Monetary Policy, the Supply of Money Is Broken Down Into Types of Money Based on How Much of an Effect Monetary Policy Can Have on That Type of Money

BASIC FINANCE

Dr. Marta Wiśniewska [email protected] Introduction Course Outline Literature Grading Introduction Course Outline Literature Grading

This is an introductory finance module.

It outlines the basic principles of (1) public finance (2) portfolio theory and (3) corporate finance.

The main objective is to create awareness of financial choices faced by various agents. Introduction Course Outline Literature Grading

Day Time Lectures PRACTICAL QUESTIONS 20.10 (1)Introduction (2)Money and Monetary Systems (3)Central Banks and Banking System (1)Time value of money

21.10 (4)Introduction to Portfolio Theory (5) Introduction to Investments (2) Risk and return

3.11 (6) Introduction to Public Finance (7) Finance of EU (8) Social Protection (9) Introduction to Corporate Finance 1.12 TEST Group Presentation/ Report Introduction Course Outline Literature Grading

 Levich, Richard M. (2003), International Financial Markets, Second Edition, McGraw Hill  Brealey, Richard A. and Myers, Stewart C. (2003), Principles of Corporate Finance, Seventh Edition, McGrawHill  Markowitz, Harry M. (1952). Portfolio Selection, Journal of Finance, 7 (1), 77-91.  Sharpe, William F. (1964). Capital asset prices: A theory of market equilibrium under conditions of risk, Journal of Finance, 19(3), 425-442.  Lintner, J. (1965). The Valuation of Risk Assets and the Selection of Risky Investments in Stock Portfolios and Capital Budgets, The Review of Economics and Statistics, 47 (1), 13-39. LECTURE NOTES  Finanse, red. Ostaszewski J., Difin, Warszawa 2003;  Owsiak S., Podstawy nauki finansów, PWE, Warszawa 2002.  Fedorowicz Z., Podstawy teorii finansów, Poltext, Warszawa 2000;  Finanse i prawo finansowe, t. 1 i 2, red. Ruśkowski E., KiK, Warszawa 2002;  Groppelli A. A., Ehsan Niktakht, Wstęp do finansów, WIG PRESS, Warszawa 1999;  Sektor finansowy w Polsce, red. Owsiak S., PWE, Warszawa 2002.  Finanse, praca zbior., red. Ostaszewski J., Difin, 2003; Introduction Course Outline Literature Grading

www.witor.biz/BF Introduction Course Outline Literature Grading

(1)Group Presentation* (30%) (2)Test (70%)

* obligatory Introduction Course Outline Literature Grading

Country presentation- Requirements

(1) Each group should choose one of the following countries: UK, USA, Japan, Germany, Norway

(2) The presenation/ report should cover following issues: . Brief general introduction to the contry and its economy (incl. GDP, current economic situation, crisis?, population etc) . Country budget . Taxes . Pension system . Financial markets

DUE: 1st December, pdf report submitted until 12pm 10-12 min presentation, all members of the group are presenting Introduction Course Outline Literature Grading

Final Exam

2 Sections:

Section 1 . Numerical tast . Answer all questions . 60% of exam mark . You decide what position you take: long, short . You decide for how long you hold the position (exit strategy)

Section 2 . Describe/ explain question . Answer 2 out of 3 questions . 40% of exam mark

see Exam Paper 2015 Introduction Course Outline Literature Grading

Questions? Class 1:

(1)Introduction (2)Money and Monetary Systems (3)Central Banks and Banking System

PQ 1: Time value of money 1. Introduction Basic Finance: Introduction Marta Wisniewska

. What Is Finance?

. The Financial System

. Financial Instruments

. Financial Markets Basic Finance: Introduction Marta Wisniewska

What is Finance?

The science of managing money Finance is the study of how and under what terms savings (money) are allocated between lenders and borrowers.

Financial contracts or securities occur whenever funds are transferred from issuer to buyer. Basic Finance: Introduction Marta Wisniewska

What is Finance?

Moving scarce resources over . time and . states of nature.

Example:

car loan time car insurance state of nature Basic Finance: Introduction Marta Wisniewska

What is Finance?

. The study of finance requires a basic understanding of: . Securities . Corporate law . Financial institutions and markets Basic Finance: Introduction Marta Wisniewska

What is Finance? Real vs. Financial Assets

Real assets Financial assets . tangible things owned by . what one persons and businesses individual has . Residential structures and lent to another property . Consumer credit . Major appliances and . Loans automobiles . Mortgages . Office towers, factories, mines . Machinery and equipment Basic Finance: Introduction Marta Wisniewska

What is Finance? Real vs. Financial Assets

Table 1-2 Assets and Liabilities of Households, 2005

Assets $ Billion Liabilities $ Billion Houses 1,086 Consumer credit 260 Consumer Durables 435 Loans 131 Land 827 Mortgages 588 Real Assets 2,348 Total Liabilities 979 Deposits 683 Debt 114 Pensions and insurance 1,200 Shares 1,254 Foreign and other 72 Financial Assets 3323 Total Assets 5,671

Source: Statistics Canada. National Balance Sheet Accounts, Quarterly Estimates, Fourth Quarter 2005. Ottawa: M inister of Industry, 2006 (Catalogue No. 13-214-XIE). Basic Finance: Introduction Marta Wisniewska

What is Finance?

Finance is used by Basic Finance: Introduction Marta Wisniewska

What is Finance?

Personal finance

How do we obtain money? …and what do we do with money (spend? save?)

Ways in which individuals or families obtain, budget, save and spend monetary resources over time, taking into account various financial risks and future life events. Basic Finance: Introduction Marta Wisniewska

What is Finance?

Corporate finance

What project should the company undertake?

…and how to pay for those projects

The primary goal of corporate finance is to maximize corporate value while reducing the firm's financial risks. Basic Finance: Introduction Marta Wisniewska

What is Finance?

Public finance

What should the government or collective organizations do or be doing?

…and how to pay for those activities

The broader term (public economics) and the narrower term (government finance) are also often used.

Country, state, county, city or municipality finance is called public finance. Basic Finance: Introduction Marta Wisniewska The Financial System Overview Basic Finance: Introduction Marta Wisniewska The Financial System Overview

The financial system facilitates the flow of capital between the entities with funds surplus and those in need of funds. Basic Finance: Introduction Marta Wisniewska The Financial System Overview

. The household is the primary provider of funds to businesses and government. . Households must accumulate financial resources throughout their working life times to have enough savings (pension) to live on in their retirement years

. Financial intermediaries transform the nature of the securities they issue and invest in . Banks, trust companies, credit unions, insurance firms, mutual funds

. Market intermediaries simply help make markets work . Investment dealers . Brokers Basic Finance: Introduction Marta Wisniewska The Financial System Overview

The circulation of funds in the financial system may take place through different channels.

Bank-oriented financial Market-oriented financial system system . Dominant role of banks . Capital is obtained through as institutions the financial market, where intermediating in the enterprises issue securities capital exchange (stocks/bonds). between entities in the . Investors may purchase them economy. directly on the financial . Germany, Japan market or through the intermediation of financial institutions . UK, USA Basic Finance: Introduction Marta Wisniewska

The Financial System where financial Channels of Intermediation intermediary such as a bank direct offers deposit- transfer from taking services saver to and lends those borrower – a deposits out as non-market mortgages or transaction loans

market- based transaction usually through a market intermediary such as a broker Basic Finance: Introduction Marta Wisniewska The Financial System Financial Intermediaries

Banks and other deposit-taking Insurance institutions companies

Pension Funds Mutual/ Investment Funds Basic Finance: Introduction Marta Wisniewska The Financial System Financial Intermediaries: Banks

The deposits are ‘pooled’ in the Bank

B A N K

The bank takes these pooled funds Banks take deposits and lends them out to households from numerous and businesses in the form of depositors mortgages and loans

The bank transforms the original nature of the savers (depositors) money: . Deposits are usually small in amount…face little or no risk, and depositors expect to withdraw the amount at any time . Loans and mortgages on the other hand usually have the following characteristics: . Large sums . Borrowed for long periods of time . Borrowed for risky purposes. Basic Finance: Introduction Marta Wisniewska The Financial System Financial Intermediaries: Insurance Companies

They invest the premiums so that the accumulated value in the future will grow

INSURANCE COMPANIES

…to meet the Insurers sell policies and collect premiums from anticipated customers based on the pricing of those policies claims of the given the probability of a claim and the size the policyholders. policy and administrative fees.

. In this way, unsupportable risks (such as the death of wage earner or the burning down of a business) are shared among a large number of policyholders through the insurance company. . Insurance allows households, business and government to engage in risky activities without having to bear the entire risk of loss themselves. Basic Finance: Introduction Marta Wisniewska The Financial System Financial Intermediaries: Pension Plans

those funds are invested(?) to grow (?) over time…

PENSION PLAN

Individuals and employers Ultimately, the accumulated value make payments over the in the pension can (?) be used by entire working life of a the person in retirement. person

. Pension plans accumulate considerable sums of money, and their managers invest those funds with long-term investment time horizons in diversified portfolios of investments. . These investments are a major source of capital, fuelling investment in research and development, capital equipment, resource exploration and ultimately contributing in a substantial way to growth in the economy. Basic Finance: Introduction Marta Wisniewska The Financial System Financial Intermediaries: Mutual Funds

those funds are invested in diversified professionally managed portfolios

MUTUAL FUND

Many (small) Ultimately, the investors obtain investors put money better (?) investment result then to into the fund invest on their own

. Mutual (/Investment) funds give small investors access to diversified, professionally-managed portfolios of securities. . Small investors often do not have the funds necessary to invest directly into market-traded stocks and bonds. . This is called denomination intermediation because the mutual fund makes investments available in smaller, more affordable amounts of money. Basic Finance: Introduction Marta Wisniewska The Financial System The Major Borrowers

. Public Debt . Private Debt . Governments . Households . Federal . Non-financial . Provincial Corporations . Municipal . Crown Corporations Basic Finance: Introduction Marta Wisniewska Financial Instruments

There are two major categories of financial securities:

Debt Instruments Equity Instruments . Commercial paper . Common stock . Bankers’ acceptances . Preferred stock . Treasury bills . Mortgage loans . Bonds . Debentures Basic Finance: Introduction Marta Wisniewska Financial Instruments

Non-marketable securities Marketable securities

. Cannot be traded . Can be traded between or between or among among investors after investors their original issue in . May be redeemable (a public markets and before reverse transaction they mature or expire between the borrower and the lender) . Examples: . Savings accounts Market Capitalization . Term Deposits . It is the total market value of a . Guaranteed company Investment . It is found by multiplying the Certificates number of shares outstanding by the market price per share.

푀푎푟푘푒푡 퐶푎푝𝑖푡푎푙𝑖푧푎푡𝑖표푛 = 푁푢푚푏푒푟 표푓 푠ℎ푎푟푒푠 ∗ 푃푟𝑖푐푒 푝푒푟 푠ℎ푎푟푒 Basic Finance: Introduction Marta Wisniewska Financial Instruments Marketable Securities categorized by the time to maturity:

1 year time to maturity

Money Market Securities Capital Market Securities

. short-term debt securities . long-term debt or equity with maturities shorter than securities with maturities greater 1 year than 1 year . Bankers’ acceptances . Bonds . Commercial Paper . Debentures . Treasury Bills . Common Stock . Preferred Stock Financial Markets Financial Markets

Market – any place or process that brings together buyers and sellers with a view to agreeing a price

The basis of how an economy operates – through production and subsequent exchange Basic Finance: Introduction Marta Wisniewska Financial Markets Purpose of Financial Markets

To facilitate the transfer of funds between borrowers To trade time & risk and lenders

Price discovery: Trading on secondary markets provides public information on asset prices (market price = last traded price of an asset)

Lower search costs: Since all trading parties converge to the same location, matching is made easier

Provides liquidity: investors can sell assets prior to maturity on secondary markets to satisfy their time preference for consumption and diversification needs. Basic Finance: Introduction Marta Wisniewska Financial Markets

1 year time to maturity

Money Market Capital Market

. for short-term debt securities . for long-term debt or equity with maturities shorter than securities with maturities greater 1 year than 1 year Basic Finance: Introduction Marta Wisniewska Financial Markets

Primary Market Secondary Market . Markets that . Markets that involve involve the issue buyers and sellers of new securities of existing securities . Capital formation occurs . No capital formation occurs Basic Finance: Introduction Marta Wisniewska Financial Markets Types of Secondary Markets

Exchanges or Dealer or Over-the- Auction Markets counter (OTC) Markets

. Secondary . Secondary markets markets that that do not have a involve a physical location bidding process and consist of a that takes place network of dealers in specific who trade directly location with one another.

. For example TSX, . For example FX NYSE market Basic Finance: Introduction Marta Wisniewska

. What Is Finance?

. The Financial System

. Financial Instruments

. Financial Markets 2. Money and Monetary System Basic Finance: Money… Marta Wisniewska

. Money

. Money Creation

. Monetary Systems

. Exchange Rates Regimes Basic Finance: Money… Marta Wisniewska Money

What is money?

Money is anything that can be used in settlement of a debt or as a mean to store value. Basic Finance: Money… Marta Wisniewska Money

Money is a matter of functions four:

measure

medium of exchange Money is used as an intermediary for trade, in order to avoid the inefficiencies of a barter system. unit of account A unit of account is a standard numerical unit of measurement of the market value of goods, services, and other transactions. store of value To act as a store of value, a commodity, a form of money, or financial capital must be able to be reliably saved, stored, and retrieved — and be predictably useful when it is so retrieved. Fiat currency like paper or electronic currency no longer backed by gold in most countries is not considered by some economists to be a store of value. Basic Finance: Money… Marta Wisniewska Money

Means of Metal Electronic Exchange exchange Notes of goods (e.g. shell, currency money cattle) Basic Finance: Money… Marta Wisniewska Money

Money supply is the total amount of money available in an economy at a particular point in time.

There are varying measures of money supply*: M0, M1, M2, M3

*Since most modern economic systems are regulated by governments through monetary policy, the supply of money is broken down into types of money based on how much of an effect monetary policy can have on that type of money. Basic Finance: Money… Marta Wisniewska Money M0

= Physical currency

Combines any liquid or cash assets held within a central bank and the amount of physical currency circulating in the economy.

. Most liquid measure of the money supply.

. This measure is known as narrow money because it is the smallest measure of the money supply.

M0: The total of all physical currency, plus accounts at the central bank that can be exchanged for physical currency (Federal Reserves). Basic Finance: Money… Marta Wisniewska Money M1

= M0 + demand deposits

Used by economists as a measurement to quantify the amount of money in circulation.

The M1 is a very liquid measure of the money supply, as it contains cash and assets that can quickly be converted to currency.

M1 is a measure of money supply including all coins and notes plus personal money in current accounts (OECD)

M1: M0 - those portions of M0 held as reserves or vault cash + the amount in demand accounts ("checking" or "current" accounts) (Federal Reserves).

M1: Currency in circulation + overnight deposits (ECB) Basic Finance: Money… Marta Wisniewska Money M2

= M1 + all time-related deposits, savings deposits, and non-institutional money-market funds

M2 is a broader classification of money than M1.

Also used by economists to quantify the amount of money in circulation and to explain different economic monetary conditions.

A key economic indicator used to forecast inflation.

M2 is M1 plus personal money in deposit accounts (OECD)

M2: M1 + most savings accounts, money market accounts, and small denomination time deposits (certificates of deposit of under $100,000) (Federal Reserves).

M2: M1 + Deposits with an agreed maturity up to 2 years + Deposits redeemable at a period of notice up to 3 months (ECB) Basic Finance: Money… Marta Wisniewska Money M3

= M2 + all large time deposits, institutional money-market funds, short-term repurchase agreements, along with other larger liquid assets

The broadest measure of money; it is used by economists to estimate the entire supply of money within an economy

M3 is M2 plus government and other deposits (OECD).

M3: M2 + all other CDs (large time deposits, institutional money market mutual fund balances), deposits of eurodollars and repurchase agreements (Federal Reserves).

M3: M2 + Repurchase agreements + Money market fund (MMF) shares/units + Debt securities up to 2 years (ECB) Basic Finance: Money… Marta Wisniewska Basic Finance: Money… Marta Wisniewska Basic Finance: Money… Marta Wisniewska Components of US money supply (currency, M1, M2, and M3) since 1959 Basic Finance: Money… Marta Wisniewska Basic Finance: Money… Marta Wisniewska Basic Finance: Money… Marta Wisniewska Basic Finance: Money… Marta Wisniewska Money Creation

Money creation is the process by which money is produced or issued.

There are two different ways to create money:

physically loaning out a physical manufacturing a new monetary unit multiple monetary unit, such as times through paper currency or fractional-reserve metal coins lending Basic Finance: Money… Marta Wisniewska Money Creation

Fractional-reserve banking creates money whenever a new loan is created.

In short, there are two types of money in a fractional- reserve banking system: . central bank money (physical currency) . commercial bank money (money created through loans) sometimes referred to as checkbook money

When a loan is supplied with central bank money, new commercial bank money is created. As a loan is paid back, the commercial bank money disappears from existence. Basic Finance: Money… Marta Wisniewska

Table Fractional-Reserve Lending individual amount loaned Cycled 10 times with a 20 percent amount deposited reserves reserve rate bank out A 100 80 20 B 80 64 16 C 64 51.20 12.80 D 51.20 40.96 10.24 E 40.96 32.77 8.19 How much money F 32.77 26.21 6.55 can be created in G 26.21 20.97 5.24 the system? H 20.97 16.78 4.19 I 16.78 13.42 3.36 J 13.42 10.74 2.68

K 10.74

total reserves: total reserves + last total amount deposited: total amount loaned out: amount deposited: 89.26 457.05 357.05 100 commercial bank money commercial bank money created + central bank central bank money created money Although no new money was physically created in addition to the initial $100 deposit, new commercial bank money is created through loans. The 2 boxes marked in red show the location of the original $100 deposit throughout the entire process. The total reserves plus the last deposit (or last loan, whichever is last) will always equal the original amount, which in this case is $100. As this process continues, more commercial bank money is created. Basic Finance: Money… Marta Wisniewska Money Creation

The most common mechanism used to measure this increase in the money supply is called the money multiplier

The money multiplier (m) is the inverse of the reserve requirement (R):

Multiplied by the initial deposit shows the maximum amount of money can be expanded to.

