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Chapter 1. What is finance ?. Three Main Areas of Finance. Financial Management Financial Markets & Institutions Investments. Markets in the financial system. the supply of an item or service where there is a demand for that item or service.
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Chapter 1 What is finance ?
Three Main Areas of Finance • Financial Management • Financial Markets & Institutions • Investments
Markets in the financial system • the supply of an item or service where there is • a demand for that item or service. There are different markets in a system, such as • the services market • the products market • the financial markets.
The development of financial markets and instruments The basic needs in the financial world, are the following: • the need to invest excess money (supply) • the need to borrow money (demand) where there is a shortage of money. To match different financial needs such as the need to borrow and the need to invest, intermediaries are mostly used, for Example : • where an institution wants to invest a certain sum of money, for a certain time, giving them a certain yield • another institution wants to borrow a certain amount of money for a period at the lowest cost possible, the lender’s and the borrower’s demands might differ.
Large financial transactions involving the lending and borrowing of money (such as the example above), which are done through intermediaries or as principal by the lender, are often structured and standardised regarding: • the amount of the loan or investment • the interest paid and received thereon • the term to redemption of the loan.
A certificate representing the contract between the lender and borrower is issued for the duration of the loan. Appendix 1 is an example of a bond (capital market instrument) which is a financial instrument. • Instruments (certificates) issued by the ultimate borrower are called primary securities. • Instruments issued by intermediaries on behalf of the ultimate borrower are called indirect securities.
Primary Market The market for instruments (also called securities) issued for the first time, is called the primary market. Because of the standardisation of these instruments, different needs in the markets at different times, and different views of economic factors, these instruments are traded between institutions after they have been issued for the first time. If a lender needs his money before redemption date of the loan, the lender could trade the loan by selling the certificate to another institution. The buyer of the instrument pays the seller an amount (the present value of the future cash flows of the loan), and the buyer becomes the new lender.
Secondry Market The secondary market in some of the securities is a very active market. Activities in the secondary market have a strong determining influence on issues in the primary market as liquidity, tradability, market rates, scale of demand, etc. of specific instruments are reflected in the secondary market. The variables of the economy in these markets are expressed through the interest rate (the price mechanism) determined in the secondary market (called the market rate), and this has an influence on the rate and value at which issues can take place in the primary market.
Classification of Financial Markets Markets can be classified into different categories depending on the characteristic of the market or instrument used to create categories. Securities created by institutions in the markets normally pay an interest on the nominal amount (the amount shown on the certificate or contract). The interest- bearing securities market is split into the money market and the capital market, based on the term to maturity (the term left to redemption of the debt) of the securities. • The capital market is the market for the issue and trade of long-term securities. • The money market is that of short-term securities.
When goods such as financial instruments are traded in a market, there are certain differences between transactions done in these markets. The differences in transactions in the financial markets can be categorised in different categories, two of which are the following: • The timing difference between the closing of the transaction and the delivering of the goods or settlement of the transaction • The difference in certainty that the other party will honour the transaction.
In the spot market, the closing of the transaction and the delivery of the goods take place simultaneously or within a short-term time span prescribed by the specific market. Uncertainty about delivery from the other party is very limited, otherwise no transaction would take place. • The forward market is the market where a transaction is closed in the present, and the settlement of the transaction and the delivery of goods are in the future. The delivery date and the price are determined at the closing of the transaction. Because of the time lapse between the closing and the settlement of the transaction, the risk that one of the parties might not be able to deliver at the settlement date is higher than in the spot market.
The futures market is similar to the forward market, except that in the futures market, the risks of settlement and quality of the product are addressed. The same transaction as in the forward market would be closed, with the addition of the standardisation of the amount of goods, the quality of the goods and guarantee (by an exchange) of the payment of the price and delivery of goods or cash settlement of the difference.
Risks of Financial Transactions : • That the borrower will not be able to repay the money • That the lender is receiving a fixed rate on his investment while market rates fluctuate in such a way that the yield on his initial investment is now below current market related rates • That the value of the capital invested could decrease due to movements in the market.
Primary Goal of the Corporation • Maximize wealth—should be the primary goal of the financial manager. Unlike profit (earnings per share, EPS) maximization, wealth maximization considers the impact of current decisions on the long-term financial health of the firm. • Social Responsibility—firms should be socially responsible at the same time they earn “normal” profits; otherwise they probably will go out of business. • Wealth Maximization and Social Responsibility—actions that maximize the value of the firm also are beneficial to society; wealth maximization improves the standard of living.
Agency Problem • Agency Relationships—persons who make decisions that affect the firm are “agents” who are responsible for acting in the best interests of the owners (stockholders) of the firm. • Agency problems arise when managers satisfy their own interests rather than the interests of the owners—that is, the common stockholders. Methods that help managers act in the best interests of owners include: • Managerial compensation (incentives)—reward managers for acting in the best interests of owners • Shareholder intervention—suggest remedies to problems, sponsor proposals/ changes to the governance of the firm, threaten to change the board of directors • Takeover threat—upper management generally is “let go” when a firm is taken over by another firm
Agency Problem • There is no agency problem/relationship in a proprietorship form of business, because the firm’s owner also makes the firm’s decisions; thus, he or she will make decisions that are in his or her best interest • Business Ethics—“Standards of conduct or moral behavior”; “ethical” businesses “act” morally; generally “ethical” businesses are valued higher than similar business that are perceived to be unethical. • Corporate Governance—how the firm is run/managed when doing business; the “rules” that the corporation follows when conducting business
