Published on January 24, 2008
Finance 525 Week 1: Finance 525 Week 1 Introduction to the Course and to the Concept of Money Fin 525 Mission Statement: Fin 525 Mission Statement To give every student a practical understanding of how the world of finance works. Course Syllabus: Course Syllabus Available on paper in class Also available on the Internet at: http://www.riggedonline.com/Finance/Fin525Fall2006Syllabus.pdf The most critical points from the syllabus are reiterated on the next several slides Overview of the Course Calendar: Overview of the Course Calendar Weeks 1 – 3 (Part I): Money of all Kinds Weeks 3 (Part II) – 5: Long-Term Debt Week 6: Midterm Exam Weeks 7 – 11: Equity and Portfolio Management Week 12: Capital Budgeting Week 13: (Optional) Final Exam Grading: Grading The raw grade for the course is the average of the best three of the following four: Mid-term exam Stock prediction and hedging exercise 401(k) group project Final exam (optional) Class participation and evidence of improvement will influence grades of students with grades near the border between two grades What is Different About How I Teach This Course: What is Different About How I Teach This Course Textbooks and traditional finance classes focus on the wonderful things that academics have discovered This course focuses on financial instruments, how they are used, and how finance professionals attempt to value them Topics concerning international finance and derivative securities are integrated directly into the course and not ignored or relegated to advanced courses Readings: Readings Custom course textbook Time value of money and capital budgeting covered by Ross/Westerfield/Jaffe (RWJ) chapters Stocks and portfolios covered by Bodie/Kane/Marcus (BKM) Other basic content covered by material on class slides or on the Internet (with links from the slides and/or WebCT) Current financial events from the Wall Street Journal: 10-week subscription for $13.95 or a 15-week subscription for $19.95 (School zip code is 12222) A Note on the Custom Textbook: A Note on the Custom Textbook It is designed as a central source for financial formula and their application It is not designed to entertain you (that is my job) The financial world moves so quickly that all textbooks are out-of-date even before they are published Use of WebCT in the Course: Use of WebCT in the Course Repository for course materials Primary means of contacting the professor (via E-mail) Can also send mail to firstname.lastname@example.org Discussions and notifications (especially concerning topics that arise in class discussions and problem solutions) Slides are also available at: http://home.earthlink.net/~millerrisk/FinanceNotes.htm Assignments: Assignments Assignments appear on the last slides for each week and on WebCT Most weeks have specific readings that must be read prior to the next class meeting Most weeks also have exam-like problems to answer Assignments are not handed in or graded, but experience indicates that students who fail to do them encounter real trouble on the exams Smile: Smile I will take digital photos of all class members at both the Week 2 and Week 3 class meetings A Bit of Advice: A Bit of Advice If you are lost, others probably are lost too, so ASK THE PROFESSOR TO EXPLAIN WHAT IN THE WORLD HE IS TALKING ABOUT! A Disclaimer: A Disclaimer The slides used in this course incorporate much more information per slide than is considered acceptable for standard corporate communications This is done so that they can serve as a more comprehensive form of notes that goes well beyond what is in the “textbook” What is Finance?: What is Finance? Two major elements Time Uncertainty (particularly involving the risk of an unfavorable outcome) A typical very simple financial transaction Borrow money to purchase capital equipment to produce goods or services and use some of the revenue to repay the money at a specified later time Finance Focuses on Cash Flows: Finance Focuses on Cash Flows There are three basic ways that cash flows can be structured Straight financing: Pay cash now in return for the right to receive something, often just more cash, later Forward contract: Agree now to buy or sell an item at a fixed price at some future date(s) Option contract: Pay cash now in return for the option to buy or sell an item at a fixed price at some future date(s) Financial Instruments Involve the Creative Packaging of Cash Flows: Financial Instruments Involve the Creative Packaging of Cash Flows Stocks and bonds Pay now, have the right to (but not necessarily receive) a stream of future cash flows Futures contracts A forward contract with collateral (called margin) paid up front and maintained until delivery Mutual funds (including ETFs) An often useful bundle of stocks, bonds, or