Example With the reserve ratio of 20 percent or

Money will grow 5 times. Basic Finance: Money… Marta Wisniewska Money Creation Basic Finance: Money… Marta Wisniewska Monetary System

International Monetary System the European Plaza-Louvre The Economic International Accords and Bretton Floating- and The Floating-Rate Monetary Woods Rate Dollar Dollar Standard Union Agreement Standard 1985-1996 1999 1945 1973-1984

time

The The Spirit international The European of the gold standard The Fixed- Monetary System as European 1879-1913 Rate Dollar a Greater DM Area Monetary Standard, 1979-1998 1950-1970 System 1979 Basic Finance: Money… Marta Wisniewska Monetary System

The international gold standard (1879-1913)

By 1879 all major industrial countries addopted gold standard, no treaty marks the beginning of the international gold standard

Rules of the game: 1. Fix an offical gold price or ‘mint parity’ and allow free convertability between domestic money and gold at the price 2. Impose no restrictions on the import or export of gold by private citizens, or on the use of gold for international transactions 3. Issue national currency and coins only with gold backing, and link the growth in national bank deposits to the availability of national gold reserves 4. In the event of short run liquidity crises associated with gold outflows, the central bank should lend freely to domestic banks at higher interest rates (Bagehot’s Rule) 5. If rule 1 is ever temporarly suspended restore convertibility at the orginal mint parity as soon as practical. 6. As the result the worldwide price level would be endogenously determined based on the overall world demand and supply of gold Basic Finance: Money… Marta Wisniewska Monetary System

The international gold standard (1879-1913)

. stable exchange rates . prices of tradable commodities were equalized across countries . purchasing power parity tend to hold (PLN price * $/Pln= $ price)

llustration of an automatic adjustment to a trade imbalances, as long as contries submit to Rules 1-3.

Suppose country A runs a balance of trade surplus (export exceed imports). Country A exports goods and imports gold from country B. The gold supply in country A expands, while it contracts in country B. Because of Rule 3 international reserves and the money supply expand in country A while they contract in country B. Goods price in country A tend to rise while those in country B tend to fall, which acts to dampen the trade imbalance and stop the flow of gold between countries. Basic Finance: Money… Marta Wisniewska Monetary System

. After WWI imbalances between US and the rest of world, gold reserves in Europe decreesed (as Europe had to pay in gold to US), not enought gold in Europe to sustain the free exchange of the currency to gold

. 1922 conference in Genua

. 1930 BIS was established

. 1936 US, UK and France signed an agreement to maintain stability of main currencies

. WWII brought problems in monetary system: payment problems, end of convertability of currency into gold, lack of stability of exchange rates, Basic Finance: Money… Marta Wisniewska Monetary System

The Spirit of the Bretton Woods Agreemnet, 1945

To set the rules that would permit grater authonomy for national monetary policies. International Monetary Fund (IMF) was established.

Rules of the game: 1. Fix an offical par value for domestic currency in terms of gold or a currency tied to gold as a numeraire. 2. In the short run, keep the exchange rate pegged within 1 percent of its par value, but in the long run leave open the option to adjust the par value unilaterally if the IMF concurs. 3. Permit free convertibility of currencies for current account transactions, but use capital controls to limit currency speculation. 4. Offset short-run balance of payments imbalances by use of official reserves and IMF credits, and sterilize the impact of exchange market interventions on the domestic money supply. 5. Permit national macroeconomic autonomy, each member pursues its own price level and employemnt objectives Basic Finance: Money… Marta Wisniewska

The Role of International Reserves in Exchange Rate Determination Price of sterling D S D” b

c d $2.82 D’ D” S’ a $2.78 f g i j e D’ h S S’ D

Quantity of sterling/Time

Assume demand for GBP falls to D’ following a rise in British prices that makes British goods less attractive to Americans. With the demand for GBP at D’ there is an excess supply of GBP equal to fg at the lower intervention level $2.78/GBP. It is 0.75 percent below the central rate. Since the diagram represents flows per unit of time, the Bank of England must buy up fg pounds each period (at cost of $2.78/GBP *fg GBP) in order to keep the exchange rate from falling to price e. Notice that the Bank of England uses US$ reserves to buy up the excess supply of pounds. Once reserves are depleted and no more can be borrowed, the central bank has no choice but to devaluate (lower the price) its currency.

D”: Bank of England must supply cd pounds per period to keep pound from appreciating (boe is accumulating US$ reserves) Basic Finance: Money… Marta Wisniewska Monetary System The Yen During Bretton Woods

JPY Exchange Rate: 1950 - 1970 361.5

361

360.5

360 Exchange Rate Exchange

359.5

359 1950 1951 1952 1953 1954 1955 1956 1957 1958 1959 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 Basic Finance: Money… Marta Wisniewska Monetary System The Pound During Bretton Woods

GBP Exchange Rate: 1950 - 1970 2.9

2.8

2.7

2.6

2.5

2.4 Exchange Rate Exchange 2.3

2.2

2.1 1950 1951 1952 1953 1954 1955 1956 1957 1958 1959 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 Basic Finance: Money… Marta Wisniewska Monetary System

The Fixed-Rate Dollar Standards, 1950-1970

Rules of the game: Industrial Countries other than the United States: 1. Fix an offical par value for domestic currency in terms of US dollar, and keep the exchange rate within 1 % of this par value indefinitely 2. Permit free convertibility of currencies for current account transactions, use capital controls to insulate domestic financial markets, but begin liberalization 3. Use the U.S. dollar as the intervention currency and keep official reserves in US Treasure bonds 4. Elevate the importance of maintaining the fixed exchange rate; make domestic monetary policy subordinate to this target as well as to the price level of traded goods in the United States 5. Limit current account imbalances by adjusting national fiscal policy (government expenditures minus tax revenues) to offset imbalances between private savings and investment.

United States: 6. Remain passive in the foreign exchange market; practice free trade without a balance of payments or exchange rate target 7. Keep US capital markets open for borrowing and investing by private residents and foreign sovereigns 8. Maintain an international creditor position in dollar-denominated assets, and limit fiscal deficits. 9. Pursue an independent monetary policy that established a stable price level for tradable goods Basic Finance: Money… Marta Wisniewska Monetary System

The Fixed-Rate Dollar Standards, 1950-1970

Redundancy problem: in world with N countries problems arrise because the policy of N-1 of those countries are sufficient to determine the policies of the Nth country (2 country example US and D, there is only one exchange rate, if D sets exchnage rate to 4DM/$ then US must accept 0.25 $/DM). US gold reserves vs US liabilities to foreign insitutions . Triffin dilemma: (1960s) based on US commitment to convert currency into gold st $35 per ounce, the stock of US liabilities held by foreigners would exceed the US gold reserves within next few years . The two-tier market for gold (market price, official price), special drawing right (SDR) introduced as ‘paper gold’ Aug 15, 1971 Nixon announced devaluation of the dollar, changing the offical parity rate to $42 for one ounce of gold. Dec 1971 new set of exchange rate parities and a return to pegging Canadian dollar is floating since June 1970 British pound since June 1972 Since March 1973 all currencies of the major industrial countries were allowed to float against each other Basic Finance: Money… Marta Wisniewska Monetary System The Floating-Rate Dollar Standard, 1973-1984

Rules of the game: Industrial Countries other than the United States: 1. Smooth short-term variability in the dollar exchange rate, but do not commit to an official par value or to long-term exchange rate stability. 2. Permit free convertibility of currencies for current account transactions, while trying to eliminate all remaining restrictions on capital account transactions 3. Use the US dollar as the intervention currency (except for transactions to stabilize European exchange rates) and keep official reserves primarily in US Treasure bonds. 4. Modify domestic monetary policy to support major exchange rate interventions, reducing the money supply when the national currency is weak against the dollar and expanding the money supply when the national currency is strong 5. Set long-run national monetary and price-level targets independently of the United States, let the exchange rate adjust over the long run to offset these differences.

United States: 6. Remain passive in the foreign exchange market; practice free trade without a balance of payments or exchange rate target. No need for sizable official foreign exchange reserves 7. Keep US capital markets open for borrowing and investing by private residents and foreign sovereigns 8. Pursue a monetary policy independent of the exchange rate or policies in other countries, thereby not striving for a common, stable price level (or anchor) for tradable goods. Basic Finance: Money… Marta Wisniewska Monetary System The Floating-Rate Dollar Standard, 1973-1984

In 1974 IMF created a set of guidlines to limit the potential for conflicts regarding exchance rate policies: 1. Have an obligation to intervine to prevent ‘disorderly conditions’ in the foreign exchange market 2. Should avoide manipulating exchange rates to prevent balance of payments adjustment or gain an unfair campetitive advantage in trade 3. Should take into account the ineterest and policies of other members when setting their own intervention policies

Exchange rates were left to the market forces

They were left to play the role of a residual variable that did a great deal of the adjusting to offset the macroeconomic policy differences across countries. Basic Finance: Money… Marta Wisniewska Monetary System The Yen After Bretton Woods Basic Finance: Money… Marta Wisniewska Monetary System The Pound After Bretton Woods Basic Finance: Money… Marta Wisniewska Monetary System The Floating-Rate Dollar Standard, 1973-1984

In 1981 introduction of expansive US fiscal policy combined with tight monetary control started prolonged appreciation of US dollar.

(gov attempts to influence the direction of the economy through changes in government spending or taxes, expansive policy: net increase in government spending G gov spending>T tax, monetary policy attempts to stabilize the economy by controling interest rates and the supply of money)

The problem revealed that: . exchange rates are too important to be left to market forces . exchange rates are too important to be residual from uncoordinated economic policies

as a result a new set of rules was established in 1985 Basic Finance: Money… Marta Wisniewska Monetary System Plaza-Louvre International Accords and the Floating-Rate Dollar Standard, 1985-1996

Rules of the game: Germany, Japan and the United States (G-3) 1. Set broad target zones for the $/DM and $/yen exchnage rates. Do not announce the agreed-upon central rates, and allow for flexible zonal boundries 2. Allow the implicit central rates to adjust when economic fundamentals among the G-3 countries change substantially 3. Central banks intervene collectively but infrequently to reverse short-run exchange rate trends that treaten a zonal boundary. Signal the collective intent by announcing rather than hiding intervention 4. G-3 countries hold reserves in each other’s currencies, for the Unites States, this means building up reserves in deutsche marks, yen, and possibly other convertible currencies 5. Sterilize the immediate impact of exchange market interventions by not adjusting short- term interest rates 6. Each G-3 country aims its monetary policy toward stable prices (measured by domestic consumer or wholesale prices or the GNP deflator), which indirectly anchors the world price level and reduces the drift in exchange rate target zones

Other Industrial Countries: 7. Support or do not oppose interventions by the G-3 to keep the dollar within its target zone limits Basic Finance: Money… Marta Wisniewska Monetary System Plaza-Louvre International Accords and the Floating-Rate Dollar Standard, 1985-1996

The Plaza meeting provided clear signal to markets that the major industrial countries were willing to intervene in a coordinated efford to influence exchange rates.

Feb 22, 1987 Louvre meeting, set a target zones, or exchange rates ranges, that the central banks agreed to defend using active foreign exchange intervention. Basic Finance: Money… Marta Wisniewska Monetary System

The Spirit of the European Monetary System, 1979

To limit exchange rates fluctuations against eachother and to establish coordinated economic policies across Europe Rules of the game: All Member Countries: 1. Fix a par value for each exchange rate in terms of the European Currency Unit, a basket weighted according to country size 2. Keep exchange rates stable in the sort run by limiting movements in bilateral rates to 2.25 percent on either side of the central rate 3. When an exchange rate threatens to breech a bilateral limit, the strong currency central bank must lend freely to the weak-currency central bank to support the exchange rate 4. Adjust the par value in the intermediate term only if necessary to realign national price levels, and only with the collective agreement of other EMS countries 5. Work towards a convergance of national macroeconomic policies that would lead to stable long-run par values for exchange rates 6. Maintain free currency convertibility for current account transactions 7. Hold foreign exchange reserves primarily in ECUs with the European Fund for Monetary Cooperation (EFMC), and reduce US dollar reserves 8. Repay central bank debts quickly from exchange reserves or by borrowing from th EFMC within strict long-term credit limits 9. No single country’s money serves as a reserve currency nor does its national monetary policy serve (asymmetrically) as the nominal price anchor for the group Basic Finance: Money… Marta Wisniewska Monetary System

The Spirit of the European Monetary System, 1979

In March 1979 European Monetary System (EMS) was established.

EMS was build upon 3 blocks: . The European Currency Unit (ECU) . The Exchange Rate Mechanism (ERM) . European Monetary Cooperation Fund (EMCF)

1999 formation of European Economic and Monetary Union (EMU) Basic Finance: Money… Marta Wisniewska The Spirit of the European Monetary System, 1979 The European Currency Unit (ECU) . It is basket currency, defined as a fixed amount of national currencies of the European Union member states. . Basket was first defined in 1979, then redifines in 1984 (to include Greek drachma), revised in 1989 (Spanish peseta, Portugese escudo), Mastricht Treaty brought futher revision of ECU . On 1 Jan 1999 euro replaced ECU on one-for-one basis

Country CurrencyDenmark Basket Amount at Sept 21, 1989 Germany DM 0.6242 France FFr 1.332 Uk Pound 0.08784 Netherlands Guilder 0.2198 Belgium BFr 3.301 Italy Lira 151.8

Spain Peseta 6.885 Denmark Krone 0.1976 Portugal Escudo 1.393 Ireland Irish Pound 0.00855 Luxembourg LFr 0.13 Greece Drachma 0.1976 Basic Finance: Money… Marta Wisniewska Monetary System European Monetary System as a ‘Greater DM’ Area, 1979-1998

Rules of the game: All Member Countries: 1. Through 5. as in the „Spirit of the Treaty’ 6. Avoide using the credit facilities of the EFMC

Member Countries except Germany 7. Intervene inside the formal bilateral parity banks to stabilize currency values vis-a- vis the deutsch mark (DM). Intervene in DM rather than in US dollars 8. Keep exchange reserves in DM instruments as well as in US Treasury bonds 9. Adjust national monetary growth and short-term interest rates to support exchange market interventions 10. Subordinate national monetary policy so that long-term price inflation converges to or remains the same as that in Germany 11. Continue to liberalize capital controls

Germany 12. Remain passive in the foreign exchange market with respect to other EMS countries 13. Keep German capital markets open for borrowing and investing by foreign residents and sovereigns 14. Sterilize the effect of official intervention on the German monetary policy 15. Set German monetary policy independently to serve as an anchor for the EMS price level Basic Finance: Money… Marta Wisniewska Monetary System European Monetary System as a ‘Greater DM’ Area, 1979-1998

The EMS Crisis of 1992-1993

Dec 1991 Draft of Mastricht Treaty . rejected by Denmark . speculation attacts Basic Finance: Money… Marta Wisniewska Monetary System The Spirit of the European Economic and Monetary Union, 1999

Rules of the game: The ‘In countries’ (EU countries taking part in EMU) 1. Offer admission to only those EU countries that meet the five convergence criteria on budget deficit, total public debt, inflation, long-term interest rates, and ERM membership without devaluation for two years 2. Fix a final conversion rate for exchanging old ‘legacy currencies’ for the new surviving currecny, the euro 3. Establish a new European central bank that is independent from national governmants and community institutions. The European Central Bank (ECB) has sole responsibility fr monetary policy among EMU countries. The primary objective of the ECB is price stability across EMU countries. 4. National central banks no longer have any monetary policy authority, but continue in existance to form (along with ECB) a European System of Central Banks (ESCB) intended for regulation and monitoring EMU financial institutions 5. National governments retain independence over other economic policies such as taxation and government expenditures, but within a set of commonly agreed rules (the Stability and Growth Pact) 6. The euro replaces DM as the principal currency of Europe. The euro acquires a greater role as an international reserve currency 7. The ECB allows the euro to float against the US$ and Yen Basic Finance: Money… Marta Wisniewska Monetary System

The Spirit of the European Economic and Monetary Union , 1999

Rules of the game: The ‘Out Countries’ (EU countries Not Initially Taking Part in EMU) 8. „Out countries’ retain their national currencies. Hovever, these countries are to take part in the new Exchange Rate Mechanism where by their currencies are permitted to fluctuate with a bank 15 % either side of a central rate against euro. Participation in the new ERM-2 is voluntary 9. „Out countries’ are encouraged to orient their policies towards stability and covergance withthe euro area, to limit foreign exchange pressures versus the euro and to promote their eventual membership in EMU. Basic Finance: Money… Marta Wisniewska Monetary System

Exchange Rate Regimes

Fixed or pegged ex Floating (Flexible) rates ex rates would work like a gold the ex rates are standard determined by the market forces of To keep their prices demand and supply fixed, countries have to buy or sell their currencies in FX market No intervention takes (FX market Intervention) place Basic Finance: Money… Marta Wisniewska

Exchange Rate Regimes

. Fixed Peg: The ex rate is fixed against a major currency. Active intervention needed. . Crawling Peg: The ex rate is adjusted periodically in small amounts at a fixed, preannounced rate. . Dollarization: The dollar circulates as the legal tender. . Currency Board: A legislative commitment to exchange domestic currency for a specified foreign currency at a fixed ex rate. Basic Finance: Money… Marta Wisniewska

Exchange Rate Regimes

. Managed Floating: MA influences ex rates through active FX market intervention . (Independently) Floating: the ex rate is market determined. No FX intervention. Basic Finance: Money… Marta Wisniewska Distribution of EM exchange rate regimes The biggest rise is in the “managed float” category

Distribution of Exchange Rate Regimes in Emerging Markets, 1980-2011 (percent of total) }

Atish Rex Ghosh, Jonathan Ostry & Mahvash Qureshi, 2013, “Exchange Rate Management and Crisis Susceptibility: A Reassessment,” International Monetary Fund Annual Research Conference, Nov.. Basic Finance: Money… Marta Wisniewska

Exchange Rate Regimes Advantages of Flexible rates

. Each country can produce independent macroeconomic policies. . Countries can choose different inflation rates. Basic Finance: Money… Marta Wisniewska

Exchange Rate Regimes Advantages of Fixed rates

. Stable ex rates . Each country’s inflation rate is “anchored” to the inflation rate in the US.  price stability Basic Finance: Money… Marta Wisniewska

Exchange Rate Regimes Disadvantage of Flexible rates

. The system is subject to destabilizing speculation . Increase the variability of ex rates . Self-fulfilling prophecy . “evening out” swings in ex rates Basic Finance: Money… Marta Wisniewska

Exchange Rate Regimes Disadvantage of Fixed rates

. A country cannot follow macroeconomic policies independent of those of other countries.

. To maintain the fixed rates, countries need to share a common inflation experience. Basic Finance: Money… Marta Wisniewska

Exchange Rate Regimes Choice of Peg or Float

Peg Float . Small size (GDP) . Large size . Open economy . Closed economy . Divergent . Harmonious inflation rate inflation rate . Diversified trade . Concentrated trade Basic Finance: Money… Marta Wisniewska

Exchange Rate Regimes Choice of Peg or Float Basic Finance: Money… Marta Wisniewska

Future:

To Create Multiple System of International Reserve Money and Reduce Monetary Dependence on the Dollar

. To stabilize the Euro (?)

