Chapter 1 The Financial Environment © 2011 John Wiley and Sons

2 Chapter Outcomes n Define finance and explain why it should be studied n Describe the six principles of finance n Identify characteristics of an effective financial system n Describe financial functions performed in an effective financial system

3 Chapter Outcomes (Continued) n Describe the four types of financial markets n Describe characteristics of the mortgage markets n Discuss the developments that led to the recent financial crisis n Identify several major career opportunities in finance

4 What is Finance? n FINANCE: Study of how individuals, institutions, governments, and businesses acquire, spend, and manage money and other financial assets n FINANCIAL ENVIRONMENT: Encompasses the financial system, institutions, markets, and individuals that make the economy operate efficiently

5 Three Areas of Finance within the Financial System nInInstitutions and Markets nInInvestments nFnFinancial Management [Note: These areas do not operate in isolation but rather interact or intersect with each other. Figure1.1 provides a graphic illustration. ]

6 Finance Area Definitions nFnFINANCIAL INSTITUTIONS: Help the financial system operate efficiently and transfer funds from savers to investors nFnFINANCIAL MARKETS: Physical locations or electronic forums that facilitate the flow of funds

7 Finance Area Definitions (Continued) nInINVESTMENTS: Area involves sale or marketing of securities, analysis of securities, and management of investment risk nFnFINANCIAL MANAGEMENT: Involves financial planning, asset management, and fund raising decisions to enhance firm value

8 Two Themes within the Finance Topic nEnENTREPRENEURIAL FINANCE: Study of how growth-driven, performance- focused, early-stage firms raise funds and manage operations and assets nPnPERSONAL FINANCE: Study of how individuals prepare for financial emergencies, protect against premature death and the loss of property, and accumulate wealth

9 Why Study Finance? 1. To make informed economic decisions 2. To make informed personal and business investment decisions 3. To make informed career decisions based on a basic understanding of business finance

10 Six Principles of Finance n Money has a time value n Higher returns are expected for taking on more risk n Diversification of investments can reduce risk

11 Six Principles of Finance (Cont’d) n Financial markets are efficient in pricing securities n Manager and stockholder objectives may differ n Reputation matters

12 1. Time Value of Money n Money in hand today is worth more than the promise of receiving the same amount of money in the future n Time value of money exists because a sum of money today could be invested and “grow” over time

13 2. Risk-Return Tradeoff n Risk is the uncertainty about the outcome or payoff of an investment in the future n Rational investors would choose a riskier investment only if they feel the expected return is high enough to justify the greater risk

14 3. Diversification of Investments n All investment risk is not the same n Some risk can be removed or diversified by investing in several different assets or securities n We will explore the benefits of investment diversification in Part 2 of this text

15 4. Efficient Financial Markets n A financial market is “information efficient” if at any point in time the prices of securities reflect all information available to the public n When new information becomes available, prices quickly change to reflect that information n Information efficient markets provide liquidity and fair prices

16 5. Management Vs. Owner Objectives n Management objectives may differ from owner objectives (called principal-agent problem) n Owners or equity investors want to maximize the returns on their investments n Managers may seek to emphasize the size of firm sales, assets, or other perks n Solution: tie manager compensation to performance measures beneficial to owners

17 6. Reputation Matters! n Ethical Behavior: How an individual or organization treats others legally, fairly, and honestly n High reputation value reflects high quality ethical behavior, so employing high ethical standards is the “right” thing to do

18 Overview of the Financial System nPnPolicy Makers President, Congress & U.S. Treasury Federal Reserve Board Role: Pass laws & set fiscal & monetary policies nMnMonetary System Federal Reserve Central Bank Commercial Banking System Role: Create & transfer money

19 Overview of the Financial System nFnFinancial Institutions Depository Institutions, Contractual Savings organizations, Securities Firms, and Finance Firms Role: Accumulate & lend/invest savings nFnFinancial Markets Securities Markets, Mortgage Markets, Derivatives Markets, and Currency Exchange Markets Role: Market & facilitate transfer of financial assets

Depository Institutions n Accept deposits or savings from individuals and then lend these pooled savings to business, governments, and individuals n Ex. Commercial banks n Thrift institutions n Saving banks and credit unions 20

Contractual Savings Organizations n Collect premiums and contributions from participants and provide retirement benefits and insurance against major financial losses n Insurance company n Pension funds. 21

Securities firms n Accept and invest individual savings and also facilitate the sale and transfer of securities between investors n Mutual fund: open-ended, they can issue unlimited number of shares and use the pooled proceeds to purchase corporate and gov. securities 22

Cont. n Investment banking firms: sell or market new securities issued by businesses to individual and institutional investors. n Brokerage firms: assist individuals who want to purchase new securities issues or who want to sell previously purchased securities 23

Finance Firms n Provide loans directly to consumers and business as well as help borrowers obtain mortgage loans on real property. 24

Financial Markets Characteristics n Money Markets: where debt securities with maturities of one year or less are issued/traded n Capital Markets: where debt securities with maturities longer than one year and corporate equity securities are issued/traded 25

Financial Markets Characteristic n Primary Markets: where the initial offering/origination of debt and equity securities takes place n Secondary Markets: where the transfer of existing bonds, mortgages, and equity securities between investors occurs 26

Major Types of Financial Markets n Debt Securities Markets: where money market securities, bonds, & mortgages are sold and traded n Equity Securities Markets: where ownership rights in the form of stocks are initially sold and traded 27

Major Types of Financial Markets n Derivative Securities Markets: where financial contracts that derive their values from underlying securities are originated and traded n Foreign Exchange Markets: electronic markets in which banks & traders buy and sell currencies on behalf of businesses and clients 28

Mortgage Markets n Mortgage: loan backed by real property in the form of buildings and houses n Mortgage Markets: where mortgage loans to purchase buildings and houses are originated and traded 29

Mortgage Markets n Fixed-Rate Mortgage: fixed interest rate with a constant periodic payment over the real estate loan’s life n Adjustable-Rate Mortgage (ARM): interest rate and periodic payments that vary with market interest rates over the real estate loan’s life 30

Mortgage Markets n Securitization: process of pooling or packaging mortgage loans into debt securities n Mortgage-Backed Security: debt security created by pooling together a group of mortgage loans 31

Mortgage Markets n Credit Rating: indicates the expected likelihood that a borrower will pay a debt according to the terms agreed to n Credit Score: number that indicates likelihood that a borrower will make loan payments when due 32