Download Finance 525 Week 1

Finance 525
Week 1
Introduction to the Course and
to the Concept of Money
Fall 2006
Professor Ross Miller
University at Albany
School of Business
Copyright 2006 by Ross M. Miller. All rights reserved
Fin 525 Mission Statement
To give every student a practical
understanding of how the world
of finance works.
Professor Ross Miller • Fall 2006
1
Course Syllabus
 Available on paper in class
 Also available on the Internet at:
http://www.riggedonline.com/Finance/Fin525Fall
2006Syllabus.pdf
 The most critical points from the syllabus are
reiterated on the next several slides
Professor Ross Miller • Fall 2006
2
Overview of the Course Calendar
 Weeks 1 – 3 (Part I): Money of all Kinds
 Weeks 3 (Part II) – 5: Long-Term Debt
 Week 6: Midterm Exam
 Weeks 7 – 11: Equity and Portfolio Management
 Week 12: Capital Budgeting
 Week 13: (Optional) Final Exam
Professor Ross Miller • Fall 2006
3
Grading
 The raw grade for the course is the average of
the best three of the following four:
•
•
•
•
Mid-term exam
Stock prediction and hedging exercise
401(k) group project
Final exam (optional)
 Class participation and evidence of improvement
will influence grades of students with grades
near the border between two grades
Professor Ross Miller • Fall 2006
4
What is Different About
How I Teach This Course
 Textbooks and traditional finance classes focus
on the wonderful things that academics have
discovered
 This course focuses on financial instruments,
how they are used, and how finance
professionals attempt to value them
 Topics concerning international finance and
derivative securities are integrated directly into
the course and not ignored or relegated to
advanced courses
Professor Ross Miller • Fall 2006
5
Readings
 Custom course textbook
• Time value of money and capital budgeting covered
by Ross/Westerfield/Jaffe (RWJ) chapters
• Stocks and portfolios covered by Bodie/Kane/Marcus
(BKM)
 Other basic content covered by material on class
slides or on the Internet (with links from the slides
and/or WebCT)
 Current financial events from the Wall Street Journal:
10-week subscription for $13.95 or a 15-week
subscription for $19.95 (School zip code is 12222)
Professor Ross Miller • Fall 2006
6
A Note on the Custom Textbook
 It is designed as a central source for financial
formula and their application
 It is not designed to entertain you (that is my job)
 The financial world moves so quickly that all
textbooks are out-of-date even before they are
published
Professor Ross Miller • Fall 2006
7
Use of WebCT in the Course
 Repository for course materials
 Primary means of contacting the professor
(via E-mail)
• Can also send mail to [email protected]
 Discussions and notifications (especially concerning
topics that arise in class discussions and problem
solutions)
 Slides are also available at:
http://home.earthlink.net/~millerrisk/FinanceNotes.htm
Professor Ross Miller • Fall 2006
8
Assignments
 Assignments appear on the last slides for each
week and on WebCT
 Most weeks have specific readings that must be
read prior to the next class meeting
 Most weeks also have exam-like problems to
answer
 Assignments are not handed in or graded, but
experience indicates that students who fail to do
them encounter real trouble on the exams
Professor Ross Miller • Fall 2006
9
Smile
 I will take digital photos of all class members at
both the Week 2 and Week 3 class meetings
Professor Ross Miller • Fall 2006
10
A Bit of Advice
 If you are lost, others probably are lost too, so
ASK THE PROFESSOR TO EXPLAIN WHAT IN
THE WORLD HE IS TALKING ABOUT!
Professor Ross Miller • Fall 2006
11
A Disclaimer
 The slides used in this course incorporate much
more information per slide than is considered
acceptable for standard corporate
communications
 This is done so that they can serve as a more
comprehensive form of notes that goes well
beyond what is in the “textbook”
Professor Ross Miller • Fall 2006
12
What is Finance?