. Bitcoin Basic Finance: Money… Marta Wisniewska

. Money

. Money Creation

. Monetary Systems

. Exchange Rates Regimes 3. Central Banks and Banking System Basic Finance: Central Banks… Marta Wisniewska

. Banks

. Central Bank . Monetary Policy

. Commercial Banks

. Banking System Basic Finance: Central Banks… Marta Wisniewska Banks What is a Bank?

A banker or bank is a financial institution whose primary activity is (1)to act as a payment agent for customers and (2)to borrow and lend money.

Banks are responsible for: . transfer in time/ maturity . e.g. sort term deposits vs. long term loans . transfer of risk . througt diversification: loans to many customers Basic Finance: Central Banks… Marta Wisniewska Banks What is a Bank?

The first modern bank was founded in Italy in Genoa in 1406, its name was Banco di San Giorgio (Bank of St. George).

Historically, the primary purpose of a bank was to provide loans to trading companies. Banks provided funds to allow businesses to purchase inventory, and collected those funds back with interest when the goods were sold.

For centuries, the banking industry only dealt with businesses, not consumers. Banking services have expanded to include services directed at individuals, and risk in these much smaller transactions are pooled. Basic Finance: Central Banks… Marta Wisniewska

Banks can perform this Banks transformation function because they become What is a Bank? experts at risk assessment, financial contracting (pricing the risk) and monitoring the The deposits are activities of borrowers. ‘pooled’ in the Bank

B A N K

The bank takes these pooled funds Banks take deposits and lends them out to households from numerous and businesses in the form of depositors mortgages and loans

On the basis of creation of money: . Central Bank . Commercial Bank

On the basis of Function: . Investment Bank . Saving Bank . Consumer Bank . Exchange Bank . Mortgage Bank . Cooperative Banks Basic Finance: Central Banks… Marta Wisniewska Central Bank History In Europe prior to the 17th century most money was commodity money, typically gold or silver.

However, promises to pay were widely circulated and accepted as value at least five hundred years earlier in both Europe and Asia.

The medieval European Knights Templar ran probably the best known early prototype of a central banking system, as their promises to pay were widely regarded, and many regard their activities as having laid the basis for the modern banking system.

At about the same time, Kublai Khan of the Mongols introduced fiat currency to China, which was imposed by force. Basic Finance: Central Banks… Marta Wisniewska Central Bank History

The oldest central bank in the world is the Riksbank in Sweden, which was opened in 1668 with help from Dutch businessmen.

This was followed in 1694 by the Bank of England, created by Scottish businessman William Paterson in the City of London at the request of the English government to help pay for a war.

The US Federal Reserve was created by the U.S. Congress through the passing of the Glass-Owen Bill, signed by President Woodrow Wilson on December 23, 1913. Basic Finance: Central Banks… Marta Wisniewska Central Bank

Central bank (reserve bank, or monetary authority) is the entity responsible for the monetary policy of a country or of a group of member states.

Its primary responsibility is to maintain the stability of the national currency and money supply. Basic Finance: Central Banks… Marta Wisniewska Central Bank Functions*

implementation of monetary policy

controls the nation's entire money supply

the Government's banker and the bankers' bank ("Lender of Last Resort")

manages the country's foreign exchange and gold reserves and the Government's stock register

regulation and supervision of the banking industry

setting the official interest rate - used to manage both inflation and the country's exchange rate - and ensuring that this rate takes effect via a variety of policy mechanisms

* not all functions are carried out by all banks Basic Finance: Central Banks… Marta Wisniewska Monetary Policy

Monetary policy is the process by which the government, central bank, or monetary authority of a country controls:

. the supply of money, . availability of money, . and cost of money or rate of interest, in order to attain a set of objectives oriented towards the growth and stability of the economy. Basic Finance: Central Banks… Marta Wisniewska Monetary Policy

Main monetary policy instruments available to central banks are:

. open market operation

. bank reserve requirement

. interest rate policy

. re-lending and re-discount (including using the term repurchase market)

. credit policy (often coordinated with trade policy)

While capital adequacy is important, it is defined and regulated by the Bank for International Settlements, and central banks in practice generally do not apply stricter rules. Basic Finance: Central Banks… Marta Wisniewska Monetary Policy

Through open market operations, a central bank influences the money supply in an economy directly.

Each time it buys securities, exchanging money for the security, it raises the money supply.

Conversely, selling of securities lowers the money supply.

Buying of securities thus amounts to printing new money while lowering supply of the specific security. Basic Finance: Central Banks… Marta Wisniewska Monetary Policy

The main open market operations are:

. Temporary lending of money for collateral securities (“reverse operations" or "repurchase operations", otherwise known as the "repo" market). These operations are carried out on a regular basis, where fixed maturity loans (of 1 week and 1 month for the ECB) are auctioned off.

. Buying or selling securities ("direct operations") on ad-hoc basis.

. Foreign exchange operations such as forex swaps.

All of these interventions can also influence the foreign exchange market and thus the exchange rate Basic Finance: Central Banks… Marta Wisniewska Monetary Policy

Another significant power that central banks hold is the ability to establish reserve requirements for other banks.

By requiring that a percentage of liabilities be held as cash or deposited with the central bank (or other agency), limits are set on the money supply.

The capital requirement is a bank regulation, which sets a framework on how banks and depository institutions must handle their capital. The categorization of assets and capital is highly standardized so that it can be risk weighted. => Basel II

All banks are required to hold a certain percentage of their assets as capital, a rate which may be established by the central bank or the banking supervisor. Basic Finance: Central Banks… Marta Wisniewska Monetary Policy

Basel I: Tier I capital (core capital): shareholders equity amound originally paid to purchase the stocks, retained profits, substracting accumulated losses

Tier 2 capital (supplementary capital): undisclosed reserves, revaluation reserves, general provisions, hybrid instrumnets, subordinated term debt

Most countries set lending limits as a multiply of a banks capital adjusted to inflation

Basel II: 3 philars: minimum capital requirements; supervisory review; market discipline (bank disclosure) Basic Finance: Central Banks… Marta Wisniewska Monetary Policy

USA: 10% on transaction deposits (M1), 0 on time deposits UK: non, but in reality it is 3,1% Eurozone: 2%

Cash reserves ration over time:

Country 1968 1978 1988 1998 UK 20.5 15.9 5 3.1 Germany 19 19.3 17.2 11.9 USA 12.3 10.1 8.5 10.3 Basic Finance: Central Banks… Marta Wisniewska Monetary Policy

Typical central bank has several interest rates or monetary policy tools it can set to influence markets. . Marginal Lending Rate: a fixed rate for institutions to borrow money from the CB.(In the US this is called the Discount rate). . Main Refinancing Rate: the publicly visible interest rate the central bank announces. It is also known as Minimum Bid Rate and serves as a bidding floor for refinancing loans. (In the US this is called the Federal funds rate). . Deposit Rate: the rate parties receive for deposits at the CB.

These rates directly affect the rates in the money market, the market for short term loans.

The mechanism to move the market towards a 'target rate' (whichever specific rate is used) is generally to lend money or borrow money in theoretically unlimited quantities, until the targeted market rate is sufficiently close to the target. Central banks may do so by lending money to and borrowing money from (taking deposits from) a limited number of qualified banks, or by purchasing and selling bonds. As an example of how this functions, the Bank of Canada sets a target overnight rate, and a band of plus or minus 0.25%. Qualified banks borrow from each other within this band, but never above or below, because the central bank will always lend to them at the top of the band, and take deposits at the bottom of the band. The target rates are generally short-term rates. Basic Finance: Central Banks… Marta Wisniewska Commercial Banks

The role of commercial banks: . issue of banknotes (promissory notes issued by a banker and payable to bearer on demand) . processing of payments by way of telegraphic transfer, EFTPOS, internet banking or other means . issuing bank drafts and bank cheques . accepting money on term deposit . lending money by way of overdraft, installment loan or otherwise . providing documentary and standby letters of credit (trade finance), guarantees, performance bonds, securities underwriting commitments and other forms of off balance sheet exposures . safekeeping of documents and other items in safe deposit boxes . currency exchange . sale, distribution or brokerage, with or without advice, of insurance, unit trusts and similar financial products as a 'financial supermarket' Basic Finance: Central Banks… Marta Wisniewska Banking System

Separated Universal banking banking system system (Germany, Japan) (historically: UK, USA- Glass-Steagall Act of 1933) Basic Finance: Central Banks… Marta Wisniewska

. Banks

. Central Bank . Monetary Policy

. Commercial Banks

. Banking System Practical Questions: Time value of money Basic Finance: PQ 1: Time Value … Marta Wisniewska

. Time value of money

. Future Value (FV), Present Value(PV) . Types of Interest Rates/ Compounding . Annuity, Perpetuity

. Applications Basic Finance: PQ 1: Time Value … Marta Wisniewska Time Value of Money

Which would you prefer:

(a)$ 10 000 today

(b) $ 10 000 in 5 years time? Basic Finance: PQ 1: Time Value … Marta Wisniewska

Time Value of Money

Reasons why a cash flow in the future is worth less than a similar cash flow today:

. Individuals prefer present consumption to future consumption. People would have to be offered more in the future to give up present consumption.

. When there is monetary inflation, the value of currency decreases over time. The greater the inflation, the greater the difference in value between a cash flow today and the same cash flow in the future.

. Any uncertainty (risk) associated with the cash flow in the future reduces the value of the cashflow. A promised cash flow might not be delivered for a number of reasons: the promisor might default on the payment, the promisee might not be around to receive payment; or some other contingency might intervene to prevent the promised payment or to reduce it. Basic Finance: PQ 1: Time Value … Marta Wisniewska Time Value of Money

The process by which future cash flows are adjusted to reflect these factors is called discounting, and the magnitude of these factors is reflected in the discount rate.

t=0 t=5 Present value (PV) Future value (FV)

? $10 000 < $10 000 Basic Finance: PQ 1: Time Value … Marta Wisniewska Time Value of Money

Cash flows at different points in time cannot be compared and aggregated.

All cash flows have to be brought to the same point in time before comparisons and aggregations can be made. Basic Finance: PQ 1: Time Value … Marta Wisniewska Types of Interest

. Simple Interest Interest paid (earned) on only the original amount, or principal, borrowed (lent).

. Compound Interest Interest paid (earned) on any previous interest earned, as well as on the principal borrowed (lent). Basic Finance: PQ 1: Time Value … Marta Wisniewska Simple Interest

If P = principal, r = annual interest rate, and t = time (in years),

then the simple interest I is given by I = Prt. Basic Finance: PQ 1: Time Value … Marta Wisniewska Simple Interest

Assume that you deposit $4,800 in an account earning 7% simple interest for 6 months. What is the interest at the end of the 6th month?

I = P(r)(t)

= $4,800(.07)(6/12)

= $168 Basic Finance: PQ 1: Time Value … Marta Wisniewska Simple Interest

What is the Future Value (FV) of the deposit?

FV = P + I = $4,800 + $168 = $4,968

Future Value is the value at some future time of a present amount of money, or a series of payments, evaluated at a given interest rate. Basic Finance: PQ 1: Time Value … Marta Wisniewska Simple Interest

What is the Present Value (PV) of the previous problem?

The Present Value is simply the $4,800 you originally deposited. That is the value today!

Present Value is the current value of a future amount of money, or a series of payments, evaluated at a given interest rate. Basic Finance: PQ 1: Time Value … Marta Wisniewska Compound Interest

If P = principal

Rm = annual interest rate compounded m times a year and n = number of periods of time

then the FVn is given by

푅 푚푛 퐹푉 = 푃 1 + 푚 푛 푚 Basic Finance: PQ 1: Time Value … Marta Wisniewska Compound Interest Basic Finance: PQ 1: Time Value … Marta Wisniewska Compound Interest

Continuous compounding

As m → ∞ :

푅푐푛 퐹푉푛 = 푃 푒

where:

Rc is the annual interest rate n is time period (expressed as a fraction of year) Basic Finance: PQ 1: Time Value … Marta Wisniewska Types of Interest

Value of 1 GBP years annual semi quarter month continous 5% interest rate 0.05 0.050625 0.050945 0.051162 0.051271 1 1.05 1.050625 1.050945 1.051162 1.051271 5 1.276282 1.280085 1.282037 1.283359 1.284025 10 1.628895 1.638616 1.643619 1.647009 1.648721 15 2.078928 2.097568 2.107181 2.113704 2.117 20 2.653298 2.685064 2.701485 2.71264 2.718282 25 3.386355 3.437109 3.463404 3.48129 3.490343 30 4.321942 4.39979 4.440213 4.467744 4.481689 10% interest rate 0.1 0.1025 0.103813 0.104713 0.105171 1 1.1 1.1025 1.103813 1.104713 1.105171 5 1.61051 1.628895 1.638616 1.645309 1.648721 10 2.593742 2.653298 2.685064 2.707041 2.718282 15 4.177248 4.321942 4.39979 4.45392 4.481689 20 6.7275 7.039989 7.209568 7.328074 7.389056 25 10.83471 11.4674 11.81372 12.05695 12.18249 30 17.4494 18.67919 19.35815 19.8374 20.08554 Basic Finance: PQ 1: Time Value … Marta Wisniewska Types of Interest Basic Finance: PQ 1: Time Value … Marta Wisniewska Types of Cash Flows

. Simple cash flows

. Perpetuities

. Growing perpetuities

. Annuities

. Growing annuities Basic Finance: PQ 1: Time Value … Marta Wisniewska Simple Cash Flow

A simple cash flow is a single cash flow in a specified future time period; it can be depicted on a time line:

CFt

0 t

where CFt = the cash flow at time t.

This cash flow can be discounted back to the present using a discount rate that reflects the uncertainty of the cash flow. Concurrently, cash flows in the present can be compounded to arrive at an expected future cash flow. Basic Finance: PQ 1: Time Value … Marta Wisniewska Simple Cash Flow

The present value (PV) of a cash flow (CFt):

Compounding m times a year:

푪푭 푹 −풎풏 푷푽 = 풕 = 푪푭 ퟏ + 풎 푹 풎풏 풕 풎 ퟏ + 풎 풎

Continuous compounding: −풓풏 푷푽 = 푪푭풕풆 where

CFt = Cash Flow at the end of time period t

Other things remaining equal, the present value of a cash flow will decrease as the discount rate increases and continue to decrease the further into the future the cash flow occurs. Basic Finance: PQ 1: Time Value … Marta Wisniewska Perpetuity

A perpetuity is a constant cash flow (CF) at regular intervals forever.

The present value of a perpetuity can be written as

푪푭 푷푽 풐풇 푷풆풓풑풆풕풖풊풕풚 = 풓 Basic Finance: PQ 1: Time Value … Marta Wisniewska Perpetuity

Example: Valuing a Console Bond

A console bond is a bond that has no maturity and pays a fixed coupon. Assume that you have a 6% coupon console bond.

The value of this bond, if the interest rate is 9%, is as follows:

Value of Console Bond = $60 / .09 = $667

The value of a console bond will be equal to its face value (which is usually $1000) only if the coupon rate is equal to the interest rate. Basic Finance: PQ 1: Time Value … Marta Wisniewska Growing Perpetuity

A growing perpetuity is a cash flow that is expected to grow at a constant rate forever.

The present value of a growing perpetuity can be written as:

퐶퐹 푃푉 표푓 퐺푟표푤𝑖푛푔 푃푒푟푝푒푡푢𝑖푡푦 = 1 푟−푔

where CF1 is the expected cash flow next year, g is the constant growth rate and r is the discount rate.

The fact that a growing perpetuity lasts forever puts constraints on the growth rate. It has to be less than the discount rate for this formula to work. Basic Finance: PQ 1: Time Value … Marta Wisniewska Growing Perpetuity

Example: Valuing a Stock with Stable Growth in Dividends In 1992, Southwestern Bell paid dividends per share of $2.73. Its earnings and dividends had grown at 6% a year between 1988 and 1992 and were expected to grow at the same rate in the long term. The rate of return required by investors on stocks of equivalent risk was 12.23%. Current Dividends per share = $2.73 Expected Growth Rate in Earnings and Dividends = 6% Discount Rate = 12.23%

Value of Stock = $2.73 *1.06 / (.1223 -.06) = $46.45

As an interesting aside, the stock was actually trading at $70 per share. This price could be justified by using a higher growth rate. The value of the stock is graphed in figure 3.7 as a function of the expected growth rate.

The growth rate would have to be approximately 8% to justify a price of $70. This growth rate is often referred to as an implied growth rate. Basic Finance: PQ 1: Time Value … Marta Wisniewska Annuity

An annuity is a constant cash flow that occurs at regular intervals for a fixed period of time.

Defining A to be the annuity, the time line for an annuity may be drawn as follows:

$10 $10 $10 $10 $10

0 1 2 3 4 5

An annuity can occur at the end of each period, as in this time line, or at the beginning of each period. Basic Finance: PQ 1: Time Value … Marta Wisniewska Annuity

The present value of an annuity can be calculated by taking each cash flow and discounting it back to the present and then adding up the present values.

Alternatively, a formula can be used in the calculation. In the case of annuities that occur at the end of each period, this formula can be written as:

1 1 − 1 + 푟 푛 푃푉 표푓 푎푛 퐴푛푛푢𝑖푡푦 = 푃푉 퐴, 푟, 푛 = 퐴 푟

where A = Annuity r = Discount Rate n = Number of years the present value of an annuity will be PV(A,r,n). Basic Finance: PQ 1: Time Value … Marta Wisniewska Annuity

An annuity vs. a difference between 2 perpetuities

퐶퐹 1 $10 $10 $10 $10 $10 1 − 푟 1 + 푟 푛 0 1 2 3 4 5

$10 $10 $10 $10 $10 $10 $10 퐶퐹 푟 0 1 2 3 4 5 6 7

$10 $10 퐶퐹 1 0 1 2 3 4 5 6 7 푟 1 + 푟 푛

Since the cash flows are the same, the values must be the same Basic Finance: PQ 1: Time Value … Marta Wisniewska Annuity

Example: Estimating the Present Value of Annuity

Assume that you are the owner of Compnay X, and that you have a choice of buying a copier for $10,000 cash down or paying $ 3,000 a year for 5 years for the same copier. If the opportunity cost is 12%, which would you rather do?

