MATH3090/7039: Financial mathematics Lecture 1
Function of the financial system
Basic concepts and principles of finance
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Recommended resources for this week
Madura, Financial Institutions & Markets, Cengage Learning.
Crisis of Credit video, available on learn.uq.edu.au.
This week we to develop basic principles & language in finance, mostly for math students who may not have previously studied finance.
Function of the financial system
Basic concepts and principles of finance
The financial system
The financial system consists of
• a number of financial institutions
• operating within various financial markets • to facilitate
◦ the flow of capital or funds
◦ financial risk management
◦ cashflow or liquidity management
• via financial instruments or securities.
The financial system
Investments and savings
Flow of capital
Financial system:
– Institutions. – Markets.
– Instruments.
Borrowings and capital raisings
Suppliers of funds: investors / savers:
– Participants who have either:
o Excess cashflows or income compared to their current or
immediate consumption
requirements or expenses. o Excess capital or funds
compared to their current investment opportunities in real assets in the economy.
Raisers of funds: borrowers / capital raisers:
– Participants who have either:
o Shortfall in cashflows or income
compared to their current or immediate consumption requirements or expenses.
o Shortfall in capital or funds compared to their current investment opportunities in real assets in the economy.
Liquidity and risk management Liquidity and risk management
Function of the financial system
Flow of funds: long-term investments and savings flows to borrowers and capital raisers engaged in production in growth parts of economy. The activities take place in capital markets by means of bank loans, bond and share market issues, etc.
Risk management: managing the financial risks that arise in the day-to-day operations of market participants.
Activities take place in insurance and derivative markets by means of life and non-life insurance, options, futures, swaps, forwards, etc.
Cash-flow management: ensuring the timely receipt and payment of cash during the day-to-day operations of market participants. Activities take place in money markets by means of overdrafts, bank accounts, T-notes, etc.
Financial instruments
Financial instruments are contracts specifying future financial or cashflow obligations or commitments between market participants in terms of size, timing, and risk. There are three types.
• Debt instruments: the funds are lent on the basis of a promise to repay the funds with interest.
• Equity instruments: the funds are invested in the company in the basis of a promise to share in the distribution of profits (dividends).
• Hybrid instruments: securities with elements of both debt and equity.
We always view a financial instrument in terms of the future cashflow obligations or structure it represents.
Financial institutions
Financial institutions may be classified as:
• Deposit-taking institutions: banks, building societies, credit unions.
• Wealth management and investment advisory firms: financial planning dealer groups, stockbroking houses, other.
• Insurance companies: life and nonlife (general) insurance.
• Investment banks and corporate finance houses.
• Fund managers, including superannuation product providers.
• Reserve banks and other government entities.
Market participants
Financial system participants include: • Retail:
◦ Households, individuals, small to medium-sized business (SMEs).
• Wholesale and institutional:
◦ Large corporates and other private-sector organisations.
◦ Government and other public-sector institutions.
◦ Financial institutions (banks, fund managers, insurance
companies, financial planning and stockbroking companies, etc).
They can be domestic and international.
Financial markets
Financial markets are mechanisms by which participants perform the above by trading/transacting in financial instruments and products. Some financial market classifications:
• Primary vs secondary markets.
• Direct vs intermediated markets.
• Over-the-counter (OTC) markets vs organised exchanges. • Retail vs wholesale/institutional markets.
• Capital vs non-capital markets.
• Debt vs equity markets.
• Debt markets: short-term vs long-term.
• Equity markets: public/exchanges vs private equity.
• Foreign exchange (FX), derivative, and insurance markets.
Primary vs secondary markets
Classified in terms of raising new funds vs secondary trading. • Primary markets:
◦ Participants issue/raise new funds for the first time.
◦ New financial securities/products are created.
◦ Securities issued via public offering or via private placement.
◦ Example: bank loan, share & bond issues, etc.
◦ This is the primary/main role of the financial system – flow
• Secondary markets:
◦ The trading of existing securities/instruments.
◦ New securities/products are not created.
◦ Example: trading on the share market, options trading, etc.
◦ This is a secondary role, but facilitates the primary market
Direct vs intermediated markets
Markets are classified in terms of “interaction” with financial system. • Direct markets:
◦ Funds flow from investors directly to capital raisers.
◦ Flow is facilitated by third parties, usually brokers or dealers. ◦ Contractual obligation is between investor & capital raiser.
◦ Example: company issuing shares or bonds.
• Intermediated markets:
◦ Participants interact with (contract with) an intermediary.
◦ Contractual obligation is between investor/borrow &
intermediary.
