Introduction to Financial Economics.pptx

the introduction to financial economics, chapter 1

1. Introduction to Financial Economics Presented by: Dr. Arifa Saeed

2. Learning Objectives Define financial economics and its scope Understand key financial principles Explain the role of financial markets Recognize real-world applications with case studies

3. What is Financial Economics? Financial economics studies how resources are allocated in financial markets Examines how economic theories apply to financial decision-making Focuses on investment strategies, financial instruments, and risk assessment Plays a critical role in corporate finance, public policy, and individual investments

4. Importance of Financial Economics Helps in assessing and qualifying financial risks Supports policy-making to enhance economic stability and growth Plays a role in predicting and managing economic cycles

5. Financial Markets Overview Capital Markets: Long-term investments such as stocks and bonds Money Markets: Short-term financing for liquidity management Foreign Exchange ( Forex ) Markets: Trading of global currencies Derivatives Markets: Instruments based on underlying assets

6. Market Type Definition Key Features Participants Instruments Traded Time Horizon Capital Markets Long-term investment markets Funds long-term investments and economic growth Corporations, governments, investors Stocks, bonds, mutual funds, ETFs Long-term (years/decades) Money Markets Short-term financing for liquidity management High liquidity, lower risk, lower returns Banks, financial institutions, corporations Treasury bills, commercial paper, CDs Short-term (less than a year) Foreign Exchange (Forex) Markets Trading of global currencies Largest and most liquid market, 24/7 trading Banks, central banks, traders, corporations Currency pairs (e.g., USD/EUR, GBP/JPY) Short-term to long-term Derivatives Markets Instruments based on underlying assets Used for hedging and speculation, high leverage Investors, hedge funds, corporations Futures, options, swaps, forwards Varies (short to long term)

7. What is the Derivatives Market? A derivatives market is where people buy and sell special financial contracts called derivatives . These contracts get their value from something else, like stocks, gold, oil, currencies, or interest rates .

8. Why Do People Use Derivatives? To Protect Against Losses (Hedging) – Businesses use derivatives to avoid big losses. For example, a farmer can lock in a price for wheat today to avoid losing money if prices drop in the future . To Make a Profit (Speculation) – Traders buy and sell derivatives to guess price changes and make money. To Trade with Less Money (Leverage) – Derivatives let people control large investments with a small amount of money.

9. Types of Derivatives Futures: A promise to buy or sell something (like oil or gold) at a set price in the future . Options : The right (but not the obligation) to buy or sell something at a fixed price before a deadline . Swaps : A deal where two people exchange cash flows, like swapping fixed and floating interest rates . Forwards : A private agreement to buy or sell something at a future date at an agreed price.

10. Who Uses Derivatives? Farmers & Businesses – To protect themselves from price changes. Investors & Traders – To try to make profits from price movements. Banks & Companies – To manage financial risks. Example : Imagine an airline that buys fuel every month. If fuel prices go up, their costs increase. To avoid this, the airline can buy a futures contract to lock in a fuel price now, ensuring they pay the same amount no matter what happens to fuel prices.

11. Role of Financial Markets Facilitates mobilization of savings and investments Ensures liquidity for market participants Enables efficient capital allocation Provides risk management opportunities through derivatives

12. Key Concepts in Financial Economics Time Value of Money (TVM): Importance of money’s value over time Risk and Return Tradeoff: Relationship between risk-taking and financial rewards Market Efficiency: How prices reflect all available information Asset Pricing: Determination of stock, bond, and derivative values Financial Instruments: Stocks, bonds, derivatives, and alternative investments

13. What is the Time Value of Money (TVM)? The Time Value of Money (TVM) means that money today is worth more than the same amount in the future because you can use it to earn more money.

14. Why is Money Worth More Today? Earning Potential (Interest or Investment Profits) – If you have money now, you can invest it and make more money over time. Inflation – Prices of goods and services increase over time, so money loses value in the future. Risk & Uncertainty – There's always a chance you may not get the same amount of money in the future. Example : If you get $100 today , you can invest it and earn interest. If the bank gives a 5% interest rate , after one year, you will have: 100+(100×5%)=100+5=105100 + (100 \times 5\%) = 100 + 5 = 105100+(100×5%)=100+5=105But if you receive $100 next year , it will still be $100, and you lose the chance to earn extra money .

15. Important TVM Concepts Concept: Money today is worth more than the same amount in the future Formula: PV = FV / (1+r)^n, where: PV = Present Value FV = Future Value r = Discount Rate n = Number of periods Applications: Loan amortization, investment valuation, and retirement planning

16. 2 - Understanding Risk and Return Definition of Risk: Uncertainty regarding future financial returns Types of Risk: Market Risk Credit Risk Liquidity Risk Inflation Risk Expected Return Calculation: Weighted average of potential returns Importance of Diversification: Reducing risk by spreading investments

17. Types of Risks Market Risk This happens when the value of investments goes up or down due to changes in the stock market, interest rates, or currency prices. Example: If you invest in stocks and the market crashes, you may lose money . Credit Risk This is the risk of someone not paying back borrowed money (loan or credit). Example: If you lend money to a friend and they don’t return it, that’s credit risk. Banks also face this risk when giving loans.

18. Liquidity Risk This happens when you cannot easily sell an asset or investment to get cash when needed. Example: If you own property but cannot find a buyer quickly, you have liquidity risk . Inflation Risk Inflation reduces the purchasing power of money over time, meaning the same amount of money will buy fewer things in the future. Example: If you save $100 today, but inflation increases, in 5 years that $100 may buy much less than today.