1 1 − 1 + 0.12 5 푃푉 표푓 $3000 푒푎푐ℎ 표푓푟 푛푒푥푡 5 푦푒푎푟 = $3000 = $10,814 0.12

The present value of the installment payments exceeds the cash- down price; therefore, you would want to pay the $10,000 in cash now. Basic Finance: PQ 1: Time Value … Marta Wisniewska Annuity

Alternatively, the present value could have been estimated by discounting each of the cash flows back to the present and aggregating the present values as illustrated below: Basic Finance: PQ 1: Time Value … Marta Wisniewska Annuity

Example : Present Value of Multiple Annuities Suppose you are the pension fund consultant and that you are trying to estimate the present value of the expected pension obligations, which amount in nominal terms to the following: Years Annual Cash Flow 1 - 5 $ 200.0 million 6 - 10 $ 300.0 million 11 - 20 $ 400.0 million If the discount rate is 10%, the present value of these three annuities can be estimated as follows:

Present Value of 1st annuity = $ 200 million * PV (A, 10%, 5) = $ 758 million Present Value of 2nd annuity = $ 300 million * PV (A,10%,5) / 1.105 = $ 706 million Present Value of 3rd annuity = $ 400 million * PV (A,10%,10) / 1.1010 = $ 948 million

The present values of the second and third annuities can be estimated in two steps: . First, the standard present value of the annuity is computed over the period that the annuity is received. . Second, that present value is brought back to the present.

Thus, for the second annuity, the present value of $ 300 million each year for 5 years is computed to be $1,137 million; this present value is really as of the end of the fifth year. It is discounted back 5 more years to arrive at today’s present value which is $ 706 million. Cumulated Present Value = $ 758 million+$706 million+$948 million = $2,412 million Basic Finance: PQ 1: Time Value … Marta Wisniewska Annuity

In some cases, the present value of the cash flows is known and the annuity needs to be estimated.

This is often the case with home and automobile loans, for example, where the borrower receives the loan today and pays it back in equal monthly installments over an extended period of time.

This process of finding an annuity when the present value is known is examined below

푟 퐴푛푛푢𝑖푡푦 푔𝑖푣푒푛 푃푟푒푠푒푛푡 푉푎푙푢푒 = 푃푉 1 1 − 1 + 푟 푛 Basic Finance: PQ 1: Time Value … Marta Wisniewska Annuity

Example: Calculating The Monthly Payment On A House Loan

Suppose you are trying to borrow $200,000 to buy a house on a conventional 30-year mortgage with monthly payments. The annual percentage rate on the loan is 8%. The monthly payments on this loan can be estimated using the annuity due formula:

Monthly interest rate on loan = APR/ 12 = 0.08/12 = 0.0067

0.0067 푀표푛푡ℎ푙푦 푃푎푦푚푒푛푡 표푛 푀표푟푡푔푎푔푒 = $200,000 = $1473.11 1 1 − 1 + 0.0067 360

This monthly payment is an increasing function of interest rates. When interest rates drop, homeowners usually have a choice of refinancing, though there is an up-front cost to doing so. Basic Finance: PQ 1: Time Value … Marta Wisniewska

Applications Basic Finance: PQ 1: Time Value … Marta Wisniewska

Question 1:

You must decide between $25,000 in cash today or $30,000 in cash to be received two years from now. If you can earn 8% interest on your investments, which is the better deal? Basic Finance: PQ 1: Time Value … Marta Wisniewska

Question 2:

What is the value of $100 per year for four years, with the first cash flow one year from today, if one is earning 5% interest, compounded annually? Find the value of these cash flows four years from today. Basic Finance: PQ 1: Time Value … Marta Wisniewska

Question 3:

What is today’s value of a $1,000 face value bond with a 5% coupon rate (interest is paid semi-annually) which has three years remaining to maturity. The bond is priced to yield 8% Basic Finance: PQ 1: Time Value … Marta Wisniewska

Question 4:

You have an expected liability (cash outflow) of $500,000 in 10 years, and you use a discount rate of 10%. a. How much would you need right now as savings to cover the expected liability? b. How much would you need to set aside at the end of each year for the next 10 years to cover the expected liability? Basic Finance: PQ 1: Time Value … Marta Wisniewska

Question 5:

You are examining whether your savings will be adequate to meeting your retirement needs. You saved $1500 last year, and you expect your annual savings to grow 5% a year for the next 15 years. If you can invest your money at 8%, how much would you expect to have at the end of the fifteenth year? Basic Finance: PQ 1: Time Value … Marta Wisniewska

Question 6:

You have just taken a 30-year mortgage loan for $200,000. The annual percentage rate on the loan is 8%, and payments will be made monthly. Estimate your monthly payments. Basic Finance: PQ 1: Time Value … Marta Wisniewska

Question 7:

You are planning to buy a car worth $20,000. Which of the two deals described below would you choose: . the dealer offers to take 10% off the price, and lend you the balance at the regular financing rate (which is an annual percentage rate of 9%) . the dealer offers to lend you $20,000 (with no discount) at a special financing rate of 3% Basic Finance: PQ 1: Time Value … Marta Wisniewska

Question 8:

A company is planning to set aside money to repay $100 million in bonds that will be coming due in 10 years. If the appropriate discount rate is 9%, a. how much money would the company need to set aside at the end of each year for the next 10 years to be able to repay the bonds when they come due? b. how would your answer change if the money were set aside at the beginning of each year? Basic Finance: PQ 1: Time Value … Marta Wisniewska

Question 9:

What is the value of 15-year corporate bonds, with a coupon rate of 9%, if current interest rates on similar bonds is 8%? How much would the value change if interest rates increased to 10%? Under what conditions will this bond trade at par (face value)? Basic Finance: PQ 1: Time Value … Marta Wisniewska

Question 10:

What is the value of stock in a company that currently pays out $1.50 per share in dividends and expects these dividends to grow 6% a year forever? (You can assume that investors require a 13% return on stocks of equivalent risk.) Basic Finance: PQ 1: Time Value … Marta Wisniewska

Question 11:

What is the value of stock in a company that currently pays out $1.00 per share in dividends, and expects these dividends to grow 15% a year for the next 5 years, and 6% a year forever after that? (You can assume that investors require a 12.5% return on stocks of equivalent risk and that the dividend payout ratio will double after the fifth year.) Basic Finance: PQ 1: Time Value … Marta Wisniewska

Question 12:

You buy a 10-year zero-coupon bond, with a face value of $1000, for $300. What is the rate of return you will make on this bond? Basic Finance: PQ 1: Time Value … Marta Wisniewska

Question 13:

You are reviewing an advertisement by a finance company offering loans at an annual percentage rate of 9%. If the interest is compounded weekly, what is the effective interest rate on this loan? Basic Finance: PQ 1: Time Value … Marta Wisniewska

Question 14:

You have an relative who has accumulated savings of $ 250,000 over his working lifetime and now plans to retire. Assuming that he wishes to withdraw equal instalments from these savings for the next 25 years of this life, how much will each instalment amount to if he is earning 5% on his savings? Basic Finance: PQ 1: Time Value … Marta Wisniewska

Question 15:

You are offered a special set of annuities by your insurance company, whereby you will receive $20,000 a year for the next 10 years and $30,000 a year for the following 10 years. How much would you be willing to pay for these annuities, if your discount rate is 9% and the annuities are paid at the end of each year? How much would you be willing to pay if they were at the beginning of each year? Basic Finance: PQ 1: Time Value … Marta Wisniewska

Question 16:

A bill that is designed to reduce the nation's budget deficit passes both houses of legislature. Congress tells us that the bill will reduce the deficit by $500 billion over 10 years. What it does not tell us is the timing of the reductions. Year Deficit Reduction 1 $ 25 Billion 2 $ 30 Billion 3 $ 35 Billion 4 $ 40 Billion 5 $ 45 Billion 6 $ 55 Billion 7 $ 60 Billion 8 $ 65 Billion

If the federal government can borrow at 8%, what is the true deficit reduction in the bill? Basic Finance: PQ 1: Time Value … Marta Wisniewska

Question 17:

New York State has a pension fund liability of $25 billion, due in 10 years. Each year the legislature is supposed to set aside an annuity to arrive at this future value. This annuity is based on what the legislature believes it can earn on this money. a. Estimate the annuity needed each year for the next 10 years, assuming that the interest rate that can be earned on the money is 6%. b. The legislature changes the investment rate to 8% and recalculates the annuity needed to arrive at the future value. It claims the difference as budget savings this year. Do you agree? Basic Finance: PQ 1: Time Value … Marta Wisniewska Question 18:

Mr X is making the following amounts for the next 5 years:

Year Amount

0 (now) $ 5.5 million (Sign up Bonus)

1 $ 4 million 2 $ 4 million 3 $ 4 million 4 $ 4 million 5 $ 7 million a. Assuming that Mr X can make 7% on his investments, what is the present value of his contract? b. If you wanted to raise the nominal value of his contract to $30 million, while preserving the present value, how would you do it? (You can adjust only the sign up bonus and the final year's cash flow.) Basic Finance: PQ 1: Time Value … Marta Wisniewska

Question 20:

You bought a house a year ago for $250,000, borrowing $200,000 at 10% on a 30-year term loan (with monthly payments). Interest rates have since come down to 9%. You can refinance your mortgage at this rate, with a closing cost that will be 3% of the loan. Your opportunity cost is 8%. Ignore tax effects. a. How much are your monthly payments on your current loan (at 10%)? b. How would your monthly payments be if you could refinance your mortgage at 9% (with a 30-year term loan)? c. You plan to stay in this house for the next 5 years. Given the refinancing cost (3% of the loan), would you refinance this loan? d. How much would interest rates have to go down before it would make sense to refinance this loan (assuming that you are going to stay in the house for five years)? Basic Finance: PQ 1: Time Value … Marta Wisniewska

Question 21:

You are 35 years old today and are considering your retirement needs. You expect to retire at age 65 and your actuarial tables suggest that you will live to be 100. You want to move to the Bahamas when you retire. You estimate that it will cost you $ 300,000 to make the move (on your 65th birthday) and that your living expenses will be $30,000 a year (starting at the end of year 66 and continuing through the end of year 100) after that. a. How much will you need to have saved by your retirement date to be able to afford this course of action? b. You already have $50,000 in savings. If you can invest money, tax-free, at 8% a year, how much would you need to save each year for the next 30 years to be able to afford this retirement plan? c. If you did not have any current savings and do not expect to be able to start saving money for the next 5 years, how much would you have to set aside each year after that to be able to afford this retirement plan? Basic Finance: PQ 1: Time Value … Marta Wisniewska

Question 22:

You have been hired to run a pension fund for TelDet Inc, a small manufacturing firm. The firm currently has $5 million in the fund and expects to have cash inflows of $2 million a year for the first 5 years followed by cash outflows of $ 3 million a year for the next 5 years. Assume that interest rates are at 8%. a. How much money will be left in the fund at the end of the tenth year? b. If you were required to pay a perpetuity after the tenth year (starting in year 11 and going through infinity) out of the balance left in the pension fund, how much could you afford to pay? Basic Finance: PQ 1: Time Value … Marta Wisniewska

Question 23:

You are an investment advisor who has been approached by a client for help on his financial strategy. He has $250,000 in savings in the bank. He is 55 years old and expects to work for 10 more years, making $100,000 a year. (He expects to make a return of 5% on his investments for the foreseeable future. You can ignore taxes) a. Once he retires 10 years from now, he would like to be able to withdraw $80,000 a year for the following 25 years (his actuary tells him he will live to be ninety years old.). How much would he need in the bank 10 years from now to be able to do this? b. How much of his income would he need to save each year for the next 10 years to be able to afford these planned withdrawals ($80,000 a year) after the tenth year? c. Assume that interest rates decline to 4% 10 years from now. How much, if any, would you client have to lower his annual withdrawal by, assuming that he still plans to withdraw cash each year for the next 25 years? Basic Finance: PQ 1: Time Value … Marta Wisniewska

Question 24:

You have been asked to estimate the value of a 10-year bond with a coupon that will be low initially but it is expected to grow later in the bonds life. The coupon is expected to be 5% of the face value of the bond (which is $ 1000) for the first 5 years, and will increase by 1% every year for the next 5 years ñ the coupon rate will be 6% in year 6, 7% in year 7, 8% in year 8, 9% in year 9 and 10% in year 10. Estimate the value of this bond. Basic Finance: PQ 1: Time Value … Marta Wisniewska

Question 25:

You are trying to assess the value of a small retail store that is up for sale. The store generated a cash flow to its owner of $ 100,000 in the most year of operation, and is expected to have growth of about 5% a year in perpetuity. . If the rate of return required on this store is 10%, what would your assessment be of the value of the store? . What would the growth rate need to be to justify a price of $ 2.5 million for this store? Class 2:

(4)Introduction to Portfolio Theory (5)Introduction to Investments

PQ 2: Risk and return 4. Modern Portfolio Theory: Introduction Basic Finance: Modern… Marta Wisniewska

. Types of securities . Risk and Return . Diversification . Capital Asset Pricing Model(CAPM) Basic Finance: Modern… Marta Wisniewska Securities

What are securities?

Definition: a legal representation of the right to received prospective future benefits under stated conditions. Basic Finance: Modern… Marta Wisniewska Securities

. There are two major categories of financial securities: . Debt Instruments . Commercial paper . Bankers’ acceptances . Treasury bills . Mortgage loans . Bonds . Debentures . Equity Instruments . Common stock . Preferred stock Basic Finance: Modern… Marta Wisniewska The Value of $1 Investment made in 1926

S&P Small Cap 1000 Corp Bonds Long Bond T Bill

10 Index

0.1 1925 1940 1955 1970 1985 2000 Year End Source: Ibbotson Associates Basic Finance: Modern… Marta Wisniewska The Value of $1 Investment made in 1926

Real returns S&P Small Cap 1000 Corp Bonds Long Bond T Bill

10 Index

0.1 1925 1940 1955 1970 1985 2000 Year End Source: Ibbotson Associates Basic Finance: Modern… Marta Wisniewska Rates of return 1926-2000

-20 Percentage Return Percentage -40 Common Stocks Long T-Bonds T-Bills -60 26 30 35 40 45 50 55 60 65 70 75 80 85 90 95 2000

Year Source: Ibbotson Associates Basic Finance: Modern… Marta Wisniewska Basic Finance: Modern… Marta Wisniewska Basic Finance: Modern… Marta Wisniewska Risk and Return

What investors care about when making the investments?

. Return

. Risk Basic Finance: Modern… Marta Wisniewska Risk and Return

What is return (R)? . Income received on an investment plus any change in market price, usually expressed as a percent of the beginning market price of the investment.

Dt + (Pt - Pt-1 ) R = simple return Pt-1 additive properties 퐷 + 푃 표푟 푅 = ln 푡 푡 logarithmic return 푃푡−1 Basic Finance: Modern… Marta Wisniewska Risk and Return

What is risk?

 Risk, in traditional terms, is viewed as something ‘negative’. Webster’s dictionary, for instance, defines risk as “exposing to danger or hazard”.

 The Chinese symbols for risk, reproduced below, give a much better description of risk 危機

The first symbol is the symbol for danger, while the second is the symbol for opportunity, making risk a mix of danger and opportunity. You cannot have one, without the other Basic Finance: Modern… Marta Wisniewska Risk and Return

What is risk? . In finance it is something different than expected. . It is measured by standard deviation of returns. . In finance, we call this measure ‘volatility’

푛 2 휎 = 푅푖 − 푅 푝푖 푖=1 Basic Finance: Modern… Marta Wisniewska Risk and Return

The variance on any investment return measures the disparity between actual and expected (mean) returns.

Low Variance Investment

Probability High Variance Investment

NO RISK

Expected Return Basic Finance: Modern… Marta Wisniewska Risk and Return

Example: Coin Toss Game-calculating variance and standard deviation

(1) (2) (3) Percent Rate of Return Deviation from Mean Squared Deviation + 40 + 30 900 + 10 0 0 + 10 0 0 - 20 - 30 900 Variance = average of squared deviations = 1800 / 4 = 450 Standard deviation = square of root variance = 450 = 21.2% Basic Finance: Modern… Marta Wisniewska Risk and Return

Portfolio return:

푛

푅푝 = 푅푖푤푖 푖=1

2 asset portfolio:

Expected Portfolio Return  (R1w1 )  (R 2w 2 ) Basic Finance: Modern… Marta Wisniewska Risk and Return

Portfolio risk:

2 asset portfolio:

2 2 2 2 Portfolio Variance  w1 σ1  w 2σ2  2(w1w 2ρ12σ1σ2 )

The variance of a two stock portfolio is Stock 1 Stock 2 the sum of these four boxes 2 2 w1w 2cov12  Stock 1 w1 σ1 w1w 2ρ12σ1σ2

w1w 2cov12  2 2 Stock 2 w 2σ2 w1w 2ρ12σ1σ2 Basic Finance: Modern… Marta Wisniewska Risk and Return

The shaded boxes contain variance terms; the remainder contain covariance terms.

1 2 3 To calculate 4 portfolio STOCK variance add up 5 the boxes 6

N 1 2 3 4 5 6 N

STOCK Basic Finance: Modern… Marta Wisniewska Risk and Return

Example Coca - Cola Reebok w w ρ σ σ  .65.35 Suppose you invest 65% of your portfolio in Coca - Cola w 2σ2  (.65)2 (31.5)2 1 2 12 1 2 1 1 131.558.5 Coca-Cola and 35% in Reebok. The expected w1w 2ρ12σ1σ2  .65.35 2 2 2 2 Reebok w 2σ2  (.35) (58.5) dollar return on your CC is 10% x 65% = 6.5% and 131.558.5 on Reebok it is 20% x 35% = 7.0%. The expected Portfolio Valriance  [(.65)2 x(31.5) 2 ] return on your portfolio is 6.5 + 7.0 = 13.50%.  [(.35)2 x(58.5) 2 ] Assume a correlation coefficient of 1.  2(.65x.35x1x31.5x58. 5)  1,006.1

Standard Deviation  1,006.1  31.7 % Basic Finance: Modern… Marta Wisniewska Risk and Return

Expected Returns and Standard Deviations of Portfolio vary given different weighted combinations of the stocks

Expected Return (%) Reebok

Minimum Variance 35% in Reebok Portfolio (MVP) Coca-Cola

Standard Deviation

Portfolio possibility curve Efficient frontier (higher return for the same risk) Basic Finance: Modern… Marta Wisniewska Diversification

Example Correlation Coefficient = .4 Stocks s % of Portfolio Avg Return ABC Corp 28 60% 15% Big Corp 42 40% 21%

Standard Deviation = weighted avg = 33.6 Standard Deviation = Portfolio = 28.1 Return = weighted avg = Portfolio = 17.4%

Let’s add New Corp to the portfolio Correlation Coefficient = .3 Stocks s % of Portfolio Avg Return Portfolio 28.1 50% 17.4% New Corp 30 50% 19%

NEW Standard Deviation = weighted avg = 31.80 NEW Standard Deviation = Portfolio = 23.43 NEW Return = weighted avg = Portfolio = 18.20%

NOTE: Higher return & Lower risk How did we do that? DIVERSIFICATION

Strategy designed to reduce risk by spreading the portfolio across many investments. Basic Finance: Modern… Marta Wisniewska Diversification

The shape of the portfolio possibility curve depends on the correlation coefficient (ρ) between the returns of the assets −1 ≤ ρ ≤ 1

Expected Return (%)

ρ=0.2 ρ=-1 ρ=1

Standard Deviation

The lower the correlation, the higher risk reduction Basic Finance: Modern… Marta Wisniewska Diversification

Total Risk = Systematic Risk + Unsystematic Risk

Factors unique to a particular company or industry. For example, the death of a key executive or loss of a governmental defense contract. Factors such as changes in nation’s economy, tax reform by the Congress, or a change in the world situation. Unsystematic risk Total (Unique risk) Risk Systematic risk

(Market risk) STD DEV OF PORTFOLIO RETURN DEV PORTFOLIO OF STD NUMBER OF SECURITIES IN THE PORTFOLIO Basic Finance: Modern… Marta Wisniewska CAPM

The Capital Asset Pricing Model (CAPM) is a theoretical description of the way in which the market prices investment assets

Ri = rf + βi ( Rm - rf )

where:

Ri is return on asset i

rf is a risk free rate

RM is risk on market portfolio Basic Finance: Modern… Marta Wisniewska CAPM

Total risk = diversifiable risk + market risk Market risk is measured by beta, the sensitivity to market changes

Expected stock return Beta the slope +10%-10%

-10% +10% Expected market -10% return

푛 퐼 − 퐼 푀 − 푀 휎 = 푎=1 푎 푎  푖푚 푛 − 1 im  where i  2 im Covariance of asset i returns with the market returns 2 Variance of the market returns  m  m Basic Finance: Modern… Marta Wisniewska CAPM

An average stock (or the market portfolio) has a beta = 1.0.

