L1 BA2

What is Finance?

• I need money. Where can I get it from?
  • grandma
  • bank loan
  • financial markets
    • Bond Market: issue bonds
    • Stock Market: issue stocks
• I have money. Where can I put it in?
  • bank
  • invest in property, art, etc
  • financial markets
    • buy bonds or stocks

Scope

• financial markets
• instruments traded on financial markets
• how are prices formed
• performance/risk
• notions on profitability/risk
  • expected returns, “beating the market”, when does risk matter?

Dimensions of Data

• cross-sectional data
  • different entities at the same time
  • horizontal vector
• time-series data
  • same entity at different times
  • vertical vector
• panel data
  • different entities at different times
  • matrix / dataframe

Sources of Financial Data

• market data
  • trade related, transactions on a financial market
  • e.g. prices, trading volumes
• accounting data
  • reported by firms
    • Digital Tagging makes it easier to compare
• survey data
  • e.g. LIBOR, market sentiment indices, etc
• data providers (academic and industry providers)
  • Bloomberg, CRSP, Compustat, etc

Financial Markets and Instruments

• instrument … something listed on a financial market
• exchange traded
  • stocks
  • futures, ETFs, some options, etc
  • price set by supply/demand
  • more regulated environment (trading hours, disclosure requirements, etc)
• over the counter (OTC)
  • bonds
  • forwards, funds, options, etc
  • price set by seller, buyer accepts/declines
  • few regulations

Stocks

• you become an owner of the firm if you hold its stocks
• equity is divided into pieces called stocks/shares
  • proportional to the number of shares
  • usually entails voting rights
  • Dividend payed out to shareholders
    • vary over time, depending on profit of firm
  • Limited Liability - cannot lose more than the shares you own
  • in case of default - read here

Bonds

• you become a creditor of the frim if you hold its bonds
• debt financing
  • more participants than just a single entity (e.g. bank)
  • a “big loan” is divided into smaller ones - bonds
  • transfer of bond is easier than shares
    • “public traded debt”
  • coupons … regular interest payment, usually annual or semi-annual
    • like interest, just payed to you
  • repayment … the fixed date when the bond is payed back
    • called maturity (5y, 10y, 15y)
    • e.g. buying a bond with 5y maturity for 10k, after 5y you will receive the 5k back from the company

Formation of Market Prices

• primary vs secondary markets
  • primary: sold for the first time, IPO, company sets its own beginning prices
  • secondary: bought and sold between investors, e.g. on the NYSE
• price discovery: supply/demand
  • primary: book building
  • secondary: order book

Book building - Simplified

• used for OTC sales
• set reasonable price for stock
• road show … advertise the security to investors or general public
• customers send offers … x amount for y each
  • add up the demand and offers
  • choose price according to those offers
• allocate stocks to the buyers
  • maximize number of transactions
• if there are more offers than supply
  • choose highest price to sell all your supply

Order Book - Simplified

• used on exchanges
• bid price … what you want to sell it for
• ask price … how much you are willing to pay
• if there is a match i.e. bid price < ask price the transaction is executed

Prices to Returns

• one cannot compare prices, only performance
• performance … relative price change over time interval
• simple return: $r_t=\frac{p_t-p_{t-1}}{p_{t-1}}=\frac{p_t}{p_{t-1}}-1$
• log return: $r_t^l=log(p_t/p_{t-1})$
• note: $r_t=e^{r_t^l}-1$

Stylized Facts

• returns are hard to predict
  • maybe 1 minute into the future
• returns have fat-tailed distributions
  • more extreme observations than in normal distributions
    • normally smoother curve, peak not as high
  • average is normally around 0
• volatility clusters
  • volatility … different between high/low
  • volatility is “exploding” during short times and stays like that for a short while before calming down again
• correlation tends to spike/increase during market downturns / crashes
  • individual stocks follow downwards but move up separately