1. „ 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. 9th ed., New York.
Prof. Dr. Franke-Viebach
Prof. Dr. Franke-Viebach

2. 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. 9th ed., New York, chapter 1.
Prof. Dr. Franke-Viebach
Prof. Dr. Franke-Viebach

3. Prof. Dr. Franke-Viebach
Investment = current commitment of resources in the expectation of reaping future benefits
1.1 Real Assets versus Financial Assets
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

4. Prof. Dr. Franke-Viebach
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?
Toyota takes out a bank loan to finance the construction of a new factory.
Toyota pays off its loan.
Toyota uses $ 10 million of cash on hand to purchase additional inventory of spare auto parts.
Prof. Dr. Franke-Viebach
Prof. Dr. Franke-Viebach

5. Prof. Dr. Franke-Viebach
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
Prof. Dr. Franke-Viebach

6. (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
Prof. Dr. Franke-Viebach

7. Prof. Dr. Franke-Viebach7
(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
Prof. Dr. Franke-Viebach

8. Table 1.1 Balance Sheet, U.S. Households, 2011
Assets
$ Billion
% Total
Liabilities and Net Worth
Real assets
Real estate
18,117
25.2%
Mortgages
10,215
14.2%
Consumer durables
4,665
6.5%
Consumer credit
2,404
3.3%
Other
303
0.4%
Bank and other loans
384
0.5%
Total real assets
23,085
32.1%
Security credit
316
556
0.8%
Total liabilities
13,875
19.3%
Financial assets
Deposits
8,038
11.2%
Life insurance reserves
1,298
1.8%
Pension reserves
13,419
18.7%
Corporate equity
8,792
12.2%
Equity in noncorp. business
6,585
9.2%
Mutual fund shares
5,050
7.0%
Debt securities
4,129
5.7%
1,536
2.1%
Total financial assets
48,847
67.9%
Net worth
58,058
80.7%
TOTAL
71,932
100.0%
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.

9. 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.

10. Prof. Dr. Franke-Viebach
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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
Prof. Dr. Franke-Viebach

11. Prof. Dr. Franke-Viebach
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1.2 Financial Assets
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
- 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
Prof. Dr. Franke-Viebach

12. Prof. Dr. Franke-Viebach
(2) Equity (common stock)
represents an ownership share in a company
→ the holder is an owner, not a creditor! This has several implications:
(i) he can not claim his money back from the issuer
(ii) in the case of bankruptcy of the company, creditors are served first
- equity entitles to dividend payments if (a) the company can pay and (b) wants to pay
→ riskier than debt securities
- equity confers a voting right (choice of board of directors, strategy of the company, …)
Prof. Dr. Franke-Viebach
Prof. Dr. Franke-Viebach

13. Prof. Dr. Franke-Viebach
(3) Derivatives
- payments from a derivative security (so-called payoffs) are determined by the
prices of other assets (so-called underlying assets)
- example: price and thereby the payoff of an option on Toyota stock depend on the
price of the Toyota share
(4) Foreign currency (5) Addendum: real assets - commodities - real estate
Prof. Dr. Franke-Viebach
Prof. Dr. Franke-Viebach

14. Prof. Dr. Franke-Viebach
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1.3 Financial Markets and the Economy Financial assets help us to make the most of a country‘s real assets
(1) The Informational Role of Prices
Example: stock prices reflect investors’ collective assessment of a firm’s current performance
and future prospects
good performance/prospects ↓
high share price
Prof. Dr. Franke-Viebach
Prof. Dr. Franke-Viebach

15. Prof. Dr. Franke-Viebach
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(2) Consumption timing
- remember: saving = shift of consumption to the future by a shift of purchasing power
how: by temporarily investing part of income into financial assets (or directly into real assets)
- likewise: we can dissave, i. e. „pull“ future consumption to the present
how: by selling an asset
(i) this can be an existing („old“) asset
(ii) it can also be a new one, i. e. we take a credit
- all in all, we will typically watch a life-cycle of dissaving and saving
Prof. Dr. Franke-Viebach
Prof. Dr. Franke-Viebach