Beta shows how risky a stock is if the stock is held in a well-diversified portfolio.

β=1 → stock has average risk. β>1 → stock is riskier than average. β<1 → stock is less risky than average. β=0 → risk free assets (e.g., Treasury bills) Basic Finance: Modern… Marta Wisniewska CAPM

The beta of a portfolio (βP) is the weighted average of the betas from its constituent securities.

Example 1: You have $6,000 invested in IBM, $4,000 in GM. You estimate that IBM has a beta of 0.95 and GM has a beta of 1.15. What is the beta of your portfolio?

βP = 0.6*0.95 + 0.4*1.15 = 1.03 5. Investments Basic Finance: Investments Marta Wisniewska The Investment Process

Five steps: . Set investment policy . Perform security analysis . Construct a portfolio . Revise the portfolio . Evaluate performance Basic Finance: Investments Marta Wisniewska The Investment Process STEP 1: Investment Policy

. Identify investor’s unique objective

. State objectives in terms of risk and

return

. Determine amount of investable wealth

. Identify potential investment categories Basic Finance: Investments Marta Wisniewska The Investment Process STEP 1: Investment Policy

If you do not have an investment policy, you will find yourself:

1. Lacking a core set of beliefs, you will be easy prey for charlatans and pretenders, with each one claiming to have found the magic strategy that beats the market.

2. Switching from strategy to strategy, you will have to change your portfolio, resulting in high transactions costs and you will pay more in taxes.

3. With a strategy that may not be appropriate for you, given your objectives, risk aversion and personal characteristics. In addition to having a portfolio that under performs the market, you are likely to find yourself with an ulcer or worse. Basic Finance: Investments Marta Wisniewska The Investment Process STEP 1: Investment Policy

. Market Timing versus Asset Selection: With market timing, you bet on the movement of entire markets - financial as well as real assets. With asset selection, you focus on picking good investments within each market.

. Active Investing versus Passive Investing: With passive investing, you take positions in companies and hope that the market corrects its mistakes (hold an index, market is efficient). With activist investing, you play a role (or provide the catalyst) in correcting market mistakes (technical analysis, fundamental analysis, inside information, market is not efficient).

. Time Horizon: Some philosophies require that you invest for long time periods. Others are based upon short holding periods.

. Investment Universe: What assets to choose from? Bonds, Stocks, real assets? Domestic? Foreign? Basic Finance: Investments Marta Wisniewska The Investment Process STEP 2: Security Analysis

Using fundamental/ technical analysis/ inside information:

. Find the intrinsic value (intrinsic value should equal discounted present value)

. Compare current market price to true market value (intrinsic value)

. Identify undervalued/overvalued securities Basic Finance: Investments Marta Wisniewska The Investment Process STEP 3: Construct a Portfolio

. Identify specific assets and proportion of wealth in which to invest . Address issues of . Selectivity . Timing . Diversification Basic Finance: Investments Marta Wisniewska The Investment Process STEP 4: Portfolio Revision

. Periodically repeat step 3 . Revise if necessary . Increase/decrease existing securities . Delete some securities . Add new securities Basic Finance: Investments Marta Wisniewska The Investment Process STEP 5: Portfolio Performance Evaluation

. Involves periodic determination of portfolio performance with respect to risk and return . Requires appropriate measures of risk and return 푅푃 − 푟푓 . Sharpe ratio = 휎푃 . Treynor ratio

. Jensen ratio Basic Finance: Investments Marta Wisniewska

The Client

Utility Risk Investment Tax Status Tax Code Function Aversion Horizon

Risk and return: The Portfolio Manager’s Job Measuring risk Views Asset Asset Allocation: Views on: Effect of on Classes: Stocks Bonds Real Assets Inflation diversific ation markets Domestic Rates Countries: Non-Domestic growth

Valuation Market based on: Security Selection: Private Efficiency Cash flows Which stocks? Which bonds? Which real information Can you Comparable beat the charts assets? market

Trading Trading Costs Execution: Systems Commissions, How often do you trade? Trading How does Bid-Ask How large are the trades? speed trading Spread, Do you use derivatives to manage risk? affect Price Impact prices?

Performance evaluation: Market 1. How much risk did the portfolio manager take? Stock Timing 2. What return did the portfolio manager make? Selection 3. Did the portfolio manager underperform or outperform? Practical Questions 2: Risk and return Basic Finance: PQ 2: Risk… Marta Wisniewska

Question 1:

The stock price for Stock A was $10 per share 1 year ago. The stock is currently trading at $9.50 per share and shareholders just received a $1 dividend. What return was earned over the past year? Basic Finance: PQ 2: Risk… Marta Wisniewska

Question 2:

A game of chance offers the following odds and payoffs. Each play of the game costs $100, co the net profit per play is the payoff less $100.

Probability Payoff Net Profit .1 $500 $400 .5 100 0 .4 0 -100

What are the expected cash payoff and expected rate of return? Calculate variance and standard deviation of this rate of return. Basic Finance: PQ 2: Risk… Marta Wisniewska

Question 3:

Consider the following information:

State Probability ABC, Inc. (%) Boom .25 15 Normal .50 8 Slowdown .15 4 Recession .10 -3

. What is the expected return? . What is the variance? . What is the standard deviation? Basic Finance: PQ 2: Risk… Marta Wisniewska

Question 4:

Suppose you have $15,000 to invest and you have purchased securities in the following amounts:

$2000 of Doubleclick (DCLK) $3000 of Coca-Cola (KO) $4000 of Intel (INTC) $6000 of Keithley Industries (KE)

What are your portfolio weights in each security? Basic Finance: PQ 2: Risk… Marta Wisniewska

Question 5:

Consider a portfolio which consists of stock A with a beta of 1.2 and expected return of 18%, and a Treasury bill with a 7% return.

Calculate the return and beta of portfolios with following weights:

WA WT E(Rp) p

0.0 1.00

0.25 0.75

0.50 0.50

0.75 0.25

1.00 0.00

1.50 -0.50

Basic Finance: PQ 2: Risk… Marta Wisniewska

Question 6:

You invest 60% in stock X and the balance in stock Y. The standard deviation of returns in X are 10%, and 20% in Y. Calculate the variance of portfolio returns, assuming: a. Correlation between returns is 1 b. Correlation is .5 c. Correlation is 0 Basic Finance: PQ 2: Risk… Marta Wisniewska

Question 7:

Consider the following information:

State Probability X Z Boom .25 15% 10% Normal .60 10% 9% Recession .15 5% 10%

What are the expected return and standard deviation for a portfolio with an investment of $6000 in asset X and $4000 in asset Z?

How this compares to the expected return and standard deviation of individual assets? Basic Finance: PQ 2: Risk… Marta Wisniewska

Question 8:

Which portfolio is the best and why?

Expected Return (%) C

Standard Deviation Basic Finance: PQ 2: Risk… Marta Wisniewska

Question 9:

In which of the following situations would you get the largest reduction in risk by spreading your investment across two stocks: a. Two shares are perfectly correlated b. There is no correlation c. There is modest negative correlation d. There is perfect negative correlation Basic Finance: PQ 2: Risk… Marta Wisniewska

Question 10:

A portfolio contains equal investments in 10 stocks. Five have a beta of 1.2; the remaining have beta of 1.4. What is the portfolio beta? a. 1.3. b. Greater then 1.3 because the portfolio is not completely diversified c. Less then 1.3 because diversification reduces beta. Basic Finance: PQ 2: Risk… Marta Wisniewska

Question 11:

If Stephen holds a one-stock portfolio and Jennifer holds a multiple-stock portfolio. Thus Stephen is exposed to more risk than Jennifer. Do you think Stephen should be compensated for all the risk he bears? Basic Finance: PQ 2: Risk… Marta Wisniewska

Question 12:

Consider the following information:

Standard Deviation Beta Security C 20% 1.25 Security K 30% 0.95

. Which security has more total risk? . Which security has more systematic risk? . Which security should have the higher expected return? Basic Finance: PQ 2: Risk… Marta Wisniewska

Question 13:

Stock J has a beta of 1.2 and an expected return of 15.6 %, and stock K has a beta of 0.8 and an expected return of 12.4%.

What must be the expected return on the market (RM) and the risk free rate (rf) to be consistent with CAPM. Basic Finance: PQ 2: Risk… Marta Wisniewska

Question 14:

The average variance of the annual returns from a typical stock is about 1 500, and its average covariance with other stocks is about 400. Work out what this implies for the standard deviation of returns from: . fully diversified portfolio . a portfolio of 64 stocks . a portfolio of 16 stocks . a portfolio of 4 stocks

Assume equal size holding of each stock.

Portfolio variance = Average covariance + (1/N)(Average variance – Average covariance) Basic Finance: PQ 2: Risk… Marta Wisniewska

Question 15:

Suppose the risk-free rate is 4%, the market risk premium is 8.6%, and a stock has a beta of 1.3.

Based on the CAPM, what is the expected return on this stock?

What would the expected return be if the beta were to double? Basic Finance: PQ 2: Risk… Marta Wisniewska

Question 16:

In December 1995, Company X’s stocks had a beta of 0.95. The treasury bill rate at the time was 5.8%, and the treasury bond rate was 6.4%. The firm had debt outstanding of $ 1.7 billion and a market value of equity of $ 1.5 billion; the corporate marginal tax rate was 36%. a. Estimate the expected return on the stock for a short term investor in the company. b. Estimate the expected return on the stock for a long term investor in the company. Basic Finance: PQ 2: Risk… Marta Wisniewska

Question 17:

Company X is a Malaysian conglomerate, with holding in plantations and tourist resorts. The beta estimated for the firm, relative to the Malaysian stock exchange, is 1.15, and the long term government borrowing rate in Malaysia is 11.5%. The return on Malaysian market is 18%.

. Estimate the expected return on the stock.

. If you were an international investor, what concerns, if any, would you have about using the beta estimated relative to the Malaysian Index? If you do, how would you modify the beta? Basic Finance: PQ 2: Risk… Marta Wisniewska

Question 18:

Consider following portfolios: Portfolio Return beta A 12% 0.5 B 16% 1.1 C 20% 2

Which portfolio is the best and why? (Hint: see if you can duplicate B with combination of A and C?) Class 3:

(6) Introduction to Public Finance (7) Finance of EU (8) Social Protection (9) Introduction to Corporate Finance 6. Public Finance: Introduction Basic Finance: Public Finance … Marta Wisniewska

. The role of the State

. Monetary and Fiscal Policies

. IS-LM Model

. State Budget . Income and expenditures . Budget Deficit . Taxation Basic Finance: Public Finance … Marta Wisniewska The role of the State

According to P.A. Samuelson state should ensure:

. Efficiency of economy (taking into account uneven distribution of wealth)

. Justice and equality (taking into account uneven distribution of wealth)

. Stability of market economy (taking into account economic cycles) Basic Finance: Public Finance … Marta Wisniewska The role of the State

Main function of Public Finance are:

. Allocation

. Redistribution

. Stabilizing Basic Finance: Public Finance … Marta Wisniewska The role of the State

Economic policy refers to the actions that governments take in the economic field.

It covers the systems for setting interest rates and government deficit as well as the labour market, national ownership, and many other areas of government. Basic Finance: Public Finance … Marta Wisniewska The role of the State

Economic policy can be broken down into three principal areas: Fiscal policy is concerned with the size of the government deficit and the methods it uses to finance it. . The size of the deficit . Tax policy: The taxes used to collect government income. . Government spending on just about any area of government

Monetary policy is concerned with the amount of money in circulation and, consequently, interest rats and inflation. . Interest rates, if set by the Government/ Central Bank . Incomes policies which aim at imposing non-monetary controls on inflation . Bank regulations which affect the money multiplier

Trade policy refers to tariffs, trade agreements and the international institutions that govern them. Basic Finance: Public Finance … Marta Wisniewska The role of the State

The combination of these policies stimulates growth and generates employment.

It should be noted that the effectiveness of these policy depends on the economic reality of a country. Basic Finance: Public Finance … Marta Wisniewska Monetary and Fiscal Policy

Monetary policy is the process by which the government, central bank, or monetary authority of a country controls the supply of money, availability of money, and cost of money or rate of interest, in order to attain a set of objectives oriented towards the growth and stability of the economy.

Monetary policy is referred to as: . expansionary policy: increases the total supply of money in the economy . contractionary policy: decreases the total money supply. Basic Finance: Public Finance … Marta Wisniewska Monetary and Fiscal Policy

Monetary policies are described as follows: . accommodative, if the interest rate set by the central monetary authority is intended to create economic growth; . neutral, if it is intended neither to create growth nor combat inflation; . tight if intended to reduce inflation.

Stimulative/accommodative monetary policy is expected to improve the economy's rate of growth of output (measured by Gross Domestic Product or GDP) in the quarters ahead. It is traditionally used to combat unemployment in a recession by lowering interest rates .

Tight monetary policy is designed to slow the economy in the future to offset inflationary pressures. It involves raising interest rates in order to combat inflation. Basic Finance: Public Finance … Marta Wisniewska Monetary and Fiscal Policy

Main monetary policy instruments available to central banks are:

. open market operation

. bank reserve requirement

. interest rate policy

. re-lending and re-discount (including using the term repurchase market)

. credit policy (often coordinated with trade policy). Basic Finance: Public Finance … Marta Wisniewska

In practice, all types of monetary policy involve modifying the amount of base currency (M0) in circulation.

The distinction between the various types of monetary policy lies primarily with the set of instruments and target variables that are used by the monetary authority to achieve their goals

Monetary Policy: Target Market Variable: Long Term Objective:

Interest rate on A given rate of change in Inflation Targeting overnight debt the CPI

Price Level Interest rate on A specific CPI number Targeting overnight debt

The growth in money A given rate of change in Monetary Aggregates supply the CPI

The spot price of the The spot price of the Fixed Exchange Rate currency currency

Low inflation as measured Gold Standard The spot price of gold by the gold price

Usually unemployment + CPI Mixed Policy Usually interest rates change Basic Finance: Public Finance … Marta Wisniewska

Australia - Inflation targeting Brazil - Inflation targeting

Canada - Inflation targeting

Chile - Inflation targeting

China - Monetary Targeting and targets a currency basket

Eurozone - Inflation Targeting

Hong Kong - Currency board (fixed to US dollar)

India- Inflation targeting

New Zealand - Inflation targeting

Singapore - Exchange rate targeting

Turkey - Inflation targeting

United Kingdom- Inflation Targeting, alongside secondary targets on 'output and employment'.

United States- Mixed policy (and since the 1980s it is well fitted/described by the "Taylor rule" which shows that the Fed funds rate responds to shocks in inflation and output) Basic Finance: Public Finance … Marta Wisniewska Monetary and Fiscal Policy

Fiscal policy refers to government policy that attempts to influence the direction of the economy through changes in government spending or taxes.

A government's program with respect to (1) the purchase of goods and services and spending on transfer payments, and (2) the amount and type of taxes. (Samuelson & Nordhaus, Economics 1998)

The two main instruments of fiscal policy are: . government spending . taxation Basic Finance: Public Finance … Marta Wisniewska Monetary and Fiscal Policy

Changes in the level and composition of taxation and government spending can impact on the following variables in the economy:

. Aggregate demand and the level of economic activity . The pattern of resource allocation . The distribution of income. Basic Finance: Public Finance … Marta Wisniewska Monetary and Fiscal Policy

The three possible stances of fiscal policy are:

. A neutral stance of fiscal policy implies a balanced budget where G = T (Government spending = Tax revenue). Government spending is fully funded by tax revenue and overall the budget outcome has a neutral effect on the level of economic activity.

. An expansionary stance of fiscal policy involves a net increase in government spending (G > T) through a rise in government spending or a fall in taxation revenue or a combination of the two. This will lead to a larger budget deficit or a smaller budget surplus than the government previously had, or a deficit if the government previously had a balanced budget. Expansionary fiscal policy is usually associated with a budget deficit.

. A contractionary fiscal policy (G < T) occurs when net government spending is reduced either through higher taxation revenue or reduced government spending or a combination of the two. This would lead to a lower budget deficit or a larger surplus than the government previously had, or a surplus if the government previously had a balanced budget. Contractionary fiscal policy is usually associated with a surplus. Basic Finance: Public Finance … Marta Wisniewska Monetary and Fiscal Policy

Stimulative fiscal policies, tax cuts, and spending increases are normally expected to stimulate economic growth in the short run, while tight fiscal policy: tax increases and spending cuts tend to slow the rate of future economic expansion. Basic Finance: Public Finance … Marta Wisniewska Monetary and Fiscal Policy

Fiscal policy is used by governments to influence the level of aggregate demand in the economy, in an effort to achieve economic objectives of price stability, full employment and economic growth.

