Introduction of Financial Management Lecture 2: Finance and Science

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Introduction of Financial Management Lecture 2: Finance and Science Powered By Docstoc
					     Lecturer: Shaling Li
      Acc&Fin Dept, PBS
University of Portsmouth
        15 October, 2009
What is Finance?
                                          Real
                                       Investment

           Investment                   Financial
                                       Investment               Financing
                                                                 decision
 Finance




                                       Resources
           Corporate                   of money
            Finance                                                 Investment
                                        Usage of                    & Dividend
                                        money                        decisions
            Financial
           Market and
            Financial
           Institutions                     Global financial
                                            systems: banks,
                                          equity/debt markets
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Why study Finance?
 Finance is important to economy
    Economy allocates money to its highest valued use (e.g.
     stock market)
    Good business get more money (e.g. bank lending &
     interests)
 Finance is important to individual
    Manage your money: borrow/debt
    Different needs for money in different life stages: young,
     middle age, retired


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How to study finance?
 Finance as a subject in Science
 Science:
    Science refers to a system of acquiring knowledge. This
     system uses observation and experimentation to
     describe and explain natural phenomena.
    The purpose of science is to produce useful models of
     reality.
    Scientific methods




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Theory and Practice

                                          Real world:
    Theoretical                         Full of myteries
      world:                               Expected
   Assumptions                           Unexpected
   General rules                             results
      Results




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The theoretical world in Finance
 The assumptions of the theoretical world of Finance
   1. Rational self-interest
   2. Frictionless financial markets  Theoretical world:

           No transactions costs.          Assumptions: IF
                                                General
           No public information costs      rules/models:
                                                 THEN
   3.   Financial markets are liquid          Results: SO

   4.   Minimal role for government




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How realistic are the assumptions
of the finance textbook world?
 UK London stock market
    The FTSE 100 companies are the 100 biggest UK
     companies by market capitalisation
 Checking the assumptions in the UK markets
    Assumption1: Rational self-interest
       Self-interest: only focus on and seek self benefits (egotism –
        altruism)
       Rational: logic manner
       Professional investors: pension fund, insurance company,
        investment companies
   Check: yes or no?


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How realistic are the assumptions
of the finance textbook world?
 Checking the assumptions in the UK markets
    Assumption 2: Frictionless financial markets
       No transaction cost: commission fee exists, 0.35% of
        selling/buying
       No public information cost: internet, newspaper, TV
   Check: yes
   Assumption 3: Financial markets are liquid
     The total market capitalisation of all FTSE 100 stocks is well over
      £1,000 billion
     The total daily trading volume runs into the millions of shares
      traded
   Check: Yes

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How realistic are the assumptions
of the finance textbook world?
 Checking the assumptions in the UK markets
    Assumption 4: Minimal role for government
       Government: a ‘night watchman’.
       systems of internal controls: professional ethics, the strict
        legal and regulatory framework
   Check: yes




                   S Li, Acc&Fin, PBS, UoP                              9
Theory and Practice        What is
                           that??



    Theoretical
       world:
    Rationality
                                             Real world:
    Frictionless
                                         UK London exchange
      market
     Liquidity
  Government role
          +
   Models, results




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Arguments on the assumptions
 The rationality assumption is the most important
  assumption of our textbook world model
 Three arguments challenging this assumption
  Argument 1: the ‘blockheads’ argument:
    Question: Blockheads are many and not rational
    Explanation: On average the blockheads cancel each
      other out




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Arguments on the assumptions
Argument 2: the rational arbitrageurs argument:
  Question: when blockheads are not even numbered at
     short time, mispricing exists
  Explanation: rational arbitrageurs will enter the market,
     forcing stocks back to their fair value.
Argument 3: winner and loser argument
  Question: Are there more blockheads than smart guys
  Explanation: blockheads will tend to lose money over
     time, and that smart investors will tend to make
     money

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Arguments on the assumptions
Conclusions: The existing of blockheads does not
   influence the market and the assumption of
   rationality.




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How closely does the real world
resemble the world of theory?

   Theoretical world:
       Rationality
                                                  Real world:
   Frictionless market
  Liquidity Government                        UK London exchange
           role
            +
     Models, results




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How closely does the real world
resemble the world of theory?
 Whatever is thought and found in the theory world
 has two types of results if matched/applied to the
 practical world:
   Yes, largely
     The model (rules) can be applied to the practice with expected
      results most of time
     However, this does not mean everyone gains in the market
     There are always exceptions in the real world

   No, basically
     If it does not work, why? Proper assumptions, models?
     However, this also does not mean there is no random gain.



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How closely does the real world
resemble the world of theory?
 Example: US market & Successful investors
    A mutual fund, the Vanguard S&P500 Tracker
       In the early 1970s in America John Bogle decided to apply the
        textbook world finance theory that was developed by finance
        scholars during the 1960s
       looking at the thirty-year record, the investment returns on the
        Vanguard S&P500 Tracker fund have beaten those of every
        other stock market mutual fund in the United States.
   Mr. Buffett’s personal wealth is around $40 billion and
    the funds he manages are far larger


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How closely does the real world
resemble the world of theory?
 Russian market in 1990s
    Investment model & investment results
       US/UK model  likely to lose or does not work
   Checking the assumptions
       Information was expensive
       Reliable information hardly existed
       Trading had to stopped during some period (liquidity)
       Have a well-developed legal and regulatory framework
        on paper, the lack of an enforced legal and regulatory
        framework

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The approach to studying finance
1. We always start off with a problem, or a question.
2. Next we give the theoretically correct solution to the
   problem
3. The next step is empirical research




               S Li, Acc&Fin, PBS, UoP                      18
Summary
 Finance and its key elements
 The theoretical world in Finance + four assumptions
 The realistic degree of the assumptions of the finance
  textbook world
 How closely does the real world resemble the world of
  theory (yes or no examples)
 Approach to study finance




               S Li, Acc&Fin, PBS, UoP                     19
Seminar for next week
 Please see the attached.




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