16. Prof. Dr. Franke-Viebach
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(3) Allocation of risks
prices of financial assets can not be foreseen with certainty
example: share price depends on an assessment of future dividends; these may be
higher or lower
different assets have different risks
example: as bond income is contractually fixed, bonds have a lower risk than stocks
rule: higher risk is associated with higher return (see below: risk-return trade-off)
investors will chose assets (i. e. a combination of risk and return) according to their
so-called risk attitude
Prof. Dr. Franke-Viebach
Prof. Dr. Franke-Viebach

17. (4) Separation of ownership and management
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(4) Separation of ownership and management
owner-operated company: limited in size because of lack of capital
solution: create large companies by selling shares, i. e. by assembling many owners and their capital
problem: not all owners can participate in management → elect a board of directors → the directors than hire the managers → result: owners ≠ managers
benefit: stability of business despite instability of ownership
problem: can the many shareholders agree on on the company‘s objectives?
usually yes because they all have one goal in common: their wealth → they all want a high
share price
Prof. Dr. Franke-Viebach
Prof. Dr. Franke-Viebach

18. Prof. Dr. Franke-Viebach
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„principal-agent“ problem: managers may be attempted not to pursue shareholder value …!
solutions:
(i) incentive-compatible remuneration contracts
(ii) board of directos can fire bad management
(iii) outside observers monitor the management and make their successes/failures public
(v) threat of takeover by another company that fires the management
Exercise: Discuss the advantages of the following forms of management compensation in terms of
mitigating agency problems, that is, potential conflicts of interest between managers and
shareholders.
Fixed salary
Stock in the firm that must be held for five years
Salary linked to the firm‘s profits
Prof. Dr. Franke-Viebach
Prof. Dr. Franke-Viebach

19. Prof. Dr. Franke-Viebach
(5) Corporate governance and corporate ethic (a) Problems in companies - misleading/wrong financial status or income status - example: many during 2000 – 2002 “dot-com bubble” (b) Overly optimistic research reports by stock market analysts background: - many analysts belonged to investment banks - they were paid according to the business their reports generated for their investment banks
Prof. Dr. Franke-Viebach
Prof. Dr. Franke-Viebach

20. Prof. Dr. Franke-Viebach
(c) Auditors
- often, they were also business consultants → lenient in their auditing work in order
to get a consultancy mandate
- example: Arthur Anderson’s role in the Enron bankruptcy 2003
(d) Reaction of USA: Sarbanes-Oxley Act (2002) → tightens rules of corporate governance
Requires more independent directors on company boards
Requires CFO to personally verify the financial statements
Created new oversight board for the accounting/audit industry
Charged board with maintaining a culture of high ethical standards
Auditors no longer allowed to provide other services to same company
(e) Conclusion: financial markets deal with the future ↓
they require trust to function
reputation and straightforward incentive structures are essential
Prof. Dr. Franke-Viebach
Prof. Dr. Franke-Viebach

21. 1.4 The Investment Process
1.4 The Investment Process
Portfolio (French: portefeuille) = collection of assets
- created by investment, i. e. by purchase of assets
- changed by sales and puchases of assets → structure or size change
(2) Portfolio selection: “top-down” approach
(a) Step 1: asset allocation = decision on percentage shares of broad asset categories
(b) Step 2: security selection = choice of particular securities within each asset class
(3) Portfolio selection: “bottom-up” approach
- invest in the most attractive single securities!
- benefit: pulls your attention to promising investments
- danger: you may end up with a very high proportion of single sectors or even singe securities
Prof. Dr. Franke-Viebach
Prof. Dr. Franke-Viebach

22. 1.5 Markets are Competitive
Origin of competitiveness
- competition among investors for the best assets
individual investors, institutional investors
instrument of competition: purchase price
- competition among suppliers of financial assets
companies, governments, banks
instrument of competition: sales price
Prof. Dr. Franke-Viebach
Prof. Dr. Franke-Viebach

23. Prof. Dr. Franke-Viebach
(2) The risk-return trade-off
- background: returns are not known with certainty
- example: assets A and B
A has an expected return of 5 % and a risk of 3 %
B has an expected return of 9 % and a risk of 8 %
why does B have a higher return than A?
- empirical evidence USA
Stock portfolio loses money 1 of 4 years on average
Bonds: have lower average rates of return (under 6%);
have not lost more than 13% of their value in any one year
Prof. Dr. Franke-Viebach
Prof. Dr. Franke-Viebach