◦ Example: bank lending, insurance products, some
superannuation products.
Exchange-traded vs Over-the-Counter markets
Markets are classified in terms of trading mechanism. • Exchange-traded:
◦ Trading is on organised security exchanges.
◦ Trading occurs between participant & exchange via brokers.
◦ Typically don’t know the participant on other side of trade.
◦ Example: stock, options, & futures exchanges. See ASX &
• Over-the-counter (OTC) or dealer-based markets:
◦ No centralised trading facility/mechanism/market.
◦ Trading occurs directly between markets participants & is
facilitated by dealers trading via computer & telephone.
◦ Example: FX, swap, bond, forward, etc, markets. See
NASDAQ & NYSE.
Retail vs institutional markets
Markets are classified in terms of participants or users. • Retail markets:
◦ Markets for small-value (retail) transactions by individuals, families, & small to medium-sized business.
◦ Example: retail banking, financial planning, stockbroking, insurance.
• Wholesale or Institutional markets:
◦ Markets for large-value (wholesale) transactions between big
business & corporate, governments, central banks, fund
managers, etc.
◦ Example: share & bond market issues, swaps, forwards,
structured finance.
Capital vs non-capital markets
Markets are classified in terms of function. • Capital markets:
◦ Function is to facilitate the flow of funds or capital in the economy from savers/investors to borrowers/capital raisers.
◦ Example: bank lending, bond & share markets, private equity.
◦ Economically/socially the most important markets. • Non-capital markets:
◦ Trading in securities which don’t facilitate the long-term flow of capital, typically to facilitate risk & cashflow management.
◦ Example: derivative security & FX markets, money market instruments.
◦ Facilitate or enhance the functioning of capital markets.
Debt vs equity markets
Markets are classified in terms of debt or equity instruments. • Debt markets:
◦ Debt securities: lending funds on the basis of a promise to repay the funds with interest within a specified time period.
◦ I.e. debt capital is lent to business, contractual obligations to repay.
◦ Also called credit or fixed interest markets.
• Example: bank lending, govt bonds, corporate bonds & debt. • Equity or share markets:
◦ Equity securities: investing (having ownership) in a business on the basis of a promise to share in the distribution of profits, i.e. equity capital is invested in a business, is an ownership interest.
◦ Example: share & private equity markets, ownership of a small business.
Debt markets: short-term vs long-term
Debt markets classified in terms of maturity: • Short-term debt or money markets:
◦ Wholesale OTC issuing/trading of short-dated securities. ◦ Purpose: mainly cashflow/liquidity management.
◦ Typically called money-market or discount securities.
• Long-term debt or debt capital markets:
◦ Wholesale OTC issuing & trading of long-dated debt
securities, & wholesale bank lending to corporates.
◦ Purpose: flow of long-term investment & savings capital into
productive & growth parts of the economy.
Equity markets: public vs private
Equity markets classified in terms of participants. • Public equity markets:
◦ Equity markets in which the general public can participate/trade.
◦ Trading in the shares of corporations listed in an organised exchange. Example: Share market/exchange trading, see ASX.
• Private equity or venture capital markets:
◦ Investing in private corporations not listed in an organised
◦ Sources of funds include friends, family, high net worth
individuals, specialist private equity companies.
◦ Typically for start ups, expansion, turnarounds,
management buyouts.
◦ See AVCAL & Private Equity Media.
Purpose of both is flow of funds or capital into investment projects.
Foreign exchange (FX) markets
• Non-capital markets for trading in currencies.
• Main purpose is to link each country’s payment systems. • Trading is OTC (dealer based) & in both:
◦ Retail markets.
◦ Wholesale/institutional markets.
• Transactions typically arise from:
◦ International trade in goods & services (imports & exports).
◦ Trading in real & financial assets (foreign investment). ◦ Speculative trading.
◦ Central bank trading.
Derivative securities markets
A derivative security is a financial instrument whose future cashflow structure is derived from some other (underlying) financial security.
• Forwards, futures, & swaps.
Derivative security markets are regarded as non-capital markets:
• Main function is the facilitation of financial risk management.
• Also used for investment & trading/speculation. Derivative securities can be:
• Exchange-traded (see CBOE) or OTC (see NASDAQ or NYSE) • Retail (on exchanges) or wholesale (typically OTC).
Insurance markets
An insurance contract or policy specifies the regular payment of a premium by the insured in return for an insurance payout by the insurer in the case of a prespecified event. General classification:
• Life insurance: Terminal illness, death, injury, income protection.
