FT-1 [Autosaved].ppt Finanncial theory chapter 1

Finanncial theory chapter 1

1. 1
FINANCIAL THEORY

2. MODERN FINANCE THEORYMODERN FINANCE THEORY
FINANCEFINANCE
INVESTMENTINVESTMENT CORPORATE FINANCECORPORATE FINANCE
PORTFOLIOPORTFOLIO
CAPMCAPM
EMHEMH
OPTION PRICING MODELOPTION PRICING MODEL
CAPITAL STRUCTURECAPITAL STRUCTURE
DIVIDEND POLICYDIVIDEND POLICY
AGENCY THEORYAGENCY THEORY
SIGNALING THEORYSIGNALING THEORY
CORPORATE CONTROLCORPORATE CONTROL
FINANCIAL INTERMEDIATIONFINANCIAL INTERMEDIATION
FINANCIAL INSTITUTIONFINANCIAL INSTITUTION
BANKINGBANKING
MISMIS
MARKET MICROSTRUCTUREMARKET MICROSTRUCTURE
Insurance Insurance
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3. Portfolio TheoryPortfolio Theory
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Professor Harry Markowitz (1952): “Don’t put all your
eggs in one basket”.
Base concept: unsystematic risk and systematic risk
efficient portfolio
Technique and measuring correlation, covariance,
standard deviation, and total variation in portfolio
setting.

4. Capital Market Theory Capital Market Theory
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Sharpe (1964), Lintner (1965), and Mossin (1966)
Contributions:
1. Trade off risk and return: capital market line
2. Beta (β)
Ross (1976): Arbitrage Pricing Theory (APT) with
more than one factor that influence the expected
return of asset such as economic variables.

5. Efficient Market HypothesisEfficient Market Hypothesis
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Fama (1970): speed and complete of relevant
information incorporated in capital market.
Degree of efficient:
1. Weak form
2. Semi-strong form
3. Strong form
Basic concept is investors are rational.

6. Option Pricing TheoryOption Pricing Theory
(Black-Scholes Option Pricing Model)(Black-Scholes Option Pricing Model)
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Black and Scholes (1973)
It is a pricing model used to determine the fair price or
theoretical value for a call or a put option based on six
variables such as volatility, type of option, underlying
stock price, time, strike price, and risk-free rate.
8 Assumptions:
1. Market are friction
2. Short sales are allowed
3. No dividend payment or other distribution
4. Market on going (continue)
5. Stock prices random walk
6. Constant variance rate of return
7. The option can be exercised only at maturity
8. The risk less interest rate is known and constant

7. Market MicrostructureMarket Microstructure
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First modern market microstructure study was Ho and
Stol (1981) base on Demsetz (1968) and Tinic (1972)
Market crashed in American capital market in 1987
Two basic model: spread model and price formation
model
a spread refers to the difference or gap between two
prices, rates, or yields which is the gap between the
bid (from buyers) and the ask (from sellers) prices of
a security or asset.

8. Market Microstructure (continued)Market Microstructure (continued)
8
Some basic empirical model: trade-off between dealer
and informed/uninformed trader, evolution of stock
prices, trading day vs non trading day, asymmetric
information in international capital market, market
design, market mechanism, private vs public
information, herding, etc.

9. Fisher Separation TheoremFisher Separation Theorem
In a given efficient capital markets, a firm's choice of
investment is separate from its owners' investment
preferences and therefore the firm should only be motivated
to maximize profits.
Fisher (1930): how to earn higher return by lending on
the capital market than they could by seeking out
individual borrowers, and borrowers can obtain
inexpensive financing without incurring search costs.
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10. Corporate FinanceCorporate Finance
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The major study of corporate finance are capital
budgeting, capital structure, dividend policy and
merger and acquisition to maximize shareholder’s
wealth.

11. Capital StructureCapital Structure
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Modigliani and Miller (1958): M&M irrelevant
propositions, called proposition I and proposition II
The market value of a company is correctly calculated
as the present value of its future earnings and its
underlying assets and is independent of its capital
structure.

12. Dividend PolicyDividend Policy
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M & M irrelevant model
Empirical model to test the dividend policy: agency
cost/contracting model and signaling model.

13. Agency TheoryAgency Theory
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Jensen and Meckling (1976)
Contributions:
1. Agency cost model of the firm
2. Compensation policy

14. Signaling TheorySignaling Theory
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Arkelof (1970) and Spence (1973): the original economics
papers on signaling. Leland and Pyle (1977) was the first
major financial application of signaling theory.
Corporate insiders better informed than outside investor

15. Corporate ControlCorporate Control
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Bradley (1980): Merger and acquisition in business
world.
Later empirical study: stock voting rights, the value of
concentrate vs dispersed ownership structure, benefit
shareholders on the various compensation plans for
company manager, etc

16. Financial IntermediationFinancial Intermediation
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Financial Institution: reksadana
Banking: investment vs commercial banking
Banking: national banking vs Universal banking
Insurance: life, investment, pension, education, etc

17. Common theme Common theme
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The common theme is how individuals and society
allocate scarce resources through a price mechanism
based on valuation of risk securities.

18. Finance Theory Finance Theory
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Utility theory provides the foundations of rational
decision making when deciding on risky alternatives.
“How do people make choices?”
State-preference theory, mean-variance portfolio theory,
and arbitrage pricing provide descriptions of the objects
of choice.

19. Finance Theory Finance Theory
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Combining these objects of choice with the theory of
choice determines how risky alternatives are valued.
In turn, appropriately determined asset prices provide
signals to the economy for necessary resource allocation.

20. SummarySummary
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In pricing assets, only systematic risk matter
Emphasize investment rather than financing
Emphasize cash flow rather than accounting profits
Remember that finance is now a global game
Remember that finance is a quantitative discipline
All theories are based on the principles of informationally
efficient capital markets populated by rational, utility-of-wealth-
maximizing investors who can costlessly diversify unsystematic
risk and are thus concerned only with pervasive, economy-wide
forces. So, where is the behavior finance stand?