Lecturer: Shaling Li Acc&Fin Dept, PBS University of Portsmouth 15 October, 2009

What is Finance? Finance Investment Corporate Finance Financial Market and Financial Institutions Real Investment Financial Investment Financing decision Investment & Dividend decisions Global financial systems: banks, equity/debt markets Resources of money Usage of money 2S Li, Acc&Fin, PBS, UoP

Why study Finance? Finance is important to economy Economy allocates money to its highest valued use (e.g. stock market) Good business get more money (e.g. bank lending & interests) Finance is important to individual Manage your money: borrow/debt Different needs for money in different life stages: young, middle age, retired 3S Li, Acc&Fin, PBS, UoP

How to study finance? Finance as a subject in Science Science: Science refers to a system of acquiring knowledge. This system uses observation and experimentation to describe and explain natural phenomena. The purpose of science is to produce useful models of reality. Scientific methods 4S Li, Acc&Fin, PBS, UoP

Theory and Practice Theoretical world: Assumptions General rules Results Real world: Full of myteries Expected Unexpected results 5S Li, Acc&Fin, PBS, UoP

The theoretical world in Finance The assumptions of the theoretical world of Finance 1. Rational self-interest 2. Frictionless financial markets No transactions costs. No public information costs 3. Financial markets are liquid 4. Minimal role for government Theoretical world: Assumptions: IF General rules/models: THEN Results: SO 6S Li, Acc&Fin, PBS, UoP

How realistic are the assumptions of the finance textbook world? UK London stock market The FTSE 100 companies are the 100 biggest UK companies by market capitalisation Checking the assumptions in the UK markets Assumption1: Rational self-interest Self-interest: only focus on and seek self benefits (egotism – altruism) Rational: logic manner Professional investors: pension fund, insurance company, investment companies Check: yes or no? 7S Li, Acc&Fin, PBS, UoP

How realistic are the assumptions of the finance textbook world? Checking the assumptions in the UK markets Assumption 2: Frictionless financial markets No transaction cost: commission fee exists, 0.35% of selling/buying No public information cost: internet, newspaper, TV Check: yes Assumption 3: Financial markets are liquid The total market capitalisation of all FTSE 100 stocks is well over £1,000 billion The total daily trading volume runs into the millions of shares traded Check: Yes 8S Li, Acc&Fin, PBS, UoP

How realistic are the assumptions of the finance textbook world? Checking the assumptions in the UK markets Assumption 4: Minimal role for government Government: a ‘night watchman’. systems of internal controls: professional ethics, the strict legal and regulatory framework Check: yes 9S Li, Acc&Fin, PBS, UoP

Theory and Practice Theoretical world: Rationality Frictionless market Liquidity Government role + Models, results Real world: UK London exchange What is that?? 10S Li, Acc&Fin, PBS, UoP

Arguments on the assumptions The rationality assumption is the most important assumption of our textbook world model Three arguments challenging this assumption Argument 1: the ‘blockheads’ argument: Question: Blockheads are many and not rational Explanation: On average the blockheads cancel each other out 11S Li, Acc&Fin, PBS, UoP

Arguments on the assumptions Argument 2: the rational arbitrageurs argument: Question: when blockheads are not even numbered at short time, mispricing exists Explanation: rational arbitrageurs will enter the market, forcing stocks back to their fair value. Argument 3: winner and loser argument Question: Are there more blockheads than smart guys Explanation: blockheads will tend to lose money over time, and that smart investors will tend to make money 12S Li, Acc&Fin, PBS, UoP

Arguments on the assumptions Conclusions: The existing of blockheads does not influence the market and the assumption of rationality. 13S Li, Acc&Fin, PBS, UoP

How closely does the real world resemble the world of theory? Theoretical world: Rationality Frictionless market Liquidity Government role + Models, results Real world: UK London exchange 14S Li, Acc&Fin, PBS, UoP

How closely does the real world resemble the world of theory? Whatever is thought and found in the theory world has two types of results if matched/applied to the practical world: Yes, largely The model (rules) can be applied to the practice with expected results most of time However, this does not mean everyone gains in the market There are always exceptions in the real world No, basically If it does not work, why? Proper assumptions, models? However, this also does not mean there is no random gain. 15S Li, Acc&Fin, PBS, UoP

How closely does the real world resemble the world of theory? Example: US market & Successful investors A mutual fund, the Vanguard S&P500 Tracker In the early 1970s in America John Bogle decided to apply the textbook world finance theory that was developed by finance scholars during the 1960s looking at the thirty-year record, the investment returns on the Vanguard S&P500 Tracker fund have beaten those of every other stock market mutual fund in the United States. Mr. Buffett’s personal wealth is around $40 billion and the funds he manages are far larger 16S Li, Acc&Fin, PBS, UoP

How closely does the real world resemble the world of theory? Russian market in 1990s Investment model & investment results US/UK model  likely to lose or does not work Checking the assumptions Information was expensive Reliable information hardly existed Trading had to stopped during some period (liquidity) Have a well-developed legal and regulatory framework on paper, the lack of an enforced legal and regulatory framework 17S Li, Acc&Fin, PBS, UoP

The approach to studying finance 1. We always start off with a problem, or a question. 2. Next we give the theoretically correct solution to the problem 3. The next step is empirical research 18S Li, Acc&Fin, PBS, UoP

Summary Finance and its key elements The theoretical world in Finance + four assumptions The realistic degree of the assumptions of the finance textbook world How closely does the real world resemble the world of theory (yes or no examples) Approach to study finance 19S Li, Acc&Fin, PBS, UoP

Seminar for next week Please see the attached. S Li, Acc&Fin, PBS, UoP20