $213 50 223 $486 $197 53 205 $455 $117 471 $588 $104 458 $562 Stockholder's equity: Preferred stock $39 Common stock ($1 per value) 55 32 Capital surplus 347 327 Accumulated retained earnings 390 347 Less treasury stock -26 -20 Total equity $805 $725 Total liabilities and stockholder's equity $1, 879 $1, 742 NES MM 2006/7 31

The Income Statement Revenue – Expenses ≡ Income n n Summarizes the company’s profitability during a time period Categorization of expenses: – Operating: provide benefits only for the current period • Also included: depreciation (based on historical cost) and R&D – Financing: arising from non-equity financing (interest expenses) – Capital: generate benefits over multiple periods (depreciated) MM 2006/7 NES 32

U. S. COMPOSITE CORPORATION Income Statement 20 X 2 (in $ millions) the firm’s revenues and expenses from principal operations all financing costs, such as interest expense the amount of taxes levied on income. Total operating revenues Cost of goods sold Selling, general, and administrative expenses Depreciation Operating income Other income Earnings before interest and taxes Interest expense Pretax income Taxes Current: $71 Deferred: $13 Net income Retained earnings: Dividends: $2, 262 - 1, 655 - 327 - 90 $190 29 $219 - 49 $170 - 84 $86 $43 NES MM 2006/7 33

The Statement of Cash Flows CF(firm) ≡ CF(debt) + CF(equity) n Reports how much cash is generated during a period – Indicates where the cash comes from and what the firm did with that cash n Cash flow statements are independent of accounting methods – Accounting rules have a second-order effect on cash flows through taxes NES MM 2006/7 34

U. S. COMPOSITE CORPORATION Financial Cash Flow 20 X 2 (in $ millions) Cash Flow of the Firm Operating cash flow (Earnings before interest and taxes plus depreciation minus taxes) Capital spending (Acquisitions of fixed assets minus sales of fixed assets) Additions to net working capital Total Cash Flow of Investors in the Firm Debt (Interest plus retirement of debt minus long-term debt financing) Equity (Dividends plus repurchase of equity minus new equity financing) Total $238 -173 Cash received from the firm’s assets must equal cash flows to the firm’s creditors & stockholders: -23 $42 $36 6 $42 MM 2006/7 NES 35

Financial Ratio Analysis Trend / Cross-Sectional Analysis n Profitability Ratios n Activity Ratios n Liquidity Ratios n Financial Leverage Ratios n Market Value Ratios NES MM 2006/7 36

Profitability Ratios n Net Return on Assets (ROA) n n = Net Income / Total Assets Gross (Pretax) Return on Assets (ROA) = EBIT / Total Assets Return on Equity (ROE) = Net Income / BV(equity) Gross Profit Margin = EBIT / Sales Net Profit Margin = Net Income / Sales NES

Activity Ratios Measuring the efficiency of working capital management: n Total Asset Turnover = Sales / Total Assets NES

Liquidity Ratios Measuring short-term liquidity: Current Ratio = Current Assets Current Liability NES

Financial Leverage Ratios Measuring the firm’s capacity to service its debt and long-term liquidity: n n Debt-to-Capital Ratio = Debt / (Debt + Equity) Debt-to-Equity Ratio = Debt / Equity – Can be based on BV or MV – Similarly: long-term debt ratios NES

Market Value Ratios n Price-to-Earnings Ratio = PS/EPS – Stock market price to earnings per share n Dividend Yield = Div/PS – Latest dividend to current stock price n Market-to-Book Value = MV/BV – Similarly: Market-to-Book Equity = ME/BE n Tobin's Q = MV / Replacement Value NES

Asset pricing P = Σt CFt/(1+R)t n Bond with coupon C and face value F (at T) n Stocks n Project n Company NES MM 2006/7 42