Finance Theory

15.401

15.401 Finance Theory

15.401 Finance Theory

Andrew W. Lo

Andrew W. Lo

Harris & Harris Group Professor, MIT Sloan School

Harris & Harris Group Professor, MIT Sloan School

Lecture 1: Introduction and Course Overview

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Critical Concepts

Critical Concepts

ƒ Motivation

ƒ Dramatis Personae

ƒ Fundamental Challenges of Finance ƒ Framework for Financial Analysis ƒ Importance of Time and Risk

ƒ Six Principles of Finance ƒ Course Overview

ƒ How to Get the Most Out of This Course

Readings:

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Motivation

Motivation

Mathematics + $$$ = Finance

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Dramatis Personae

Dramatis Personae

Intermediaries Capital Markets Product

Markets Labor

Markets

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Fundamental Challenges of Finance

Fundamental Challenges of Finance

All Business Activities Reduce To Two Functions:

ƒ Valuation of assets (real/financial, tangible/intangible) ƒ Management of assets (acquiring/selling)

Business Decisions Involve Valuation and Management

ƒ “You cannot manage what you cannot measure” ƒ Valuation is the starting point for management ƒ Once value is established, management is easier

Objectives + Valuations ⇒ Decisions

ƒ Valuation is generally independent of objectives (why?) ƒ Role of financial markets and the “price discovery” process

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Fundamental Challenges of Finance

Fundamental Challenges of Finance

ƒ How are financial assets valued?

ƒ How should financial assets be valued?

ƒ How do financial markets determine asset values? ƒ How well do financial markets work?

Management

ƒ How much should I save/spend? ƒ What should I buy/sell?

ƒ When should I buy/sell?

ƒ How should I finance the transaction?

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The Framework of Financial Analysis

The Framework of Financial Analysis

ƒ The language of finance

ƒ Vocabulary, syntax, grammar, prose, and poetry! ƒ Language frames and circumscribes the analysis ƒ Basic concepts should be familiar to you by now ƒ “Stock” (not equities) vs. “flow” variables

Balance Sheet and Income Statement Perspectives

ƒ Balance sheet: snapshot of financial status quo (stock) ƒ Income statement: rate of change of the status quo (flow)

ƒ Financial status _{⇔ balance sheet}

ƒ Financial decisions _{⇔ income statement}

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The Framework of Financial Analysis

The Framework of Financial Analysis

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The Framework of Financial Analysis

The Framework of Financial Analysis

1. Cash raised from investors (selling financial assets) 2. Cash invested in real assets (tangible and intangible) 3. Cash generated by operations

4. Cash reinvested

5. Cash returned to investors (debt payments, dividends, etc.)

Corporate Operations Financial Manager Individual and Institutional Investors 2 1 4 5 3

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The Framework of Financial Analysis

The Framework of Financial Analysis

1. Cash raised from investors (selling financial assets) 2. Cash invested in real assets (tangible and intangible) 3. Cash generated by operations

4. Cash reinvested

5. Cash returned to investors (debt payments, dividends, etc.)

Management

ƒ Real Investment: 2, 3 ƒ Financing: 1, 4

ƒ Payout: 5

ƒ Risk management: 1, 5

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The Framework of Financial Analysis

The Framework of Financial Analysis

1. Cash raised from financial institutions (selling financial assets) 2. Cash invested in real assets (tangible and intangible)

3. Cash generated by labor supply

4. Cash consumed and reinvested in real assets 5. Cash invested in financial assets

Real Economic Activities Household Financial Assets and Liabilities (stocks, bonds, mortgage, etc.) 2 1 4 5 3

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The Framework of Financial Analysis

The Framework of Financial Analysis

1. Cash raised from financial institutions (selling financial assets) 2. Cash invested in real assets (tangible and intangible)

3. Cash generated by labor supply

4. Cash consumed and reinvested in real assets 5. Cash invested in financial assets

Management

ƒ Real investment: 2, 3

ƒ Consumption/financing: 1, 4 ƒ Saving/investment: 5

ƒ Risk management: 1, 5

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Time and Risk

Time and Risk

Two Other Factors That Make Finance Challenging

1. Time

ƒ Cashflows now are different from cashflows later ƒ Time flows in only one direction (as far as we know) ƒ How should we model temporal differences?

2. Risk

ƒ Under perfect certainty, finance theory is complete ƒ Risk creates significant challenges

ƒ How should we model the unknown?

To Address These Two Issues:

ƒ Use historical data

ƒ Use mathematics (probability and statistics)

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Six Fundamental Principles of Finance

Six Fundamental Principles of Finance

ƒ Prefer more money to less (non-satiation) ƒ Prefer money now to later (impatience) ƒ Prefer to avoid risk (risk aversion)

P3: All Agents Act To Further Their Own Self-Interest

P4: Financial Market Prices Shift to Equalize Supply and Demand P5: Financial Markets Are Highly Adaptive and Competitive

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Course Overview

Course Overview

A. Introduction

ƒ Fundamental challenges of finance ƒ A framework for financial analysis ƒ Six principles of finance

ƒ Cashflows and the time-value of money B. Valuation

ƒ Discounting and the mathematics of net present value ƒ Pricing stocks, bonds, futures, forwards, and options C. Risk

ƒ Measuring risk

ƒ Managing risk (portfolio theory)

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Course Overview

Course Overview

D. Corporate Finance

ƒ Capital budgeting and project finance

Final Lecture: Market Efficiency (putting it all together)

ƒ Do financial markets always work well in discovering prices? ƒ What about behavioral biases and human psychology?

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Course Overview

Course Overview

ƒ Lectures and Readings (attendance and participation, 10%) ƒ Acid Rain Case Study (10%)

ƒ Mid-Term (25%) and Final (55%) Examinations

Implicit Contract

ƒ Faculty should

– Come to class on time and be well prepared

– Provide clear and time-appropriate exposition of material

– Manage class discussions effectively

ƒ Students should

– Come to class on time and be well prepared

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How to Get the Most Out of This Course

How to Get the Most Out of This Course

ƒ Most of this course will be devoted to theory ƒ What about practice?

ƒ The origins of theory is common elements deduced from practice!

Some Helpful Hints

ƒ Do readings ahead of time (skim textbook chapters in advance)

ƒ Take copious notes during lectures (lecture notes are not complete) ƒ Review the lectures afterwards with your study group

ƒ Work on assignments in groups and alone ƒ “Finance is not a spectator sport”

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Critical Concepts

Critical Concepts

ƒ Motivation

ƒ Dramatis Personae

ƒ Fundamental Challenges of Finance ƒ Framework for Financial Analysis ƒ Importance of Time and Risk

ƒ Six Principles of Finance ƒ Course Overview

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Additional References

Additional References

ƒ Bernstein, P., 1993, Capital Ideas. New York: Free Press.

ƒ Lo, A., 1999, “The Three P’s of Total Risk Management”, Financial Analysts Journal 55, 13–26. ƒ Malkiel, B., 1996, A Random Walk Down Wall Street. New York: W. W. Norton and Company.

MIT OpenCourseWare http://ocw.mit.edu

15.401 Finance Theory I

Fall 2008