 Two major elements
• Time
• Uncertainty (particularly involving the risk of an
unfavorable outcome)
 A typical very simple financial transaction
• Borrow money to purchase capital equipment to
produce goods or services and use some of the
revenue to repay the money at a specified later
time
Professor Ross Miller • Fall 2006
13
Finance Focuses on Cash Flows
 There are three basic ways that cash flows can
be structured
1. Straight financing: Pay cash now in return for
the right to receive something, often just more
cash, later
2. Forward contract: Agree now to buy or sell an
item at a fixed price at some future date(s)
3. Option contract: Pay cash now in return for the
option to buy or sell an item at a fixed price at
some future date(s)
Professor Ross Miller • Fall 2006
14
Financial Instruments Involve the
Creative Packaging of Cash Flows
 Stocks and bonds
• Pay now, have the right to (but not necessarily
receive) a stream of future cash flows
 Futures contracts
• A forward contract with collateral (called margin)
paid up front and maintained until delivery
 Mutual funds (including ETFs)
• An often useful bundle of stocks, bonds, or a
combination of both
Professor Ross Miller • Fall 2006
15
Valuation is Done Two Ways
 Discounting
• Cash in the future is worth less than the same
amount of cash held now
• A lot of finance is about determining how large
this difference in value is or should be
• This is known (depending on context) as an
interest rate, discount rate, or discount factor
 Arbitrage
• Turn something new that you wish to value into
pieces of something old (“slice and dice”) that
you already know how to value
Professor Ross Miller • Fall 2006
16
Much of Finance is about “Shopping”
 Accomplish a financial goal at the least possible
cost
• Corporate financing
• Household financing
 Accomplish a financial goal with the least
possible risk
 Find bargains and sell them to others at a profit
 Avoid getting “ripped off” (too often)
Professor Ross Miller • Fall 2006
17
Finance Is Also About
Information and Expectations
 Prices reflect existing information and
expectations
 Prices change as information and expectations
change
 Just how well prices reflect information and
expectations is hotly debated—but the
consensus is very well, though not perfectly
 Prices also take other things into account—
most notably, risk
Professor Ross Miller • Fall 2006
18
A Side Note on Internet Sources
 Internet sources of financial information,
definitions are usually but not always correct
 Investopedia is especially good, but even it has
misinformation
 Be especially careful about using Wikipedia
Professor Ross Miller • Fall 2006
19
The Six Types of “Objects” in This Course
1. Financial Instruments
2. Analytic Methods E=mc2
3. Financial Indicators (indexes)
4. Events (both historical and current)
5. Institutions
6. People
Professor Ross Miller • Fall 2006
20
Financial Instruments Fall Roughly
Into Four Categories
Money (short-term debt and cash)
Long-term debt
Fixed
Income
Equity
Real assets
Professor Ross Miller • Fall 2006
21
Google Stock (Nasdaq: GOOG)
 Google went public in August 2004
 Is volatile and can behave in ways that are
atypical of most stocks
 Fin 525’s “pet stock” in AY2004–2005 and
AY2005–2006
Professor Ross Miller • Fall 2006
22
This is an Analytic Methods Slide
(Believe It or Not)
Professor Ross Miller • Fall 2006
E=mc2
23
S&P 500 Stock Index
 The stock index most often used by financial
professionals
 Vanguard’s mutual fund that is designed to
replicate the performance of the index is among
the largest mutual funds in the U.S.
 Are also the basis for the exchange-traded fund
(ETF) with the symbol SPY that are known as
Spiders (SPDRs)
Professor Ross Miller • Fall 2006
24
Both Current and Historical Events
Are Covered
Professor Ross Miller • Fall 2006
25
United States Department of Treasury
 Issuer of many of the financial securities covered
in the early on in the course
 The largest single player in the world economy
because it is responsible for funding the Federal
government’s budget deficit
 Because its securities are considered “risk free,”
the rates of interest that it pays serve as
baselines
Professor Ross Miller • Fall 2006
26
Steven A. (“Stevie”) Cohen
 Superstar billionaire hedge fund manager
 His company, SAC Capital, is responsible for a
significant amount of the volume on U.S. stock
exchanges
 Traders at SAC Capital have attracted the
attention of securities regulators
Professor Ross Miller • Fall 2006
27
Any Questions?