Keynesian economics suggests that adjusting government spending and tax rates are the best ways to stimulate aggregate demand. This can be used in times of recession or low economic activity as an essential tool in providing the framework for strong economic growth and working toward full employment. The government can implement these deficit-spending policies due to its size and prestige and stimulate trade.

During periods of high economic growth, a budget surplus can be used to decrease activity in the economy. A budget surplus will be implemented in the economy if inflation is high, in order to achieve the objective of price stability. The removal of funds from the economy will, by Keynesian theory, reduce levels of aggregate demand in the economy and contract it, bringing about price stability. Basic Finance: Public Finance … Marta Wisniewska IS-LM Model

The IS–LM model (Investment Saving–Liquidity Preference Money Supply) is a macroeconomic tool that demonstrates the relationship between interest rates and real output, in the goods and services market and the money market.

The determination of output and interest rates in the short-run.

The IS-LM model, first developed by Sir John Hicks and Alvin Hansen, has been used from 1937 onwards to summarize a major part of Keynesian macroeconomics. Basic Finance: Public Finance … Marta Wisniewska IS-LM Model The goods market and the IS relation

. Equilibrium in the goods market: . Production (Y) = Demand (Z)

or Investment = Saving  “IS” Relation . Demand (Z)= C+I+G where: C=C(Y-T) T & G are given

Now let Investment depend on the level of sales (Y) and the interest rate (i): I = I(Y,i) where Y represents income, C(Y-T) represents consumer spending as a function of disposable income (income, Y, minus taxes, T), I(Y, i) represents investment as a function of sales and the real interest rate, and G represents government spending. Basic Finance: Public Finance … Marta Wisniewska IS-LM Model The goods market and the IS relation The IS curve Y = C(Y-T) + I + G

Equilibrium: I = I(Y,i)

Y = C(Y-T) + I(Y,i) + G

Supply of Demand for Goods Goods (Z)

In the goods market, the higher the interest rate, the lower is investment and the lower is equilibrium output. Basic Finance: Public Finance … Marta Wisniewska IS-LM Model The goods market and the IS relation Equilibrium in the Goods Market

The demand for goods is an increasing function of output. Equilibrium requires that the demand for goods be equal to output.

Note: The ZZ line is flatter than the 45° line because the econometric evidence tells us that increases in consumption and investment do not exceed the corresponding increase in output. Basic Finance: Public Finance … Marta Wisniewska IS-LM Model The goods market and the IS relation The Effects of an Increase in the Interest Rate on Output

An increase in the interest rate decreases the demand for goods at any level of output. By the multiplier effect, output falls. Basic Finance: Public Finance … Marta Wisniewska IS-LM Model The goods market and the IS relation

In Words: . i rises  . Investment falls  . The ZZ curve shifts down  . Equilibrium output falls.

.  In the goods market, there is an inverse relation between i and Y. Basic Finance: Public Finance … Marta Wisniewska

The Derivation of the IS Curve

Equilibrium in the goods market implies that an increase in the interest rate leads to a decrease in output. The IS curve is downward sloping. Basic Finance: Public Finance … Marta Wisniewska IS-LM Model The goods market and the IS relation

The IS curve Shifts in the IS Curve:

An increase in taxes shifts

i the IS curve to the left

i Interest Rate, Rate, Interest

IS (T) IS´ (T´ > T)

Y´ Y Output, Y Basic Finance: Public Finance … Marta Wisniewska IS-LM Model The goods market and the IS relation

The IS curve Shifts in the IS Curve:

An increase in G shifts

i the IS curve to the right

i Interest Rate, Rate, Interest

IS’ (G’>G) IS (G)

Y Y’ Output, Y Basic Finance: Public Finance … Marta Wisniewska IS-LM Model Financial Markets and the LM Relation

Money market equilibrium: Demand for liquidity (L) = Supply of Money (M)

M = nominal money supply (controlled by the Central Bank) $YL(i) = Demand for money (function of nominal income and the interest rate)

Equilibrium Interest Rate: M=$YL(i) Basic Finance: Public Finance … Marta Wisniewska IS-LM Model Financial Markets and the LM Relation

Real money, real income, and the interest rate $Y Real Income (Y)  P  M  Real Money Supply   = Real Money Demand: Y(L)i  P  M LM relation:  Y(L)i P Basic Finance: Public Finance … Marta Wisniewska IS-LM Model Financial Markets and the LM Relation An increase in demand for real balances:

i Increase in Y => increases Md which increases i

i´ A´ Interest Rate, Rate, Interest

A i Md´ (for Y´ > Y) Md (for Y)

M/P (Real) Money, M/P Basic Finance: Public Finance … Marta Wisniewska IS-LM Model Financial Markets and the LM Relation

In Words: . Suppose Real Income increases: . Y rises → . People demand more money for transactions → . Md shifts out. . If Ms is vertical, → i rises … . … until the quantity of money demanded equals the quantity of money supplied, which is fixed. Basic Finance: Public Finance … Marta Wisniewska IS-LM Model Financial Markets and the LM Relation The LM curve

Interest Rate, i Ms LM (M/P)

i A´ i´ i´ A´

Interest Rate, Rate, Interest A i i A Md´ (for Y´ > Y)

Md (for Y)

M/P Y Y´ (Real) Money, M/P Income, Y Basic Finance: Public Finance … Marta Wisniewska IS-LM Model Financial Markets and the LM Relation The LM curve Shifts in the LM Curve: Showing changes in M & P

Ms Ms´ Interest Rate, i LM (M/P)

LM´

i (M´/P > M/P) b i´ i´ b

i´ b´ i´2 2 b´ Interest Rate, Rate, Interest a i i a Md´ (for Y´ > Y) a´ i2 i2 a´ Md (for Y)

M/P M´/P Y Y´ (Real) Money, M/P Income, Y Basic Finance: Public Finance … Marta Wisniewska IS-LM Model

Equilibrium Requires:

IS :Y  C(Y T)  I(Y,i) G M LM :  YL(i) P or IS  LM Basic Finance: Public Finance … Marta Wisniewska IS-LM Model

The IS-LM Equilibrium Graphically

LM i

i & Y is the only interest rate, output combination that yields a

simultaneous equilibrium Interest Rate, Rate, Interest i in the goods and financial markets

Y Output, Y Basic Finance: Public Finance … Marta Wisniewska IS-LM Model Fiscal Policy, Activity, and the Interest Rate

Scenario: The President and Congress agree on a policy to reduce the budget deficit by increasing taxes, while holding gov’t spending constant.

Question: What impact will this fiscal contraction policy have on output and interest rates? What shifts? IS, LM or both? ANSWER: IS Basic Finance: Public Finance … Marta Wisniewska IS-LM Model Fiscal Policy, Activity, and the Interest Rate The IS-LM Equilibrium Graphically

• IS & LM: Before the tax increase LM Equilibrium A: i & Y

• IS´: After the tax increase i • Would the tax increase change LM? • Disequilibrium at i (F, A) after tax increase F A • i´, Y´ New equilibrium A´ i

Interest Rate, Rate, Interest A´ • The fiscal contraction lowered i´ interest and output

IS (T)

IS´ (T´ > T)

Y´ Y Output, Y Basic Finance: Public Finance … Marta Wisniewska IS-LM Model Fiscal Policy, Activity, and the Interest Rate

Here’s one for the devil’s advocate…

Is deficit reduction good or bad for investment?

Interest rate falls  good for investment but Output falls  bad for investment Basic Finance: Public Finance … Marta Wisniewska IS-LM Model Monetary Policy, Activity, and the Interest Rate

Scenario: The Fed engages in monetary expansion, i.e., it increases the money supply through open market operations

Question: What impact will this monetary expansion policy have on output and interest rates? What shifts? IS, LM or both? ANSWER: LM Basic Finance: Public Finance … Marta Wisniewska IS-LM Model Monetary Policy, Activity, and the Interest Rate The IS-LM Equilibrium Graphically

LM (M/P)

LM´ (M´/P > M/P) i

• IS & LM: Before increasing M Equilibrium A: i & Y A B • LM´: After increasing M i • Disequilibrium at i (A, B)

Interest Rate, Rate, Interest A´ i´ • New equilibrium A´: i´ & Y´

• Monetary expansion lowered i & increased Y IS

Y Y´ Output, Y Basic Finance: Public Finance … Marta Wisniewska IS-LM Model

Monetary policy: In 2001 the Federal Reserve made 11 reductions in the overnight interbank interest rate or federal funds rate—these actions were designed to stimulate growth in the face of a slowing economy. In contrast, in 1999 and 2000 when the economy was experiencing very rapid growth and a potentially unsustainable expansion without an increase in the rate of inflation, the Federal Reserve raised the federal funds rates in an effort to slow the overheated economy. Basic Finance: Public Finance … Marta Wisniewska IS-LM Model

Fiscal policy in 2001 also helped stimulate the slowing economy with a combination of tax cuts and spending increases. Spending increases take effect relatively quickly, while tax cuts may take several quarters to affect overall spending and output. Basic Finance: Public Finance … Marta Wisniewska State Budget

A budget (derived from old French word bougette, purse) is a quantified financial plan for a forthcoming accounting period.

Budget tells us what will be purchased and how the purchase will be financed:

. Expenditures

. Income/ Revenues Basic Finance: Public Finance … Marta Wisniewska State Budget Expenditures

Government spending /expenditure is classified by economists into 3 main types:

. Government Consumption Government purchases of goods and services for current use.

. Government Investment Government purchases of goods and services intended to create future benefits, such as infrastructure investment or research spending.

. Transfer Payments Government expenditures that are not purchases of goods and services, and instead just represent transfers of money, such as social security payments.

John Maynard Keynes was one of the first economists to advocate government deficit spending as part of the fiscal policy response to an economic contraction. In Keynesian economics, increased government spending is thought to raise aggregate demand and increase consumption. Basic Finance: Public Finance … Marta Wisniewska

Chart showing how the United States Congress spends the federal tax revenue. Basic Finance: Public Finance … Marta Wisniewska

BBC 4.9.2014 Basic Finance: Public Finance … Marta Wisniewska Basic Finance: Public Finance … Marta Wisniewska Basic Finance: Public Finance … Marta Wisniewska State Budget Revenues

Government expenditure can be funded in a number of different ways:

. Taxation

. Borrowing money

. Consumption of fiscal reserves

. Sales of assets (e.g. privatization)

. Printing money Basic Finance: Public Finance … Marta Wisniewska State Budget

A budget deficit occurs when an entity (often a government) spends more money than it takes in.

A budget suprlus occures when an entity spends less money than it takes in.

Most governments run a deficit.

Most governments finance their debts by issuing long-term government bonds or shorter term notes and bills. Many governments use auctions to sell government bonds. Basic Finance: Public Finance … Marta Wisniewska State Budget

Source: IMF Basic Finance: Public Finance … Marta Wisniewska State Budget

Public debt as a % of GDP http://www.imf.org/external/pubs/ft/weo/2012/02/weodata/index.aspxas listed on CIA factbook, accessed March 2007. Basic Finance: Public Finance … Marta Wisniewska State Budget Basic Finance: Public Finance … Marta Wisniewska State Budget Basic Finance: Public Finance … Marta Wisniewska Taxation

Tax is a financial charge or other levy imposed on an individual or a legal entity by a state or a functional equivalent of a state (for example, secessionist movements or revolutionary movements).

Taxes are also imposed by many subnational entities.

Taxes consist of : . direct tax paid directly by the persons on whom it is imposed, e.g. income tax, corporate tax, inheritance tax . indirect tax collected by intermediaries, e.g. VAT Basic Finance: Public Finance … Marta Wisniewska Taxation

Taxation has 4 main purposes/effects: . Revenue Taxes raise money to spend on roads, schools and hospitals, and on more indirect government functions like good regulation or justice systems. . Redistribution Normally, this means transferring wealth from the richer sections of society to poorer sections, and this function is widely accepted in most democracies, although the extent to which this should happen is always controversial.

. Repricing Taxes are levied to address externalities: tobacco is taxed, for example, to discourage smoking, and many people advocate policies such as implementing a carbon tax.

. Representation The American revolutionary slogan "no taxation without representation" implied this: rulers tax citizens, and citizens demand accountability from their rulers as the other part of this bargain. Several studies have shown that direct taxation (such as income taxes) generates the greatest degree of accountability and better governance, while indirect taxation tends to have smaller effects. Basic Finance: Public Finance … Marta Wisniewska Taxation

Types of taxes . Ad valorem The tax base is the value of a good, service, or property. Sales taxes, tariffs, property taxes, inheritance taxes, and value added taxes are different types of ad valorem tax. . Environment Affecting Tax . Capital gains tax The tax levied on the profit released upon the sale of a capital asset. . Consumption tax A consumption tax is a tax on non-investment spending, and can be implemented by means of a sales tax or by modifying an income tax to allow for unlimited deductions for investment or saving . Corporation tax Direct tax levied by various jurisdictions on the profits made by companies or associations and often includes capital gains of a company . Excises Unlike an ad valorem, an excise is not a function of the value of the product being taxed. Excise taxes are based on the quantity, not the value, of product purchased. For example, in the United States, the Federal government imposes an excise tax of 18.4 cents per US gallon (4.86¢/L) of gasoline . Income tax . Inheritance tax . Poll tax A poll tax, also called a per capita tax, or capitation tax, is a tax that levies a set amount per individual. Basic Finance: Public Finance … Marta Wisniewska Taxation Types of taxes . Property tax . Retirement tax . Sales tax . Tariffs An import or export tariff (also called customs duty or impost) is a charge for the movement of goods through a political border. . Toll A toll is a tax or fee charged to travel via a road, bridge, tunnel or other route. . Transfer tax Historically, in many countries, a contract needed to have a stamp affixed to make it valid. The charge for the stamp was either a fixed amount or a percentage of the value of the transaction. In most countries the stamp has been abolished but stamp duty remains. Stamp duty is levied in the UK on the purchase of shares and securities, the issue of bearer instruments, and certain partnership transactions. Its modern derivatives, stamp duty reserve tax and stamp duty land tax, are respectively charged on transactions involving securities and land. Stamp duty has the effect of discouraging speculative purchases of assets by decreasing liquidity. In the US transfer tax is often charged by the state or local government and (in the case of real property transfers) can be tied to the recording of the deed or other transfer documents. Taxes on currency transactions are known as Tobin taxes. . Value Added Tax / Goods and Services Tax . Wealth (net worth) tax Some countries' governments will require declaration of the tax payers' balance sheet (assets and liabilities), and from that exact a tax on net worth (assets minus liabilities), as a percentage of the net worth, or a percentage of the net worth exceeding a certain level Basic Finance: Public Finance … Marta Wisniewska Taxation

Tax-to-GDP ratio in EU-27 and euro area, 1995-2014

42.0

2013 Spring 41.5 Forecast

41.0

40.5

40.0

39.5

39.0

38.5

38.0 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 EA-17 EU-27

Source: European Commission. Basic Finance: Public Finance … Marta Wisniewska Taxation Basic Finance: Public Finance … Marta Wisniewska Taxation Basic Finance: Public Finance … Marta Wisniewska Taxation Basic Finance: Public Finance … Marta Wisniewska Taxation Basic Finance: Public Finance … Marta Wisniewska Taxation Basic Finance: Public Finance … Marta Wisniewska Taxation Basic Finance: Public Finance … Marta Wisniewska Taxation Basic Finance: Public Finance … Marta Wisniewska Taxation Basic Finance: Public Finance … Marta Wisniewska Taxation Basic Finance: Public Finance … Marta Wisniewska Taxation Basic Finance: Public Finance … Marta Wisniewska Taxation Basic Finance: Public Finance … Marta Wisniewska Basic Finance: Public Finance … Marta Wisniewska Basic Finance: Public Finance … Marta Wisniewska Basic Finance: Public Finance … Marta Wisniewska Taxation

100 0.65*100 = 65 0.8*65 = 52

Income tax: 30% VAT: 20% Social Security: 5% 7. Finance of EU Basic Finance: Finance of EU Marta Wisniewska

. EU Finances: General Principles

. Legislative procedure

. EU Budget: Revenues

. EU Budget: Expenditures Basic Finance: Finance of EU Marta Wisniewska EU Finances: General Principles

. EU spending is limited by the Treaties.

. EU spending is further limited by a multi-annual agreement between Members of the European Parliament, the Council of Ministers, and the European Commission.

. This agreement contains a “Multiannual Financial Framework". EU budgets operate within 7-years MFF: (2000- 2006, 2006-2013, 2014- 2020)

. The Union budget is not allowed to be in deficit, which means that revenue has to cover the whole cost of all the different activities.

. EU budget represents around 1.10% of the member states GNI Basic Finance: Finance of EU Marta Wisniewska EU Finances: General Principles

National budgets

EU Budget

The EU budget was around € 140 billion in 2011, which is very small compared to the sum of national budgets of all 27 EU Member states, which amount to more than € 6,300 billion. In other words, total government expenditure by the 27 Member States is almost 50 times bigger than the EU budget. Basic Finance: Finance of EU Marta Wisniewska EU funds’ beneficiaries 2014

http://ec.europa.eu/budget/figures/interactive/index_en.cfm Basic Finance: Finance of EU Marta Wisniewska EU funds’ beneficiaries 2007

http://ec.europa.eu/budget/figures/interactive/index_en.cfm Basic Finance: Finance of EU Marta Wisniewska EU funds’ beneficiaries 2014

http://ec.europa.eu/budget/figures/interactive/index_en.cfm Basic Finance: Finance of EU Marta Wisniewska EU funds’ beneficiaries 2007

http://ec.europa.eu/budget/figures/interactive/index_en.cfm Basic Finance: Finance of EU Marta Wisniewska EU funds’ beneficiaries 2014

http://ec.europa.eu/budget/figures/interactive/index_en.cfm Basic Finance: Finance of EU Marta Wisniewska EU funds contributors 2014

http://ec.europa.eu/budget/figures/interactive/index_en.cfm Basic Finance: Finance of EU Marta Wisniewska EU funds contributors 2007

http://ec.europa.eu/budget/figures/interactive/index_en.cfm Basic Finance: Finance of EU Marta Wisniewska EU funds contributors 2014

http://ec.europa.eu/budget/figures/interactive/index_en.cfm Basic Finance: Finance of EU Marta Wisniewska EU funds contributors 2007

http://ec.europa.eu/budget/figures/interactive/index_en.cfm Basic Finance: Finance of EU Marta Wisniewska EU funds contributors 2014

http://ec.europa.eu/budget/figures/interactive/index_en.cfm Basic Finance: Finance of EU Marta Wisniewska EU Finances: General Principles Basic Finance: Finance of EU Marta Wisniewska EU Finances: General Principles Basic Finance: Finance of EU Marta Wisniewska EU Finances: General Principles Basic Finance: Finance of EU Marta Wisniewska EU Finances: General Principles Basic Finance: Finance of EU Marta Wisniewska Legislative procedure

The Administration of the European Union has three elements to its government:

. the Council of Ministers . the European Commission . and the European Parliament

In addition, the European Court of Justice is funded from the budget of the Administration.