a combination of both Valuation is Done Two Ways: Valuation is Done Two Ways Discounting Cash in the future is worth less than the same amount of cash held now A lot of finance is about determining how large this difference in value is or should be This is known (depending on context) as an interest rate, discount rate, or discount factor Arbitrage Turn something new that you wish to value into pieces of something old (“slice and dice”) that you already know how to value Much of Finance is about “Shopping”: Accomplish a financial goal at the least possible cost Corporate financing Household financing Accomplish a financial goal with the least possible risk Find bargains and sell them to others at a profit Avoid getting “ripped off” (too often) Much of Finance is about “Shopping” Finance Is Also AboutInformation and Expectations: Finance Is Also About Information and Expectations Prices reflect existing information and expectations Prices change as information and expectations change Just how well prices reflect information and expectations is hotly debated—but the consensus is very well, though not perfectly Prices also take other things into account— most notably, risk A Side Note on Internet Sources: A Side Note on Internet Sources Internet sources of financial information, definitions are usually but not always correct Investopedia is especially good, but even it has misinformation Be especially careful about using Wikipedia The Six Types of “Objects” in This Course: The Six Types of “Objects” in This Course Financial Instruments Analytic Methods Financial Indicators (indexes) Events (both historical and current) Institutions People E=mc2 Financial Instruments Fall Roughly Into Four Categories: Financial Instruments Fall Roughly Into Four Categories Money (short-term debt and cash) Long-term debt Equity Real assets Fixed Income Google Stock (Nasdaq: GOOG): Google Stock (Nasdaq: GOOG) Google went public in August 2004 Is volatile and can behave in ways that are atypical of most stocks Fin 525’s “pet stock” in AY2004–2005 and AY2005–2006 This is an Analytic Methods Slide (Believe It or Not): This is an Analytic Methods Slide (Believe It or Not) S&P 500 Stock Index: S&P 500 Stock Index The stock index most often used by financial professionals Vanguard’s mutual fund that is designed to replicate the performance of the index is among the largest mutual funds in the U.S. Are also the basis for the exchange-traded fund (ETF) with the symbol SPY that are known as Spiders (SPDRs) Both Current and Historical Events Are Covered: Both Current and Historical Events Are Covered United States Department of Treasury: United States Department of Treasury Issuer of many of the financial securities covered in the early on in the course The largest single player in the world economy because it is responsible for funding the Federal government’s budget deficit Because its securities are considered “risk free,” the rates of interest that it pays serve as baselines Steven A. (“Stevie”) Cohen: Steven A. (“Stevie”) Cohen Superstar billionaire hedge fund manager His company, SAC Capital, is responsible for a significant amount of the volume on U.S. stock exchanges Traders at SAC Capital have attracted the attention of securities regulators Any Questions?: Any Questions? U.S. Federal Reserve Note (Cash): U.S. Federal Reserve Note (Cash) Federal Reserve Bank: Federal Reserve Bank The central bank of the United States Founded in 1913 as the central bank of the U.S. Original mission was to provide financial stability Federal Reserve Notes constitute the bulk of its liabilities Visit its current balance sheet Text format PDF format So, What Is Money Anyway?: So, What Is Money Anyway? Money in Prison: Money in Prison “Cash is Trash”: “Cash is Trash” Cash pays no interest and its value is eaten away by “inflation” Therefore, businesses try to hold as little cash as possible To deal with short-term funding requirements, businesses hold other forms of “money” Bank deposits (and things that resemble them, like most money-market funds) are a preferred form of money Wal-Mart’s Cash on the Balance Sheet: Wal-Mart’s Cash on the Balance Sheet How Do We Know How Much Cash Wal-Mart has in its Cash Registers?Is Lots of Cash a Good Thing?: How Do We Know How Much Cash Wal-Mart has in its Cash Registers? Is Lots of Cash a Good Thing? Certificates of Deposits (CDs): Certificates of Deposits (CDs) Issued by banks How they work Deposit money with bank right now (cash outflow) Receive even more money at a specified maturity date (cash inflow) CDs are a form of time deposit (in contrast to a demand deposit) We will focus on CDs that mature in under one year, the boundary between short and long term CDs Rates are Required by Law to be Quoted as Annual Interest Rates: