Market Finance Financial Theory Course at ESC Dijon

„ Market Finance – Financial Theory“ Course at ESC Dijon Chapter 1: Investments: Background and Issues Chapter 2: Asset Classes and Financial Instruments Chapter 3: Securities Markets Chapter 4: The Market for Foreign Exchange Chapter 5: The Efficient Market Hypothesis Bibliography: Bodie, Z. / Kane, A. / Marcus, A. J. (2013): Essentials of Investments. 9 th ed. , New York. Prof. Dr. Franke-Viebach 1

Chapter 1: Investments: Background and Issues 1. 1 Real Assets versus Financial Assets 1. 2 Financial Assets 1. 3 Financial Markets and the Economy 1. 4 The Investment Process 1. 5 Markets Are Competitive 1. 6 The Players Bibliography: Bodie, Z. / Kane, A. / Marcus, A. J. (2013): Essentials of Investments. 9 th ed. , New York, chapter 1. Prof. Dr. Franke-Viebach 2

Investment = current commitment of resources in the expectation of reaping future benefits 1. 1 Real Assets versus Financial Assets (1) Real Assets = assets used to produce goods and services → they generate income and thus wealth (remember: wealth = PV of income) examples: property, plants and equipment, human capital, etc. (2) Financial assets = claims on real assets or claims on real-asset income → they distribute income or wealth examples: Toyota share, French government bond Prof. Dr. Franke-Viebach 3

Exercise: Are the following assets real or financial? a. Patents b. Lease obligations c. Customer goodwill d. College education e. U. S. treasury bill Exercise: For each transaction, identify the real and/or financial assets that trade hands. Are any financial assets created or destroyed in the transaction? a. Toyota takes out a bank loan to finance the construction of a new factory. b. Toyota pays off its loan. c. Toyota uses $ 10 million of cash on hand to purchase additional inventory of spare auto parts. Prof. Dr. Franke-Viebach 4

Exercise: Lanni Products is a start-up computer software development firm. It currently owns computer equipment worth $30, 000 and has cash on hand of $ 20, 000 contributed by Lanni‘s owners. For each of the following transactions, identify the real and/or financial assets that trade hands. Are any financial assets created or destroyed in the transactions? a. Lanni takes out a bank loan. It receives $ 50, 000 in cash and signs a note promising to pay back the loan over three years. b. Lanni uses the cash from the bank plus $ 20, 000 of its own funds to finance the development of new financial planning software. c. Lanni sells the software product to Microsoft, which will market it to the public under the Microsoft name. Lanni accepts payment in the form of 5, 000 shares of Microsoft stock. d. Lanni sells the shares of stock for $ 25 per share and uses part of the proceeds to pay off the bank loan. Prof. Dr. Franke-Viebach 5

(3) Saving – investment, financial and real - saving = that part of disposable income which is not used for present consumption but laid back („saved“) for future consumption - shift consumption to the future by a shift of purchasing power - do so by a financial investment: buy a financial asset! example: buy a Toyota share - Toyota will then use the saver‘s purchasing power to make an investment in real assets Remember: investment = current commitment of resources in the expectation of reaping future benefits → hope to get back purchasing power in the future …! Prof. Dr. Franke-Viebach 6

(4) Individual/sectoral wealth versus aggregate/ national wealth (a) Household sector - assets: real assets, financial assets - liabilities (b) National wealth (neglecting international relations) - consists of real assets only - reason: all financial assets (owner of the claim) are offset by a financial liability (issuer of the claim) → when all balance sheets are aggregated, only real assets remain (c ) Example: USA 2011 Prof. Dr. Franke-Viebach 7

Table 1. 1 Balance Sheet, $ Billion U. S. %Households, 2011 Total Liabilities and Net Worth Assets $ Billion % Total Real assets Real estate Consumer durables 18, 117 4, 665 25. 2% 6. 5% Mortgages Consumer credit 10, 215 2, 404 14. 2% 3. 3% Other Total real assets 303 23, 085 0. 4% 32. 1% Bank and other loans Security credit Other Total liabilities 384 316 556 13, 875 0. 5% 0. 4% 0. 8% 19. 3% Financial assets Deposits Life insurance reserves Pension reserves Corporate equity Equity in noncorp. business Mutual fund shares Debt securities Other Total financial assets TOTAL 8, 038 1, 298 13, 419 8, 792 6, 585 5, 050 4, 129 1, 536 48, 847 71, 932 11. 2% 1. 8% 18. 7% 12. 2% 9. 2% 7. 0% 5. 7% 2. 1% 67. 9% 100. 0% Net worth Note: Column sums may differ from total because of rounding error. SOURCE: Flow of Funds Accounts of the United States, Board of Governors of the Federal Reserve System, June 2011. 58, 058 71, 932 80. 7% 100. 0%

Table 1. 2 Domestic Net Worth, 2011 Assets $ Billion Commercial real estate 14, 248 Residential real estate 18, 117 Equipment and software 4, 413 Inventories 1, 974 Consumer durables 4, 665 TOTAL 43, 417 Note: Column sums may differ from total because of rounding error. SOURCE: Flow of Funds Accounts of the United States, Board of Governors of the Federal Reserve System, June 2011.

Exercise: In a wave of pessimism, housing prices fall by 10% across the entire economy. a. Has the stock of real assets of the economy changed? b. Are individuals less wealthy? c. Can you reconcile your answers to a. and b. ? Prof. Dr. Franke-Viebach 10

1. 2 Financial Assets (1) Debt securities (a) General feature: pay a stream of income that is determined according to a specified formula (b) Classification by maturity - money-market debt securities: short-term examples: - capital-market debt securities: long-term examples: - in any case: a limited lifetime → the holder is entitled to get his money (the „face value“ of the debt security) back at maturity: this is part of his claim because the holder is a creditor! Prof. Dr. Franke-Viebach 11