All three take a part in setting the annual budget. Basic Finance: Finance of EU Marta Wisniewska Legislative procedure Basic Finance: Finance of EU Marta Wisniewska Legislative procedure

The draft budget must be adopted by qualified majority (regularly in July). A qualified majority is reached when at least 255 votes (73.9%) out of 345, and cast by at least two- thirds of the members, are in favour.

Distribution of votes for each Member State (from 01/01/2007) Germany, France, Italy , United Kingdom X 29 = 116 Spain, Poland X 27 = 54 Romania X 14 = 14 Netherlands X 13 = 13 Belgium, Czech Republic, Greece, Hungary, Portugal X 12 = 60 Austria, Sweden, Bulgaria X 10 = 30 Denmark, Finland, Ireland, Slovakia, Lithuania X 7 = 35 Estonia, Latvia, Luxembourg, Slovenia, Cyprus X 4 = 20 Malta X 3 = 3 Total 345 votes Basic Finance: Finance of EU Marta Wisniewska Legislative procedure

In practice, around 76 % of the EU budget is managed by national or regional governments. Through grants, loans and other forms of finance, the EU budget provides financial support to hundreds of thousands of beneficiaries, including students, scientists, NGOs, SMEs, towns, regions and many others Basic Finance: Finance of EU Marta Wisniewska Legislative procedure

The Commission implements the budget on its own responsibility, but shares most of the management with the Member States.

A Community legal act – the Financial Regulation - agreed upon by the Member States sets out the rules for calling on, budgeting and using EU funding.

All income and expenditure must be accounted for.

Financial statements are drawn up showing the assets and liabilities of the Union and general and budget accounts are maintained. Basic Finance: Finance of EU Marta Wisniewska Legislative procedure

The budget for a year, or period of years, is determined in advance, but final calculations of payments required from each member state are not completed until after the budget year is over and information about revenue and expenditure is available. Basic Finance: Finance of EU Marta Wisniewska EU Budget: Revenues

The income/ revenue comes from three main sourses:

. Traditional own resources (TOR) These mainly consist of duties that are charged on imports of products coming from a non-EU state. They bring in approximately 12.07 % of the total revenue.

. The resource based on value added tax (VAT) It is a uniform percentage rate that is applied to each Member State’s harmonised VAT revenue. The VAT-based resource accounts for 13.26 % of total revenue.

. The resource based on gross national income (GNI) It is a uniform percentage rate applied to the GNI of each Member State. Although it is a balancing item, it has become the largest source of revenue (74%). Basic Finance: Finance of EU Marta Wisniewska EU Budget: Revenues Basic Finance: Finance of EU Marta Wisniewska EU Budget: Revenues Basic Finance: Finance of EU Marta Wisniewska EU Budget: Expenditures Basic Finance: Finance of EU Marta Wisniewska EU Budget: Expenditures

MFF = Multiannual financial framework Basic Finance: Finance of EU Marta Wisniewska EU Budget: Expenditures Basic Finance: Finance of EU Marta Wisniewska EU Budget: Expenditures

GDP/capita* < 75 % of EU average 75-90 % > 90 %

*index EU27=100

 Canarias Guyane 3 categories  Réunion  Guadeloupe/ of regions Martinique  Madeira Less developed regions Açores  Malta Transition regions  More developed regions 

│ 343 Basic Finance: Finance of EU Marta Wisniewska EU Budget: Expenditures Basic Finance: Finance of EU Marta Wisniewska EU Budget: Expenditures Basic Finance: Finance of EU Marta Wisniewska EU Budget: Expenditures Basic Finance: Finance of EU Marta Wisniewska EU Budget: Expenditures Basic Finance: Finance of EU Marta Wisniewska EU Budget: Expenditures Basic Finance: Finance of EU Marta Wisniewska Basic Finance: Finance of EU Marta Wisniewska 8. Social Protection Basic Finance: Social Protection Marta Wisniewska

. Social protection: introduction

. Statistical review: EU&OECD

. Poland: brief outline Basic Finance: Social Protection Marta Wisniewska Social Protection

Social protection involve an array of partially overlapping and complimentary benefits including:

. benefits for retirees and their survivors and dependents . unemployment and disability benefits . worker’s compensation . medical insurance . welfare benefits Basic Finance: Social Protection Marta Wisniewska Social Protection

Risks that social insurance institutions insure against:

. longevity risk (old age insurance) . health risks (medical insurance, disability, worker’s compensation) . job risks (unemployment insurance and the implicit insurance against lifetime earnings risk provided by progressive tax and transfer aspects of social insurance institutions). Basic Finance: Social Protection Marta Wisniewska Social Protection History of Social Security

1881 - Otto von Bismarck said that those unable to support themselves (throught work) because of late age or bad health have the right to get help from state

1883 - Krankenversicherung der Arbeiter: Workers’ health insurance

1884 – Unfallversicherung: Industrial accident insurance

1889 - Alters- und Invaliditätsversicherung für Arbeiter: Invalidity and old-age insurance

1911 Reich insurance system extended to civil servants / white-collar workers

1927 Unemployment insurance Basic Finance: Social Protection Marta Wisniewska Social Protection pay-as-you-go vs. fully funded system

Paygo problems, if: - decreased birth rates - increased life expectancies

Either benefits of older beneficiaries must fall, or tax rates on younger workers must rise. Basic Finance: Social Protection Marta Wisniewska Social Protection

In general OECD nations have large, well-developed social institutions, some of which are over 100 years olds.

Main difference in social insurance institutions in OECD countries is the level of the “safety net”:

-European nations tend to be “welfare states” with high benefit levels and tax rates;

-U.S. have lower safety nets due to a fear of socialism and the welfare state and a greater belief in lassiez- faire, individual self-reliance and initiative. Basic Finance: Social Protection Marta Wisniewska Social Protection

How many people in USA rely on Social Security for most of their income?

. 90% of people 65 and older get Social Security

. Nearly 2 in 3 (66%) get half or more of their income from Social Security

. About 1 in 5 (22%) get all their income from Social Security

SOURCE: National Academy of Social Insurance, Social Security Finances: A Primer (2005) Basic Finance: Social Protection Marta Wisniewska Basic Finance: Social Protection Marta Wisniewska Basic Finance: Social Protection Marta Wisniewska Basic Finance: Social Protection Marta Wisniewska Basic Finance: Social Protection Marta Wisniewska Basic Finance: Social Protection Marta Wisniewska Basic Finance: Social Protection Marta Wisniewska Basic Finance: Social Protection Marta Wisniewska Basic Finance: Social Protection Marta Wisniewska Basic Finance: Social Protection Marta Wisniewska Basic Finance: Social Protection Marta Wisniewska Basic Finance: Social Protection Marta Wisniewska Basic Finance: Social Protection Marta Wisniewska Basic Finance: Social Protection Marta Wisniewska Basic Finance: Social Protection Marta Wisniewska Basic Finance: Social Protection Marta Wisniewska Basic Finance: Social Protection Marta Wisniewska Basic Finance: Social Protection Marta Wisniewska Basic Finance: Social Protection Marta Wisniewska

Pension incomes in EU are presently derived primarily from public schemes financed mainly on a pay-as-you-go basis.

Presently it is only in a few Member States (e.g. IE, NL, DK, SE, UK) that privately managed funded pension schemes have a significant complementary role in adequate pension provision – and then mostly as an element that raises the aggregate replacement rate of the pension package.

Thanks to pension systems, older people in most countries are currently less exposed to the risk of poverty and severe material deprivation than the rest of the population. Yet some pensioners, in particular women 75+ living alone, tend to be exposed to rather high risks of poverty. Basic Finance: Social Protection Marta Wisniewska

DB - defined benefit

NDC - notionally defined contribution

DC - defined contribution Basic Finance: Social Protection Marta Wisniewska Basic Finance: Social Protection Marta Wisniewska Basic Finance: Social Protection Marta Wisniewska Basic Finance: Social Protection Marta Wisniewska Basic Finance: Social Protection Marta Wisniewska Basic Finance: Social Protection Marta Wisniewska Basic Finance: Social Protection Marta Wisniewska Basic Finance: Social Protection Marta Wisniewska Basic Finance: Social Protection Marta Wisniewska Basic Finance: Social Protection Marta Wisniewska Basic Finance: Social Protection Marta Wisniewska Basic Finance: Social Protection Marta Wisniewska Basic Finance: Social Protection Marta Wisniewska

Dec 2008-Dec 2013 Basic Finance: Social Protection Marta Wisniewska Basic Finance: Social Protection Marta Wisniewska Basic Finance: Social Protection Marta Wisniewska

The aggregate replacement ratio is a measure of the median individual gross pension (including old-age and other pension benefits of people aged 65-74) relative to the median individual gross earnings (of people aged 50-59). Basic Finance: Social Protection Marta Wisniewska Basic Finance: Social Protection Marta Wisniewska

Private pensions Basic Finance: Social Protection Marta Wisniewska Basic Finance: Social Protection Marta Wisniewska Basic Finance: Social Protection Marta Wisniewska Basic Finance: Social Protection Marta Wisniewska Basic Finance: Social Protection Marta Wisniewska

The Polish social security system is composed both of insurance and non- insurance (provision) elements.

500 + Basic Finance: Social Protection Marta Wisniewska

Most people in Poland, employees and self-employed outside agriculture, are covered by the general obligatory (statutory) pension system.

Apart from it, there are special schemes for: . farmers (social insurance scheme of KRUS - Kasa Rolniczego Ubezpieczenia Społecznego, Agricultural Social Insurance Fund, financed mainly from taxes) . separate state provision, tax-financed schemes for: . ‘uniformed services’ such as military, police and prison service, . as well as state provision for judges and prosecutors.

Within the general scheme, there are special rules for miners. Basic Finance: Social Protection Marta Wisniewska Basic Finance: Social Protection Marta Wisniewska Basic Finance: Social Protection Marta Wisniewska Basic Finance: Social Protection Marta Wisniewska Basic Finance: Social Protection Marta Wisniewska 9. Introduction to Corporate Finance Basic Finance: Corporate Finance… Marta Wisniewska

Corporate Finance: Bigger Picture

Maximize OBJECTIVE shareholder wealth/firm’s value

Investment Investment Financial decision Dividend decision decision Financial decision Dividend decision decision

What projects? Debt or equity? Active role? What projects? Debt or equity? Active role? Basic Finance: Corporate Finance… Marta Wisniewska

Corporate Finance: Bigger Picture

These decisions are highly inter-related

Suppose a firm wishes to invest in a new project…

The project needs financing…

This can be paid with Cash: the investment decision affects the Dividend retained earnings (cash), by decision borrowing more (debt) or Debt/Equity: the investment decision affects the by a share issue (equity) Financial decision Basic Finance: Corporate Finance… Marta Wisniewska

. What is corporation?

. Role of Financial Manager

. Maximizing Shareholders’ Value

Investment Decisions . Corporate Finance: Bigger Picture

. Financing Decisions Basic Finance: Corporate Finance… Marta Wisniewska What Is A Corporation?

Corporate Finance vs Managerial Finance Corporations vs All companies

Sole Proprietorships Unlimited Liability Personal tax on profits (US)

Partnerships

Limited Liability Corporations Corporate tax on profits + personal tax on dividends (US) Separation of ownership and management

A corporation is a legal entity (technically, a juristic person) which has a legal personality distinct from those of its members Basic Finance: Corporate Finance… Marta Wisniewska The Role of Financial Manager

cash invested in cash raised from firm investors

Firm’s Financial Financial operations manager markets

cash reinvest ed

cash generated by cash returned to operations investors

What real assets should the firm invest in? => investment, capital budgeting decision

How should the cash for investment be raised? => financing decision Basic Finance: Corporate Finance… Marta Wisniewska The Role of Financial Manager

Two basic tasks of Financial Manager

What real asset How should the cash should the firm for investment be invest in? raised?

=> investment/ => financing capital budgeting decision decision

Fundamental financial objective of a firm: Maximize the value of cash invested in the firm by shareholders Basic Finance: Corporate Finance… Marta Wisniewska Maximizing Shareholders’ Value

Corporate Finance: Bigger Picture

Maximize OBJECTIVE shareholder wealth/firm’s value

Investment Investment Financial decision Dividend decision decision Financial decision Dividend decision decision

What projects? Debt or equity? Active role? What projects? Debt or equity? Active role? Basic Finance: Corporate Finance… Marta Wisniewska Maximizing Shareholders’ Value

Choose an Objective Function Maximizing shareholders wealth

Maximizing firm’s value

Maximizing share price

The strength of the stock price maximization objective function is its internal self correction mechanism. Basic Finance: Corporate Finance… Marta Wisniewska Maximizing Shareholders’ Value

Choose a Different Objective Function  Firms can always focus on a different objective function. Examples would include Is maximizing  maximizing earnings  maximizing revenues shareholders’  maximizing firm size value easy to  maximizing market share achieve?  maximizing EVA  The key thing to remember is that these are intermediate objective functions.  To the degree that they are correlated with the long term health and value of the company, they work well.  To the degree that they do not, the firm can end up with a disaster Basic Finance: Corporate Finance… Marta Wisniewska Maximizing Shareholders’ Value Corporation: separation of ownership and management=> AGENCY COSTS &problems

STOCKHOLDERS Hire & fire Maximize managers stockholder - Board wealth - Annual Meeting

Lend Money No Social Costs BONDHOLDERS/ Managers SOCIETY LENDERS Protect All costs can be bondholder traced to firm Interests Reveal Markets are information efficient and honestly and assess effect on on time value FINANCIAL MARKETS Basic Finance: Corporate Finance… Marta Wisniewska Maximizing Shareholders’ Value What can go wrong?

STOCKHOLDERS Have little control Managers put over managers their interests above stockholders

Lend Money Significant Social Costs BONDHOLDERS/ Managers SOCIETY LENDERS Bondholders can Some costs cannot be get ripped off traced to firm

Delay bad news Markets make or provide mistakes and misleading can over react information FINANCIAL MARKETS

419 Basic Finance: Corporate Finance… Marta Wisniewska Maximizing Shareholders’ Value

I. Managers and Shareholders

 In theory: The stockholders have significant control over management.  The two mechanisms for disciplining management are (a) the annual meeting and (b) the board of directors. Specifically, we assume that  Stockholders who are dissatisfied with managers can not only express their disapproval at the annual meeting, but can use their voting power at the meeting to keep managers in check.  The board of directors plays its true role of representing stockholders and acting as a check on management.

 In Practice: Neither mechanism is as effective in disciplining management. Basic Finance: Corporate Finance… Marta Wisniewska Maximizing Shareholders’ Value

I. Managers and Shareholders

 The power of stockholders to act at annual meetings is diluted :  Most small stockholders do not go to meetings because the cost of going to the meeting exceeds the value of their holdings.  For large stockholders, the path of least resistance, when confronted by managers that they do not like, is to vote with their feet (buy other company stocks).

 Annual meetings are also tightly scripted and controlled events, making it difficult for outsiders and rebels to bring up issues that are not to the management’s liking. Basic Finance: Corporate Finance… Marta Wisniewska Maximizing Shareholders’ Value

I. Managers and Shareholders

Board of Directors as a disciplinary mechanism

 In 2010, the median board member at a Fortune 500 company was paid $212,512, with 54% coming in stock and the remaining 46% in cash. If a board member is a non-executive chair, he or she receives about $150,000 more in compensation.

 A board member works, on average, about 227.5 hours a year (and that is being generous), or 4.4 hours a week, according to the National Associate of Corporate Directors. Of this, about 24 hours a year are for board meetings.

 Many directors serve on three or more boards, and some are full time chief executives of other companies. Basic Finance: Corporate Finance… Marta Wisniewska Maximizing Shareholders’ Value

I. Managers and Shareholders The CEO often hand-picks directors  A 1992 survey by Korn/Ferry revealed that 74% of companies relied on recommendations from the CEO to come up with new directors; Only 16% used an outside search firm. While that number has changed in recent years, CEOs still determine who sits on their boards. While more companies have outsiders involved in picking directors now, CEOs still exercise significant influence over the process.

 Directors often hold only token stakes in their companies. The Korn/Ferry survey found that 5% of all directors in 1992 owned less than five shares in their firms. Most directors in companies today still receive more compensation as directors than they gain from their stockholdings. While share ownership is up among directors today, they usually get these shares from the firm (rather than buy them).

 Many directors are themselves CEOs of other firms. Worse still, there are cases where CEOs sit on each other’s boards. Basic Finance: Corporate Finance… Marta Wisniewska Maximizing Shareholders’ Value

I. Managers and Shareholders

Board of Directors as a disciplinary mechanism

 Calpers, the California Employees Pension fund, suggested three tests in 1997 of an independent board  Are a majority of the directors outside directors?  Is the chairman of the board independent of the company (and not the CEO of the company)?  Are the compensation and audit committees composed entirely of outsiders?

 Disney (1997) was the only S&P 500 company to fail all three tests. Basic Finance: Corporate Finance… Marta Wisniewska

Who’s on Board? The Disney Experience - 1997 Basic Finance: Corporate Finance… Marta Wisniewska

S&P500 Basic Finance: Corporate Finance… Marta Wisniewska Maximizing Shareholders’ Value

I. Managers and Shareholders Application Test: Who owns/runs your firm?  Who are the top stockholders in your firm?  What are the potential conflicts of interests that you see emerging from this stockholding structure?

Outside Government Stockholders Managers -size of holding -length of tenue -active or passive Control of the firm -links to insiders -short or long term

Employees Lenders

Inside stockholders -% of stock held -voting & non voting shares -control structure Basic Finance: Corporate Finance… Marta Wisniewska Maximizing Shareholders’ Value

I. Managers and Shareholders

Disney’s top stockholders in 2003 Basic Finance: Corporate Finance… Marta Wisniewska Maximizing Shareholders’ Value

I. Managers and Shareholders

Things change.. Disney’s top stockholders in 2009 Basic Finance: Corporate Finance… Marta Wisniewska Maximizing Shareholders’ Value

I. Managers and Shareholders

 When managers do not fear stockholders, they will often put their interests over stockholder interests  Maximizing the size of the company (prestige)  Increasing managerial power  Making their jobs more secure  Increasing personal remuneration  Personal projects Basic Finance: Corporate Finance… Marta Wisniewska Maximizing Shareholders’ Value

II. Shareholders’ objectives vs. Bondholders’ objectives

 In theory: there is no conflict of interests between stockholders and bondholders.