CDs Rates are Required by Law to be Quoted as Annual Interest Rates A popular place to find CD rates is bankrate.com CD calculator This deals with time periods other than a year and compounding Computing the Future Value (FV) of a CD(RWJ pp. 60-61): Computing the Future Value (FV) of a CD (RWJ pp. 60-61) Parameters Cash outflow now: C0 = $10,000 CD interest rate: r = 12% or 0.12 Formula (for a single period) FV = C0 (1+r) Applying the formula FV = $10,000 (1 + 0.12) = $10,000 (1.12) = $11,200 Reality Check: Reality Check Interest rates on any form of bank deposit have during a single period of American history and may never be that high again The textbook then uses 12% virtually risk-free return on the CD as the discount rate to evaluate (compute the present value, PV) of a “risky” project, which is not a good idea What If You Really Could Get 12% on CDs?: What If You Really Could Get 12% on CDs? Suppose You Want to Receive $11,424 One Year From Now at 12% Interest: Suppose You Want to Receive $11,424 One Year From Now at 12% Interest The size of the CD you will purchase now is the present value (PV) of the $11,424 in one year Formula (for a single period) PV = C1 / (1+r) Applying the formula PV = $11,424 / (1 + 0.12) = $11,424 / (1.12) = $10,200 PV is also a built-in Excel function Computing Present Values: Computing Present Values We will introduce two complications Periods of time shorter or longer than the period over which the interest rate is quoted (usually one year) Compounding: Getting interest on interest PV is easy to compute on any calculator, not just financial calculators PV is a built-in Excel function Note: For Excel C0 is a negative number, which makes sense, but is not the way textbooks do it Computing NPV (Net Present Value), Which Is PV with the Initial Investment Netted Out: Computing NPV (Net Present Value), Which Is PV with the Initial Investment Netted Out Parameters Cash outflow now: C0 = $10,000 Cash inflow in one year: C1 = $11,200 Interest rate on 8/22/05: 4.30% Formula: NPV = – C0 + C1 / (1+r) Applying the formula NPV = – $10,000 + $11,200 / (1 + 0.043) = – $10,000 + $10,738.26 = $738.26 Excel and NPV: Excel and NPV The computation on the previous slide is difficult to do automatically in Excel Minor problem: Excel has an NPV function, but it makes no provision for the first cash flow to occur right now The PV function can be coaxed to do this Summary of Bank Time Deposits and Discounting: Summary of Bank Time Deposits and Discounting Simple payment scheme from bank CDs Pay money in now Get more money out later The interest rate determines how much money is paid out later relative to the amount paid in To get future value multiple by (1+r) to get present value divide by (1+r), where r is the interest rate for the period The Fundamental Relationship BetweenInterest Rate (r) and Present Value (PV): The Fundamental Relationship Between Interest Rate (r) and Present Value (PV) Interest rates and the PV of any every financial instrument with constant future cash flows (fixed-income securities like CDs and bonds) always move in opposite directions Example: The PV of $10,000 at 4% interest in 1 year is $10,000/1.04 = $9,615.38 If the interest rate goes up to 5%, the PV drops to $10,000/1.05 = $9,523.81 If the interest rate goes down to 3%, the PV rises to $10,000/1.03 = $9,708.74 More on the Fundamental Relationship: More on the Fundamental Relationship We will examine the sensitivity of various fixed-income securities to interest rates before midterm using a measurement called duration While the prices of stocks and some risky bonds (both have very uncertain cash flows) tend to move in the opposite direction of interest rates, they sometimes move in the same direction when the change in interest rates indicates strength or weakness in the economy Converting Annual Interest Rates to Periods Less Than One Year: Converting Annual Interest Rates to Periods Less Than One Year Obvious method Multiply rate by the appropriate fraction of a year Examples: 12% for 6 months (or ½ year) is ½ (12%) = 6% 8% for 3 months (or ¼ year) is ¼ (8%) = 2% Warning The financial world often does not conform to the “obvious method” because annual rates can be quoted oddly or based on a 360-day year FV and PV for Less Than a Year with No Compounding: FV and PV for Less Than a Year with No Compounding Convert interest rate to new period length as demonstrated earlier Apply the FV and PV formulas as before FV = C0 (1+r) PV = C1 / (1+r) FV of $10,000 paying 4% annual rate for 6 months ( ½ year) FV = $10,000 (1 + 0.04/2) = $10,200 Suppose We Reinvest in an Identical CD After 6 Months: Suppose We Reinvest in an Identical CD After 6 Months Now our outflow (initial investment) is $10,200 The future value in six months is $10,200 (1.02) = $10,404 Notice that this is the same as investing for an entire year at 4.04% 4.04% is known as the APY (annual percentage yield) or EAR (effective annual rate) Compounding accounts for the extra 0.04%, commonly known as 4 basis points (b.p.) or bips The General Formula for Future Valuewith Compounding: The General Formula for Future Value with Compounding New parameters: m: Number of interest periods in a year m = 2 means semi-annual interest m = 4 means quarterly interest m = 12 means monthly interest m = 365 means daily interest T: Future time (in years or a fraction of a year) when inflow of cash occurs Formula: Using the Compounding Formula: Using the Compounding Formula Example: $10,000 at 4% annual rate for 6 months, compounded monthly Parameters: C0 = $10,000 r = 4% = 0.04 m = 12 T = 0.5 Plugging in: FV = $10,000 (1 + 0.04/12)0.5(12) = $10,000 (1.0033…)6 = $10,201.67 APY (or Effective Annual Interest Rate) Formula from RWJ p. 72: APY (or Effective Annual Interest Rate) Formula from RWJ p. 72 The Difference a Bip (or a Few Bips) Makes: The Difference a Bip (or a Few Bips) Makes At current interest rates, APY tends to be only a few bips (hundredths of a percentage point, also known as basis points or b.p.) higher than the simple interest rate It is important to keep interest rates straight because although they low small, every bip matters when you invest millions of dollars Professional bond traders and investors look at “spreads” (the interest rate relative to other securities) and these are measured in bips A Note on Use of the Compounding Formula by Ross/Westerfield/Jaffe (RWJ) on page 73: A Note on Use of the Compounding Formula by Ross/Westerfield/Jaffe (RWJ) on page 73 For the moment this course is focused on financial instruments that take one year or less to mature The RWJ formula states it is for multiple years, but it also works for fractions of a year as we saw in the previous slide Similarly, the Excel FV function can deal with both fractional and whole years though you have to adjust the interest rate and number of periods manually, which is not very convenient Three Important Points Worth Mentioning Now: Three Important Points Worth Mentioning Now Compounding is “magic” because the interest on interest (and interest on interest on interest…) adds up over time Over long periods of time (10 years or more depending on interest rates), a small difference in the interest rate can make a large difference in the future value of the investment Note that compounding only works if we do not withdraw the interest at the time that it is paid We will not consider the receipt of more than one cash flow from a financial instrument until we get to Treasury notes and bonds in a few weeks Assignment For Week 2: Assignment For Week 2 Check out the links in the slides covered in class Read RWJ Ch. 4, pp. 60-73 Do the problems on the 4 slides that follow this one Justify each True-False answer For the CD problems 1-3, use a calculator for one of the CDs and a calculator or spreadsheet for the rest True-False Statements (Page 1 of 2): True-False Statements (Page 1 of 2) One can make the annual percentage yield from a CD as high as one wants by choosing a short enough compounding interval. At higher stated yields, the compounding interval will make more of a difference to the annual percentage yield. In general, a $1,000 6-month bank CD should cost less to purchase now than it did at this time last year (September 2005). True-False Statements (Page 2 of 2): True-False Statements (Page 2 of 2) Doubling the interest rate on a CD will double its APY If two one-year CDs both pay $10,000 at maturity, then the one with the lower APY will cost more to purchase now The financial markets expect that the U.S. will grow faster in the second half of 2006 than it did in the first quarter of 2006. Questions about the Next Slide: Questions about the Next Slide Compute the APY (known in the textbook as Effective Annual Interest Rate) for each CD. Compute the future value at maturity for each CD for an investment of $10,000 today. Compute the present value of $10,000 received at maturity from each CD. You are considering the 3-month and 12-month (1 year) CDs offered by Beal bank. Bank of Miller (BoM) is willing to guarantee you a 9-month when the 3-month Beal CD matures if you sign with them now. What APY must BoM provide you so that after a year you will have the same amount you would have buying Beal’s 12-month CD. CD Interest Rates Compiled on September 6, 2005: CD Interest Rates Compiled on September 6, 2005 M is monthly compounding (m=12) and Q is quarterly compounding (m=4)
EXCOM. Science. Professional. Education. Administrative. By Goal. _xlnm.Print_Titles. Defer this effort until mid-2013, when the 1st two Med Phys Practice ...