Chapter 1

The Financial Environment

© 2011 John Wiley and Sons

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Chapter Outcomes

Define finance and explain why it should be studied

Describe the six principles of finance Identify characteristics of an

effective financial system Describe financial functions

performed in an effective financial system

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Chapter Outcomes(Continued)

Describe the four types of financial markets

Describe characteristics of the mortgage markets

Discuss the developments that led to the recent financial crisis

Identify several major career opportunities in finance

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What is Finance?

FINANCE:

Study of how individuals, institutions, governments, and businesses acquire, spend, and manage money and other financial assets

FINANCIAL ENVIRONMENT: Encompasses the financial system, institutions, markets, and individuals that make the economy operate efficiently

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Three Areas of Finance within the Financial System

Institutions and Markets Investments Financial Management

[Note: These areas do not operate in isolation but rather interact or intersect with each other. Figure1.1 provides a graphic illustration. ]

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Finance Area Definitions

FINANCIAL INSTITUTIONS: Help the financial system operate efficiently and transfer funds from savers to investors

FINANCIAL MARKETS: Physical locations or electronic forums that facilitate the flow of funds

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Finance Area Definitions (Continued)

INVESTMENTS: Area involves sale or marketing of securities, analysis of securities, and management of investment risk

FINANCIAL MANAGEMENT: Involves financial planning, asset management, and fund raising decisions to enhance firm value

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Two Themes within the Finance Topic

ENTREPRENEURIAL FINANCE: Study of how growth-driven, performance-focused, early-stage firms raise funds and manage operations and assets

PERSONAL FINANCE: Study of how individuals prepare for financial emergencies, protect against premature death and the loss of property, and accumulate wealth

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Why Study Finance?

1. To make informed economic decisions2. To make informed personal and business investment decisions 3. To make informed career decisions based on a basic understanding of business finance

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Six Principles of Finance

Money has a time value Higher returns are expected for

taking on more risk Diversification of investments can

reduce risk

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Six Principles of Finance (Cont’d)

Financial markets are efficient in pricing securities

Manager and stockholder objectives may differ

Reputation matters

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1. Time Value of Money

Money in hand today is worth more than the promise of receiving the same amount of money in the future

Time value of money exists because a sum of money today could be invested and “grow” over time

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2. Risk-Return Tradeoff

Risk is the uncertainty about the outcome or payoff of an investment in the future

Rational investors would choose a riskier investment only if they feel the expected return is high enough to justify the greater risk

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3. Diversification of Investments

All investment risk is not the same Some risk can be removed or

diversified by investing in several different assets or securities

We will explore the benefits of investment diversification in Part 2 of this text

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4. Efficient Financial Markets

A financial market is “information efficient” if at any point in time the prices of securities reflect all information available to the public

When new information becomes available, prices quickly change to reflect that information

Information efficient markets provide liquidity and fair prices

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5. Management Vs. Owner Objectives

Management objectives may differ from owner objectives (called principal-agent problem)

Owners or equity investors want to maximize the returns on their investments

Managers may seek to emphasize the size of firm sales, assets, or other perks

Solution: tie manager compensation to performance measures beneficial to owners

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6. Reputation Matters!

Ethical Behavior: How an individual or organization

treats others legally, fairly, and honestly

High reputation value reflects high quality ethical behavior, so employing high ethical standards is the “right” thing to do

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Overview of the Financial System

Policy Makers President, Congress & U.S. Treasury Federal Reserve Board

Role: Pass laws & set fiscal & monetary policies

Monetary System Federal Reserve Central Bank Commercial Banking System

Role: Create & transfer money

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Overview of the Financial System

Financial Institutions Depository Institutions, Contractual Savings organizations, Securities Firms, and Finance Firms

Role: Accumulate & lend/invest savings Financial Markets

Securities Markets, Mortgage Markets, Derivatives Markets, and Currency Exchange Markets

Role: Market & facilitate transfer of financial assets

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Depository Institutions

Accept deposits or savings from individuals and then lend these pooled savings to business, governments, and individuals

Ex. Commercial banks Thrift institutions Saving banks and credit unions

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Contractual Savings Organizations

Collect premiums and contributions from participants and provide retirement benefits and insurance against major financial losses

Insurance company Pension funds.

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Securities firms

Accept and invest individual savings and also facilitate the sale and transfer of securities between investors

Mutual fund: open-ended, they can issue unlimited number of shares and use the pooled proceeds to purchase corporate and gov. securities

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Cont.

Investment banking firms: sell or market new securities issued by businesses to individual and institutional investors.

Brokerage firms: assist individuals who want to purchase new securities issues or who want to sell previously purchased securities

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Finance Firms

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

Financial Markets Characteristics

Money Markets:

where debt securities with maturities of one year or less are issued/traded

Capital Markets:

where debt securities with maturities longer than one year and corporate equity securities are issued/traded

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Financial Markets Characteristic

Primary Markets:

where the initial offering/origination of debt and equity securities takes place

Secondary Markets:

where the transfer of existing bonds, mortgages, and equity securities between investors occurs

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Major Types of Financial Markets

Debt Securities Markets:

where money market securities, bonds, & mortgages are sold and traded

Equity Securities Markets:

where ownership rights in the form of stocks are initially sold and traded

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Major Types of Financial Markets

Derivative Securities Markets:

where financial contracts that derive their values from underlying securities are originated and traded

Foreign Exchange Markets:

electronic markets in which banks & traders buy and sell currencies on behalf of businesses and clients

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Mortgage Markets

Mortgage:

loan backed by real property in the form of buildings and houses

Mortgage Markets:

where mortgage loans to purchase buildings and houses are originated and traded

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Mortgage Markets

Fixed-Rate Mortgage:

fixed interest rate with a constant periodic payment over the real estate loan’s life

Adjustable-Rate Mortgage (ARM):

interest rate and periodic payments that vary with market interest rates over the real estate loan’s life

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Mortgage Markets

Securitization:

process of pooling or packaging mortgage loans into debt securities

Mortgage-Backed Security:

debt security created by pooling together a group of mortgage loans

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Mortgage Markets

Credit Rating:

indicates the expected likelihood that a borrower will pay a debt according to the terms agreed to

Credit Score:

number that indicates likelihood that a borrower will make loan payments when due

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