• Non-life insurance: Home & contents, car, boat, travel, business. Hence, insurance companies:
• Pool the regular premiums that are received from policy holders.
• Invest these pooled funds in financial markets.
• Have liabilities defined by payouts specified in insurance contracts.
Main role of insurance is obviously risk management.
Function of the financial system
Basic concepts and principles of finance
Basic concepts and principles of finance
• Cashflows.
• Returns.
• Time value of money. • Liquidity.
• Risk and return. • Present value.
• Arbitrage.
• Financial models. • Market efficiency.
In financial theory and modeling we are interested in cashflows.
A financial security or instrument is a contract specifying future financial (cashflows) obligations between market participants. Always view a financial instrument in terms of its cashflow structure:
• timing • risk
of the future cashflows that the contract (security) specifies.
A financial security represents a future set of cashflow obligations, as specified in the contract defining the security.
• Risk refers to any uncertainty you may have about whether these cashflows obligations will actually be met.
• Example: share dividends, mortgage payments.
Causes of risk: credit/default risk, market risks (volatility), liquidity risk, macroeconomic risk, political risk, operational risk, model risk, etc.
Measures of risk: variance, skewness, kurtosis, coefficient of variation, systematic and specific risk, value at risk, extreme value risk etc.
• Historical or realized return: the return that you actually earned (realised) from investing in a security/asset/product.
• Expected return: the return you expect to earn or realise from investing in a security (a probabilistic average).
• Required return: the minimum expected return you require or demand from investing in a security.
It is important not to confuse these notions of returns – they each mean completely different things.
Required return
Your required return compensates you for: • The time value of money.
• Inflation.
• Liquidity.
Conceptually, we could write
required return
= real rate of return + inflation + risk premium + liquidity premium.
Time value of money
For the same amount of money, people prefer to have it now rather than later.
This is an assumption on human behavior.
People want to be compensated for forgoing current consumption by lending or investing their money.
The real return or real interest rate is the component of a return that compensates a participant for the time value of money.
Risk and return
Risk is the possibility of a not receiving a security’s cashflows.
Risk vs return: People demand a higher required rate of return for investing in securities which display higher risk.
Ex: given two securities with the same expected future cashflows, we would pay less for the security whose cashflows are of higher risk. This is also an assumption on human behavior.
The risk premium is the component of your required rate of return which factors in the risk inherent in an investment.
Not all assets and financial securities can be immediately sold at a “reasonable” or “fair price”. Example: property, art, a small business, etc.
Liquidity refers to the ability to quickly or immediately sell assets at market-competitive rates (a price which equals the asset’s fair value). In other words, markets are liquid or deep when assets can quickly be converted into cash with little or no loss in value.
For example, property markets are not considered liquid. The market for CBA shares is about as liquid as one can get.
The liquidity premium is the component of your required rate of return which factors in the liquidity of the investment.
Present value
Present value principle: the fair value of an asset or security is • the present value of its expected future cashflows
• discounted at an appropriate required rate of return.
This is also called discounted cashflow (DCF) valuation.
Hence, the (DCF) valuation or pricing process involves three steps:
• Forecasting the future cashflows of the security.
• Determining an appropriate required rate of return. • Adding the present values of these future cashflows.
The present value principle is one framework within which to value or price assets. Assets are also valued or priced by the arbitrage principle.
• Arbitrage occurs when you enter into a contract which requires zero investment, have no probability of losing money in the future, and a positive probability of making money in the future.
When markets are operating “efficiently”, arbitrage opportunities are ruled out since everyone will know about and act upon them.
Arbitrage principle
Arbitrage principle: The value of an asset is equal to the value of any other security or portfolio which replicates the asset’s future cashflow structure.
This is an application of the law of one price.
Aside: Want to know more about arbitrage in real life? Read “Flash Boys: A Wall Street Revolt” by
Financial models
Financial models are mathematical models used to: • Price or value assets.
• Model, quantify, and manage financial risk.
They make simplifying and often unrealistic assumptions about • Human behavior.
• Structure and operation of financial markets.
• Probability distribution of asset or security returns.
“All models are wrong, but some are useful”, according to of Box-Jenkins and Box-Muller fame.
Market efficiency
Notions of market efficiency:
• Informational efficiency: ability of security prices to immediately and fully reflect all available information.
• Allocative efficiency: ability to transfer funds from savers/investors to capital raisers in growth parts of the economy.
• Operational efficiency: cost-effectiveness and administrative reliability and simplicity.
• Dynamic efficiency: how innovative, dynamic and adaptive the system is to changing technologies and participant demands.
Function of the financial system
Basic concepts and principles of finance
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