24. Prof. Dr. Franke-Viebach
(3) Diversification
- returns of various assets are not perfectly positively correlated:
perfect positive correlation means: if the return of A goes up (down), that of B always goes up (down), too
positive, but not perfect positive correlation means: if the return of A goes up (down), that of B usually also goes up (down), but not always and not always to the same extend
negative, but not perfect negative correlation means: if the return of A goes up (down), that of B usually also goes down (up), but not always and not always to the same extend
- if returns are not perfectly positively correlated, the investor can reduce the total risk of his
portfolio by diversification, i. e. by investing his funds in various assets
Exercise: The average rate of return on investments in large stocks has outpaced that on
investments in Treasury bills by about 7% points since Why, then, does anyone
invest in Treasury bills?
Prof. Dr. Franke-Viebach
Prof. Dr. Franke-Viebach

25. Prof. Dr. Franke-Viebach
(4) Efficient markets
(a) Hypothesis: prices/returns of financial assets quickly and correctly reflect available information
(b) Reason:
there is an incentive to collect information about the relevant aspects of an asset
analysts who collect and compute information faster and better than others, can be the first to discover that an asset is traded at a false price
→ they can make a bargain, e. g., buy an asset that is too cheap, at today’s low price
their actions will then drive the price up to the appropriate level
→ the price/return will finally reflect the new information correctly
(c) Reality: markets are
- … only nearly efficient
- … sometimes not efficient at all
(d) Implication: active portfolio management may pay
(passive PF management: holding a highly diversified portfolio without spending time/money to permanent security analysis)
Prof. Dr. Franke-Viebach
Prof. Dr. Franke-Viebach

26. Prof. Dr. Franke-Viebach
1.6 Market Participants
1.6.1 Original givers and takers of money
“Original”
financial business is not their business
financial business: giving and taking money; other financial services
(2) Original givers of money
they are “surplus units” in the period under consideration, i. e. they have a “financial surplus”: income > expenditure
they “give” this surplus of funds to the market, i. e. they are lenders in this period
→ they look for an investment
typical givers: private households
Prof. Dr. Franke-Viebach
Prof. Dr. Franke-Viebach

27. Prof. Dr. Franke-Viebach
(3) Original takers of money
they are “deficit units” in the period under consideration, i. e. they have a “financial deficit”: income > expenditure
they “take” these missing funds from the market, i. e. they are borrowers in this period
→ they look for finance
typical takers: companies, governments
(4) Direct finance: market-based system
when original lenders and original borrowers make contracts directly with each other, we call this “direct” finance
a system where such direct relations prevail, is called a “market-based” system
Prof. Dr. Franke-Viebach
Prof. Dr. Franke-Viebach

28. Prof. Dr. Franke-Viebach
Financial Intermediaries (FIs)
Background: FI provide convenience for original lenders and borrowers
(2) General feature of FIs
their primary business consists in taking (borrowing) and giving (lending, investing) money → they offer services to both original lenders and original borrowers:
to lenders, they offer an investment opportunity
to borrowers, they offer a financing opportunity
implication: compared to non-financial companies, their assets are overwhelmingly financial
→ compare the next two slides
Prof. Dr. Franke-Viebach
Prof. Dr. Franke-Viebach

29. Balance Sheet of Commercial Banks, 2011
Assets
$ Billion
% Total
Liabilities and Net Worth
Real assets
Liabilities
Equipment and premises
110.4
0.9%
Deposits
8,674.6
71.4%
Other real estate
46.6
0.4%
Debt and other borrowed funds
1,291.8
10.6%
Total real assets
157.0
1.3%
Federal funds and repurchase agreements
499.1
4.1%
Other
308.4
2.5%
Total liabilities
10,773.9
88.6%
Financial assets
Cash
1,066.3
8.8%
Investment securities
2,406.1
19.8%
Loans and leases
6,279.1
51.6%
Other financial assets
1,153.9
9.5%
Total financial assets
10,905.4
89.7%
Other assets
Intangible assets
373.9
3.1%
721.0
5.9%
Total other assets
1,094.9
9.0%
Net worth
1,383.4
11.4%
TOTAL
12,157.3
100.0%
Note: Column sums may differ from total because of rounding error.
SOURCE: Federal Deposit Insurance Corporation, July 2011.

