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

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

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

NES MM 2006/7 4 Potential employer / job function Investment bank Investment bank –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 Commercial bank –Loans to individuals and companies –Mortgage –Private banking

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

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

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

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

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

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

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

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

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

NES MM 2006/7 14 Books DescriptionLibraryScanned Бригхем, Гапенски. Финансовый менеджментx Sharpe, Alexander, Baily. Investmentsxx Grinblatt, Titman. Financial Markets and Corporate Strategyx Megginson. Corporate Finance Theoryx Haugen. Modern Investment Theoryx Hull. Options, Futures, and Other Derivativesxx Малюгин. Рынок ценных бумаг: Количественные методы анализа Энциклопедия финансового риск-менеджмента. Под ред. Лобанова и Чугунова x Jorion Financial Risk Manager Handbookx CFA study notesx

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

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

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

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

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

Models The one investment certainty is that we are all frequently wrong

NES MM 2006/7 21 Index models Market model: R i,t = α i + β i R M,t + ε i,t, Market model: R i,t = α i + β i R M,t + ε i,t, –where E(ε i,t )=0, cov(R M, ε i )=0 Risk management: ΔR i ≈ β i ΔR M Risk management: ΔR i ≈ β i ΔR M Separation of total risk on systematic and idiosyncratic: var(R i )=β i 2 σ 2 M +σ 2 (ε) i Separation of total risk on systematic and idiosyncratic: var(R i )=β i 2 σ 2 M +σ 2 (ε) i –Systematic risk depends on factor exposures (betas): β i 2 σ 2 M –Idiosyncratic risk can be reduced by diversification Covariance matrix: cov(R i, R j ) = β i β j σ 2 M Covariance matrix: cov(R i, R j ) = β i β j σ 2 M –Assuming E(ε i ε j )=0 for i≠j

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

NES MM 2006/7 23 Мифы / Стереотипы «Количественные модели объективны» «Чем сложнее модель, тем лучше» «Количественные модели могут дать точный прогноз» «Модели дают прогноз и расчет стоимости компании раз и навсегда»

Specifics of corporation The most investor can lose is everything?

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

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

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

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

NES MM 2006/7 Basic Financial Statements 1. Balance Sheet 2. Income Statement 3. Statement of Cash Flows Objectives: current status and past performance information current status and past performance information set performance targets and impose restrictions on the managers set performance targets and impose restrictions on the managers template for financial planning template for financial planning

NES MM 2006/7 30 The Balance Sheet Assets ≡ Liabilities + Shareholder’s Equity Tabulates a company’s assets and liabilities at a specific point in time Tabulates a company’s assets and liabilities at a specific point in time Sorting Sorting –Assets by liquidity –Liabilities by maturity Assets and liabilities are represented by historical costs 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 31 (in $ millions) 20X2 and 20X1 Balance Sheet U.S. COMPOSITE CORPORATION Liabilities (Debt) Assets20X220X1and Stockholder's Equity20X220X1 Current assets:Current Liabilities: Cash and equivalents$140$107 Accounts payable$213$197 Accounts receivable Notes payable5053 Inventories Accrued expenses Other5850 Total current liabilities$486$455 Total current assets$761$707 Long-term liabilities: Fixed assets: Deferred taxes$117$104 Property, plant, and equipment$1,423$1,274 Long-term debt Less accumulated depreciation Total long-term liabilities$588$562 Net property, plant, and equipment Intangible assets and other245221Stockholder's equity: Total fixed assets$1,118$1,035 Preferred stock$39 Common stock ($1 per value)5532 Capital surplus Accumulated retained earnings Less treasury stock Total equity$805$725 Total assets$1,879$1,742Total liabilities and stockholder's equity$1,879$1,742

NES MM 2006/7 32 The Income Statement Revenue – Expenses ≡ Income Summarizes the company’s profitability during a time period Summarizes the company’s profitability during a time period Categorization of expenses: Categorization of expenses: –Operating: provide benefits only for the current period Also included: depreciation (based on historical cost) and R&D 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)

NES MM 2006/7 33 (in $ millions) 20X2 Income Statement U.S. COMPOSITE CORPORATION 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: $43 Dividends: $43 the firm’s revenues and expenses from principal operations $2, , $ $ $ $86 all financing costs, such as interest expense the amount of taxes levied on income.

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

NES MM 2006/7 35 (in $ millions) 20X2 Financial Cash Flow U.S. COMPOSITE CORPORATION Cash Flow of the Firm Operating cash flow$238 (Earnings before interest and taxes plus depreciation minus taxes) Capital spending-173 (Acquisitions of fixed assets minus sales of fixed assets) Additions to net working capital-23 Total$42 Cash Flow of Investors in the Firm Debt$36 (Interest plus retirement of debt minus long-term debt financing) Equity6 (Dividends plus repurchase of equity minus new equity financing) Total$42 Cash received from the firm’s assets must equal cash flows to the firm’s creditors & stockholders:

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

NES MM 2006/7 Profitability Ratios Net Return on Assets (ROA) = Net Income / Total Assets Net Return on Assets (ROA) = Net Income / Total Assets Gross (Pretax) Return on Assets (ROA) = EBIT / Total Assets Gross (Pretax) Return on Assets (ROA) = EBIT / Total Assets Return on Equity (ROE) = Net Income / BV(equity) Return on Equity (ROE) = Net Income / BV(equity) Gross Profit Margin = EBIT / Sales Gross Profit Margin = EBIT / Sales Net Profit Margin = Net Income / Sales Net Profit Margin = Net Income / Sales

NES MM 2006/7 Activity Ratios Measuring the efficiency of working capital management: Total Asset Turnover = Sales / Total Assets Total Asset Turnover = Sales / Total Assets

NES MM 2006/7 Liquidity Ratios Measuring short-term liquidity: Current Ratio = Current Assets Current Liability

NES MM 2006/7 Financial Leverage Ratios Measuring the firm’s capacity to service its debt and long-term liquidity: Debt-to-Capital Ratio = Debt / (Debt + Equity) Debt-to-Capital Ratio = Debt / (Debt + Equity) Debt-to-Equity Ratio = Debt / Equity Debt-to-Equity Ratio = Debt / Equity –Can be based on BV or MV –Similarly: long-term debt ratios

NES MM 2006/7 Market Value Ratios Price-to-Earnings Ratio = P S /EPS Price-to-Earnings Ratio = P S /EPS –Stock market price to earnings per share Dividend Yield = Div/P S Dividend Yield = Div/P S –Latest dividend to current stock price Market-to-Book Value = MV/BV Market-to-Book Value = MV/BV –Similarly: Market-to-Book Equity = ME/BE Tobin's Q = MV / Replacement Value Tobin's Q = MV / Replacement Value

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

Conclusions Если вам показалось, что я выразился слишком ясно, вы, должно быть, неверно меня поняли