19. Expected Return Calculation (Weighted Average of Potential Returns) This means calculating how much profit you can expect from an investment on average , considering different possible outcomes. Example: If you invest in a stock that has a 50% chance of giving a 10% return and a 50% chance of giving a 5% return , the expected return is: (0.5×10%)+(0.5×5%)=7.5%(0.5 \times 10\%) + (0.5 \times 5\%) = 7.5\%(0.5×10%)+(0.5×5%)=7.5% This helps investors predict future earnings before making investment decisions.

20. Importance of Diversification (Reducing Risk by Spreading Investments) Diversification means investing in different types of assets (stocks, bonds, real estate) instead of putting all your money in one place . Why ? Because if one investment loses money , the others may balance out the loss . Example: If you invest only in one company's stock and it crashes, you lose a lot. But if you invest in stocks, gold, and property , the loss in one area may be covered by gains in another . Diversification is like not putting all your eggs in one basket!

21. 3 - Market Efficiency and Asset Pricing Efficient Market Hypothesis (EMH): Prices reflect all known information Asset Pricing Models: Capital Asset Pricing Model (CAPM): Relationship between risk and expected return Arbitrage Pricing Theory (APT): Multiple risk factors influencing asset prices Implications for Investors: Passive vs. active investment strategies

22. Efficient Market Hypothesis (EMH) The Efficient Market Hypothesis (EMH) says that all available information about stocks, bonds, or any investment is already included in the price . This means that you cannot consistently "beat the market" by picking stocks because prices already reflect everything that is known. Example : If a company announces a new product that could increase profits, the stock price will adjust immediately. So, investors can’t take advantage of this information to make extra profits.

23. Asset Pricing Models Asset pricing models help investors understand how risk and return are related. Capital Asset Pricing Model (CAPM) CAPM is a formula that shows how much return an investor should expect based on the level of risk. It says that higher risk leads to higher potential returns. Example : If you invest in a very stable company, you might get lower returns. But if you invest in a risky startup, you could earn more (or lose money).

24. Arbitrage Pricing Theory (APT) APT says that asset prices are influenced by multiple risk factors, not just one (like in CAPM). It considers things like inflation, interest rates, and company performance. Example: If inflation rises, stock prices might drop because businesses have to spend more money.

25. Implications for Investors EMH and asset pricing models affect how investors make decisions: Passive Investing: If prices already reflect all information (EMH), it's hard to pick winning stocks. So, many investors choose passive strategies like index funds, which track the overall market without frequent buying and selling. Active Investing: Some investors believe they can find undervalued stocks and beat the market. They analyze financial data, trends, and company performance to make investment decisions.

26. Index funding in Pakistan An index fund in Pakistan is a type of mutual fund that follows a stock market index, such as the KSE-100 Index (Karachi Stock Exchange 100 Index). Instead of trying to pick the best stocks, an index fund invests in all (or most) of the companies in that index to match the market’s performance.

27. How Does an Index Fund Work in Pakistan? if you invest in a KSE-100 Index Fund , your money is automatically spread across the top 100 companies listed on the Pakistan Stock Exchange (PSX ) . When the KSE-100 Index goes up, your investment grows; if it goes down, your investment loses value . The fund is passively managed , meaning there is no active buying and selling of stocks—this helps keep costs low.

28. Examples of Index Funds in Pakistan Some asset management companies (AMCs) in Pakistan offer index funds, including: UBL Pakistan Stock Market Fund (UBLPF) MCB Pakistan Stock Market Fund (MCB-PSM) Al Meezan Index Fund (Islamic) HBL Growth Fund Most of these funds track the KSE-100 Index or other market indices.

29. Benefits of Investing in Index Funds in Pakistan Lower Fees: Since they are passively managed, index funds have lower management fees than actively managed mutual funds . Diversification : Your money is invested in many companies, reducing the risk of losing all your money in one stock . Long-Term Growth: The Pakistan Stock Exchange (PSX) has historically grown over time, making index funds a good choice for long-term investors . No Need for Stock-Picking: Beginners can invest without needing to analyze individual companies.

30. How to Invest in an Index Fund in Pakistan? Choose an Asset Management Company (AMC) – Pick a company that offers index funds (e.g., UBL Funds, Al Meezan , MCB, HBL ). Open an Investment Account – You will need your CNIC , bank account details, and some basic documents . Select an Index Fund – Choose a fund that tracks an index like KSE-100 or Meezan Islamic Index . Invest and Monitor – Start investing with a lump sum or through monthly contributions .

31. Case Studies Stock Market Investment: Evaluating stock performance Bond Market and Interest Rate Sensitivity: Risk factors 2008 Financial Crisis: Causes, effects, lessons Sustainable Finance Projects: Green investment analysis Impact Investing Success Stories: Real-world ESG applications

32. Challenges in Financial Economics Market Volatility: Unpredictable price movements Ethical Considerations: Fraud, insider trading Technological Disruptions: Adaptation in financial institutions

33. Future Trends in Financial Economics AI and Machine Learning in Trading: Enhancing predictive models Sustainable Finance Growth: Increased focus on ESG Digital Financial Services: Expanding accessibility

34. SDG Relevance – Financial Economics and Sustainability SDG 8: Decent Work and Economic Growth SDG 9: Industry, Innovation, and Infrastructure SDG 12: Responsible Consumption and Production SDG 16: Peace, Justice, and Strong Institutions

35. Summary and Key Takeaways Recap of major topics and their relevance Importance of financial literacy and decision-making