30. Balance Sheet of Nonfinancial U.S. Business, 2011
Assets
$ Billion
% Total
Liabilities and Net Worth
Real assets
Liabilities
Equipment and software
4,109
14.6%
Bonds and mortgages
5,321
18.9%
Real estate
7,676
27.2%
Bank loans
538
1.9%
Inventories
1,876
6.7%
Other loans
1,227
4.4%
Total real assets
13,661
48.5%
Trade debt
1,863
6.6%
Other
4,559
16.2%
Financial assets
Total liabilities
13,509
47.9%
Deposits and cash
1,009
3.6%
Marketable securities
899
3.2%
Trade and consumer credit
2,388
8.5%
10,239
36.3%
Total financial assets
14,535
51.5%
TOTAL
28,196
100.0%
Net worth
14,687
52.1%
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.

31. Prof. Dr. Franke-Viebach
Exercise: Examine the balance sheets of the banks and of the non-financial firms shown in the preceding tables. a. What is the ratio of real assets to total assets for banks? b. What is that ratio for non-financial firms? c. Why should this difference be expected?
Prof. Dr. Franke-Viebach
Prof. Dr. Franke-Viebach

32. Prof. Dr. Franke-Viebach
(3) Systemic perspective
FIs’ “primary social function is to channel household savings to the business sector”
we may call this channeling of funds from surplus units to deficit units “indirect finance”
a financial system that is dominated by indirect finance is called a “bank-based system”
in practice, …
… financial systems are a mixture of direct/market-based finance and of indirect/bank-based finance
… FIs are not only at the basis of indirect finance, but they are also active in financial markets, i. e. they act as buyers and sellers of financial assets side by side with original lenders and borrowers
this is illustrated in the next slide which is taken from a publication of the European Central Bank
Prof. Dr. Franke-Viebach
Prof. Dr. Franke-Viebach

33. Prof. Dr. Franke-Viebach

34. Prof. Dr. Franke-Viebach
(4) Types of FI
commercial banks
investment companies
insurance companies
Exercise: Give an example of three financial intermediaries, and explain how they act as a
bridge between small investors and large capital markets or corporations.
Prof. Dr. Franke-Viebach
Prof. Dr. Franke-Viebach

35. Prof. Dr. Franke-Viebach
(5) Benefits from financial intermediation
(a) Pooling of resources
by collecting the funds of many small investors, FIs can lend big amounts of money to
borrowers who are in need of such big amounts
(b) Reduction of risk
- FI specialize in financial analysis → they can assess and manage risk better than
individual investors
- diversification of risk: by lending to many borrowers, they can reduce the overall risk of
their total funds → this benefits lenders as well as borrowers:
lenders
borrowers
(c) Cost reductions: by collecting and distributing large funds/dealing with many savers and borrowers, FI benefit from economies of scale
Prof. Dr. Franke-Viebach
Prof. Dr. Franke-Viebach

36. Prof. Dr. Franke-Viebach
1.6.3 Investment Bankers
General features
- they are no banks in the traditional sense
they support corporations in the sale of newly issued securities, i. e. in primary market activities
(2) Details
they advise corporations and other issuers of securities…
… on the price and on the interest rate of the security
… on the timing of the issuance
… on attractive investors for the securities etc.
- they usually “underwrite” the issue:
Prof. Dr. Franke-Viebach
Prof. Dr. Franke-Viebach

37. Prof. Dr. Franke-Viebach
they usually “underwrite” the issue:
they buy the securities from the issuer
then, they re-sell them to investors
(3) Secondary market
Exercise: Firms raise capital by issuing shares in the primary markets. Does this imply that that they can ignore trading of previously issued shares in the secondary market?
Prof. Dr. Franke-Viebach
Prof. Dr. Franke-Viebach

38. Prof. Dr. Franke-Viebach
1.6.4 Venture Capital (VC) and Private Equity
Young companies can not raise funds directly from the markets;
reasons: (i) their financial needs are too small
(ii) nobody knows them
VC funds give VC: this is also called “private equity” because they take an ownership stake in the firm → they …
… take a seat in the board of directors
… help to recruit managers
… provide business advice
VC funds also help to raise VC from other investors: business angels, pension funds
Private-equity investors usually earn money by selling their stakes in the start-up company after a couple of years
Prof. Dr. Franke-Viebach
Prof. Dr. Franke-Viebach