 In practice: Stockholder and bondholders have different objectives.  Bondholders are concerned most about safety and ensuring that they get paid their claims.  Stockholders are more likely to think about upside potential Basic Finance: Corporate Finance… Marta Wisniewska Maximizing Shareholders’ Value

II. Shareholders’ objectives vs. Bondholders’ objectives Examples of the conflict…

 Increasing dividends significantly:  When firms pay cash out as dividends, lenders to the firm are hurt and stockholders may be helped. This is because the firm becomes riskier without the cash.

 Taking riskier projects than those agreed to at the outset:  Lenders base interest rates on their perceptions of how risky a firm’s investments are. If stockholders then take on riskier investments, lenders will be hurt.

 Borrowing more on the same assets:  If lenders do not protect themselves, a firm can borrow more money and make all existing lenders worse off. Basic Finance: Corporate Finance… Marta Wisniewska Maximizing Shareholders’ Value

II. Shareholders’ objectives vs. Bondholders’ objectives

An Extreme Example: Unprotected Lenders? Basic Finance: Corporate Finance… Marta Wisniewska Maximizing Shareholders’ Value

III. Firms and Financial Markets

 In theory: Financial markets are efficient. Managers convey information honestly and in a timely manner to financial markets, and financial markets make reasoned judgments of the effects of this information on 'true value'. As a consequence-  A company that invests in good long term projects will be rewarded.  Short term accounting gimmicks will not lead to increases in market value.  Stock price performance is a good measure of company performance.

 In practice: There are some holes in the 'Efficient Markets' assumption. Basic Finance: Corporate Finance… Marta Wisniewska Maximizing Shareholders’ Value

III. Firms and Financial Markets

Managers control the release of information to the general public  Information (especially negative) is sometimes suppressed or delayed by managers seeking a better time to release it.

 In some cases, firms release intentionally misleading information about their current conditions and future prospects to financial markets. Basic Finance: Corporate Finance… Marta Wisniewska Maximizing Shareholders’ Value

III. Firms and Financial Markets

Evidence that managers delay bad news? Basic Finance: Corporate Finance… Marta Wisniewska Maximizing Shareholders’ Value

III. Firms and Financial Markets

Some critiques of market efficiency...

Investors are irrational and prices often move for no reason at all. As a consequence, prices are much more volatile than justified by the underlying fundamentals. Earnings and dividends are much less volatile than stock prices.  Investors overreact to news, both good and bad.  Financial markets are manipulated by insiders; Prices do not have any relationship to value.  Investors are short-sighted, and do not consider the long-term implications of actions taken by the firm Basic Finance: Corporate Finance… Marta Wisniewska Maximizing Shareholders’ Value

IV. Firms and the Society  In theory: All costs and benefits associated with a firm’s decisions can be traced back to the firm.  In practice: Financial decisions can create social costs and benefits.  A social cost or benefit is a cost or benefit that accrues to society as a whole and not to the firm making the decision. Environmental costs (pollution, health costs, etc..) Quality of Life' costs (traffic, housing, safety, etc.)  Examples of social benefits include: creating employment in areas with high unemployment supporting development in inner cities creating access to goods in areas where such access does not exist Basic Finance: Corporate Finance… Marta Wisniewska Maximizing Shareholders’ Value

IV. Firms and the Society

Social Costs and Benefits are difficult to quantify because ...

 They might not be known at the time of the decision. In other words, a firm may think that it is delivering a product that enhances society, at the time it delivers the product but discover afterwards that there are very large costs. (Asbestos was a wonderful product, when it was devised, light and easy to work with… It is only after decades that the health consequences came to light)

 They are ‘person-specific’, since different decision makers can look at the same social cost and weight them very differently.

 They can be paralyzing if carried to extremes. Basic Finance: Corporate Finance… Marta Wisniewska Maximizing Shareholders’ Value

IV. Firms and the Society

A test of your social consciousness: Put your money where you mouth is…

 Assume that you work for Disney and that you have an opportunity to open a store in an inner-city neighborhood. The store is expected to lose about a million dollars a year, but it will create much-needed employment in the area, and may help revitalize it.  Would you open the store?  Yes  No  If yes, would you tell your stockholders and let them vote on the issue?  Yes  No  If no, how would you respond to a stockholder query on why you were not living up to your social responsibilities? Basic Finance: Corporate Finance… Marta Wisniewska Investment decisions

Shareholders invest in companies to make money.

How to chose which project to invest in?

Investment decision = Capital Budgeting Basic Finance: Corporate Finance… Marta Wisniewska Investment decisions

Investment Appraisal Methods

 Traditional techniques (1) Payback Period (2) Return on Capital Employed (ROCE)

 Discounted cash flows methods (3) Net Present Value (NPV) (4) Internal Rate of Return (IRR) Basic Finance: Corporate Finance… Marta Wisniewska Investment decisions

Investment Appraisal Methods Payback period

 How long does it take the project to “pay back” its initial investment?

 Payback period = # years required for the future cumulative cash flows to match the initial outlay

 A modified version that takes time value of money into account: Discounted payback period = # years required for the future cumulative discounted cash flows to match the initial outlay Basic Finance: Corporate Finance… Marta Wisniewska Investment decisions

Investment Appraisal Methods Payback period

Year Cash flow ($) Cumulative cash flow ($) 0 (450) (450) 1 100 (350) 2 200 (150) 3 100 (50) 4 100 50 5 80 130  Payback period = between 3 and 4 years  Payback period = 3.5 years  Ranking criterion: Select the project with the lowest payback period first Basic Finance: Corporate Finance… Marta Wisniewska Investment decisions

Investment Appraisal Methods Payback period  Advantages • Easy to understand, calculate, and communicate • Useful for companies that face cash flows constraints (e.g. small companies) since it is biased toward liquidity

 Disadvantages • Ignores cash flows after the payback period • Biased against long-term projects • Arbitrary acceptance criterion (i.e. when there is a single project to consider) • Accepted projects may not actually add value to the company (or the shareholders’ wealth) Basic Finance: Corporate Finance… Marta Wisniewska Investment decisions

Investment Appraisal Methods Return on Capital Employed (ROCE)  Also known as return on investment (ROI) and accounting rate of return (ARR)

 All definitions relate accounting profit to some measure of the capital employed

 We will follow following formula: 퐴푣푒푟푎푔푒 푎푛푛푢푎푙 푎푐푐표푢푛𝑖푡푛푔 푝푟표푓𝑖푡 푅푂퐶퐸 = × 100 퐴푣푒푟푎푔푒 𝑖푛푣푒푠푡푚푒푛푡

 Accounting profits = before-tax operating cash flows adjusted to take account of depreciation

 Average investment must take account of scrap value Basic Finance: Corporate Finance… Marta Wisniewska Investment decisions

Investment Appraisal Methods Return on Capital Employed (ROCE) EXAMPLE:  Project A generates annual cash flows (receipts less payments) of $210,000 for 5 years  The initial cost of machinery is $500,000; no scrap value

 Average investment = (500,000 + 0)/2 = 250,000  Total cash profit = 210,000 × 5 = 1,050,000 Total accounting profit (after depreciation) = 550,000 Average accounting profit = 550,000/5 = 110,000

 ROCE = 110,000/250,000 = 44%  Ranking criterion: Select the project with the highest ROCE first Basic Finance: Corporate Finance… Marta Wisniewska Investment decisions

Investment Appraisal Methods Return on Capital Employed (ROCE)

 Advantages • Easy to understand and communicate: “Return on (long-term) investment” • Accounting information readily available

 Disadvantages • Accounting profits are not cash flows, since depreciation is an accounting adjustment • Ignores time value of money • Arbitrary acceptance criterion: Compare ROCE to some ‘target’ rate of return → Is 44% ROCE high enough? Basic Finance: Corporate Finance… Marta Wisniewska Investment decisions

Investment Appraisal Methods Net Present Value (NPV)

퐶 퐶 퐶 퐶 푁푃푉 = −퐼 + 1 + 2 + 3 + ⋯ + 푛 0 (1 + 푟) 1 + 푟 2 1 + 푟 3 1 + 푟 푛

where: I0 is the initial investment

C1, C2, C3 … are the cash flows expected in time 1, 2, 3,… r is the cost of capital or required rate of return

 Minimum acceptance criterion: Accept if NPV > 0 A positive NPV indicates that the investment offers a return in excess of the cost of capital

 Ranking criterion: Select the project with the highest NPV first Basic Finance: Corporate Finance… Marta Wisniewska Investment decisions

Investment Appraisal Methods Net Present Value (NPV)

 NPV is based in solid theory • It makes use of the time value of money • And the PV concept we considered earlier in the module

 NPV measures actual wealth creation because • It uses cash flows • It uses ALL cash flows during the project life • It discounts ALL cash flows during the project life, using the cost of capital (or the required rate of return) Basic Finance: Corporate Finance… Marta Wisniewska Investment Appraisal Methods Investment Appraisal Methods Net Present Value (NPV) Example

 Can be done very easily in a spreadsheet/Excel

 Notice that NPV has an inverse relationship with r  As r increases the NPV of a given project falls  This makes sense; the higher the rate of return we require the fewer projects we would expect to be profitable Basic Finance: Corporate Finance… Marta Wisniewska Investment decisions

Investment Appraisal Methods Net Present Value (NPV)

To estimate NPV we need to:

 Estimate the initial cost → Usually this is known for certain

 Estimate future cash flows → “Expected” future cash flows, so subject to errors → Risk of appraisal methods in general, not only NPV

 Estimate discount rate → Required rate of return We will do that at the → CAPM next lecture Basic Finance: Corporate Finance… Marta Wisniewska Investment decisions Investment Appraisal Methods Investment Appraisal Methods Net Present Value (NPV) Advantages

 Takes account of the time value of money

 Uses cash flows rather than accounting profit

 Uses all relevant cash flows

 Academically(!) preferred method

 If capital is available NPV gives good investment advice Basic Finance: Corporate Finance… Marta Wisniewska Investment decisions

Investment Appraisal Methods Net Present Value (NPV)

Disadvantages

 Hard to forecast future cash flows  But this is true of all investment appraisal techniques!

 Cost of capital may change over the lifetime of the project Basic Finance: Corporate Finance… Marta Wisniewska Investment decisions

Investment Appraisal Methods Internal Rate of Return (IRR)

 It is defined implicitly as the discount rate at which NPV is equal to zero

퐶 퐶 퐶 퐶 1 + 2 + 3 + ⋯ + 푛 − 퐼 = 0 1 + 푟∗ 1 + 푟∗ 2 1 + 푟∗ 3 1 + 푟∗ 4 0

where r* is the Internal Rate of Return

 Minimum acceptance criterion: Accept a project if its IRR exceeds the cost of capital (or required rate of return)

 Ranking criterion: Select the project with the highest IRR first Basic Finance: Corporate Finance… Marta Wisniewska Investment decisions

Investment Appraisal Methods Internal Rate of Return (IRR) Example: You can purchase a turbo powered machine tool gadget for $4,000. The investment will generate $2,000 and $4,000 in cash flows for two years, respectively. What is the IRR on this investment?

2,000 4,000 NPV  4,000    0 IRR  28.08% (1 IRR)1 (1 IRR)2

2500 IRR= 28% 2000 1500 1000 500 0

NPV NPV (,000s) -500 10 20 30 40 50 60 70 80 90 100 -1000 -1500 -2000 Discount rate (%) Capital Budgeting Investment decisions

Investment Appraisal Methods Internal Rate of Return (IRR)

퐶1 퐶2 퐶3 퐶푛 + + + ⋯ + − 퐼 = 0 (1) 1 + 푟∗ 1 + 푟∗ 2 1 + 푟∗ 3 1 + 푟∗ 4 0

Equation (1) is not easy to solve (even if C = C1 = C2 = C3 = … = Cn)

퐶 1 퐼 = 1 − (2) 0 푟∗ 1 + 푟∗ 푛

PV of Annuity  We would need to solve equation (2) to find r*

 Before we had Excel the solution was basically to guess... Basic Finance: Corporate Finance… Marta Wisniewska Investment decisions

Investment Appraisal Methods Internal Rate of Return (IRR)

 Of course mathematicians don’t guess!

 Instead they use Numerical Analysis...

 …and in this case Linear Interpolation

 Which sounds far more sophisticated than ‘guessing’

 Let’s see how it works… Basic Finance: Corporate Finance… Marta Wisniewska Investment decisions

Investment Appraisal Methods Internal Rate of Return (IRR) Suppose we know the two end points

[x0, y0],[x1,y1] Substituting for y and x in the standard formula for a straight line, y = ax+b, gives: 푦 − 푦 푎 = 1 0 푥1 − 푥0

푦1−푦0 and 푏 = 푦0 − 푥0 푥1−푥0

This means the formula for a straight line becomes:

푦1 − 푦0 푦1 − 푦0 푦 = 푥 + 푦0 − 푥0 푥1 − 푥0 푥1 − 푥0 Basic Finance: Corporate Finance… Marta Wisniewska Investment decisions

Investment Appraisal Methods Internal Rate of Return (IRR) To find the approximation of a true IRR, i.e. IRR* is equivalent with solving the below for x: NPV

푦1 − 푦0 푦1 − 푦0 A(R1,NPV1) 푦 = 푥 + 푦0 − 푥0 푥1 − 푥0 푥1 − 푥0 +

(IRR*, 0) we obtain: 0 Discount rate IRR 푥1 − 푥0 - B(R ,NPV ) 푥 = 푥0 − 푦0 2 2 푦1 − 푦0 which can be written in terms of points A and B as:

∗ 푅2 − 푅1 퐼푅푅 = 푅1 − 푁푃푉1 푁푃푉2 − 푁푃푉1 Basic Finance: Corporate Finance… Marta Wisniewska Investment decisions

Investment Appraisal Methods Internal Rate of Return (IRR)  To finding the IRR*, which is an approximation is called Linear NPV Interpolation.

A(R1,NPV1)

+  Of course the closer the NPV1 and NPV2 are to zero (from above and below) the (IRR*, 0) closer the approximation 0 Discount rate IRR

- B(R2,NPV2)  Since the relationship between NPV and the discount rate of a conventional cash flow is negatively sloped and convex the estimate will always be an over-estimate Basic Finance: Corporate Finance… Marta Wisniewska Investment decisions

Investment Appraisal Methods Internal Rate of Return (IRR)  Generally, very computationally challenging, i.e. no formula, not as straightforward as NPV  Trial & error – keep trying different discount rates untill NPV=0

Use Solver in Excel Basic Finance: Corporate Finance… Marta Wisniewska Investment decisions

Investment Appraisal Methods Internal Rate of Return (IRR) Pitfall 1 - Lending or Borrowing? With some cash flows (as noted below) the NPV of the project increases as the discount rate increases. This is contrary to the normal relationship between NPV and discount rates. NPV C0 C1 C2 C3 IRR NPV@10% 1,000  3,600 4,320 1,728  20% .75

Discount Rate

Pitfall 2 - Multiple Rates of Return Certain cash flows can generate NPV=0 at two different discount rates. The following cash flow generates NPV=0 at both (-50%) and 15.2%. NPV

C0 C1 C2 C3 C4 C5 C6 1,000  800 150 150 150 150 150 IRR=15.2%

Discount Rate IRR=-50% Basic Finance: Corporate Finance… Marta Wisniewska Investment decisions

Investment Appraisal Methods Internal Rate of Return (IRR)

Pitfall 3 - Mutually Exclusive Projects IRR sometimes ignores the magnitude of the project. The following two projects illustrate that problem.

At 10% IRRA=19.5% while IRRB= 17%.

As the discount rate decreases, and before the lines cross, NPV suggests B, while IRR suggests A .

Pitfall 4 - Term Structure Assumption We assume that discount rates are stable during the term of the project. This assumption implies that all funds are reinvested at the IRR. This is a false assumption. NPV allows for change in discount rate. Basic Finance: Corporate Finance… Marta Wisniewska Investment decisions

Investment Appraisal Methods NPV vs. IRR

 There is no conflict between these two methods when a single project with conventional cash flows is being considered

 But for non-conventional (strange cash flows) mutually exclusive projects, a conflict might arise

 NPV is academically preferred because it measures the absolute increase in value of the company

 In all cases where there is no constraint on capital, the NPV decision rule offers sound investment advice Basic Finance: Corporate Finance… Marta Wisniewska Investment decisions

Investment Appraisal Methods NPV vs. IRR

There are a number of issues that we need to take into account when applying NPV in practice (i.e. how do we come up with the cash flows and what considerations do we need to make?):

 Relevant project cash flows – Ask whether a cash flow occurs as a result of undertaking a project (Incremental cash flows)

 Taxation – what effect does taxation have on the cash flow from the project

 Inflation – reduces the real value of future cash flows

 Investment risk – when things don’t go as you expect Basic Finance: Corporate Finance… Marta Wisniewska Investment decisions

Investment Appraisal Methods

 Traditional techniques (1) Payback Period (2) Return on Capital Employed (ROCE)

 Discounted cash flows methods (3) Net Present Value (NPV) (4) Internal Rate of Return (IRR) Basic Finance: Corporate Finance… Marta Wisniewska Financing decisions

 Does it matter which source of capital company chooses?  If some forms of capital costs less than others this suggests there could be a capital structure that maximizes shareholder wealth Basic Finance: Corporate Finance… Marta Wisniewska Financing decisions

Financing decisions concern the type and quantity of financial assets issued by the corporation to acquire real and financial assets and where those financial assets should be issued.

Company can be finance by debt or equity or a mix of both.

. Irrelevance Theory . Relevance Theory

. Peaking Order Theory Basic Finance: Corporate Finance… Marta Wisniewska Financing decisions Irrelevance Theory

Miller and Modigliani

Under a certain market price process (the random walk), in the absence of taxes, bankruptcy costs, agency costs, and asymmetric information, and in an efficient market, the value of a firm is unaffected by how that firm is financed. Basic Finance: Corporate Finance… Marta Wisniewska Financing decisions Relevance Theory

M&M assumptions don’t hold in real world:

. prices don’t behave like random walk . there are taxes . bankruptcy costs . agency costs . asymmetric information . the market is not efficient

Therefore the value of a firm is affected by how that firm is financed. Basic Finance: Corporate Finance… Marta Wisniewska Financing decisions Peaking Order Theory

The announcement of a stock issue drives down the stock price because investors believe managers are more likely to issue when shares are overpriced.

Therefore firms prefer internal finance since funds can be raised without sending adverse signals.

If external finance is required, firms issue debt first and equity as a last resort.

The most profitable firms borrow less not because they have lower target debt ratios but because they don't need external finance. Basic Finance: Corporate Finance… Marta Wisniewska

. What is corporation?

. Role of Financial Manager

. Maximizing Shareholders’ Value

. Investment Decisions

. Financing Decisions Class 4:

Group Presentation

Test Group Presentation TEST