Professor Ross Miller • Fall 2006
???
28
U.S. Federal Reserve Note (Cash)
Professor Ross Miller • Fall 2006
29
Federal Reserve Bank
 The central bank of the United States
 Founded in 1913 as the central bank of the U.S.
 Original mission was to provide financial stability
 Federal Reserve Notes constitute the bulk of its
liabilities
 Visit its current balance sheet
• Text format
• PDF format
Professor Ross Miller • Fall 2006
30
So, What Is Money Anyway?
Professor Ross Miller • Fall 2006
???
31
Money in Prison
Professor Ross Miller • Fall 2006
32
“Cash is Trash”
 Cash pays no interest and its value is eaten
away by “inflation”
 Therefore, businesses try to hold as little cash as
possible
 To deal with short-term funding requirements,
businesses hold other forms of “money”
 Bank deposits (and things that resemble them,
like most money-market funds) are a preferred
form of money
Professor Ross Miller • Fall 2006
E=mc2
33
Wal-Mart’s Cash on the Balance Sheet
Professor Ross Miller • Fall 2006
E=mc2
34
How Do We Know How Much Cash
Wal-Mart has in its Cash Registers?
Is Lots of Cash a Good Thing?
Professor Ross Miller • Fall 2006
???
35
Certificates of Deposits (CDs)
 Issued by banks
 How they work
• Deposit money with bank right now (cash
outflow)
• Receive even more money at a specified
maturity date (cash inflow)
 CDs are a form of time deposit (in contrast to a
demand deposit)
 We will focus on CDs that mature in under one
year, the boundary between short and long term
Professor Ross Miller • Fall 2006
36
CDs Rates are Required by Law to be
Quoted as Annual Interest Rates
 A popular place to find CD rates is bankrate.com
 CD calculator
• This deals with time periods other than a year
and compounding
Professor Ross Miller • Fall 2006
37
Computing the Future Value (FV) of a CD
(RWJ pp. 60-61)
 Parameters
• Cash outflow now: C0 = $10,000
• CD interest rate: r = 12% or 0.12
 Formula (for a single period)
• FV = C0 (1+r)
 Applying the formula
• FV = $10,000 (1 + 0.12) = $10,000 (1.12) =
$11,200
Professor Ross Miller • Fall 2006
E=mc2
38
Reality Check
 Interest rates on any form of bank deposit have
during a single period of American history and
may never be that high again
 The textbook then uses 12% virtually risk-free
return on the CD as the discount rate to evaluate
(compute the present value, PV) of a “risky”
project, which is not a good idea
Professor Ross Miller • Fall 2006
E=mc2
39
What If You Really Could Get 12%
on CDs?
Professor Ross Miller • Fall 2006
???
40
Suppose You Want to Receive $11,424
One Year From Now at 12% Interest
 The size of the CD you will purchase now is the
present value (PV) of the $11,424 in one year
 Formula (for a single period)
• PV = C1 / (1+r)
 Applying the formula
• PV = $11,424 / (1 + 0.12) = $11,424 / (1.12) =
$10,200
 PV is also a built-in Excel function
Professor Ross Miller • Fall 2006
E=mc2
41
Computing Present Values
 We will introduce two complications
• Periods of time shorter or longer than the period
over which the interest rate is quoted (usually
one year)
• Compounding: Getting interest on interest
 PV is easy to compute on any calculator, not just
financial calculators
 PV is a built-in Excel function
• Note: For Excel C0 is a negative number, which
makes sense, but is not the way textbooks do it
Professor Ross Miller • Fall 2006
E=mc2
42
Computing NPV (Net Present Value), Which
Is PV with the Initial Investment Netted Out
 Parameters
• Cash outflow now: C0 = $10,000
• Cash inflow in one year: C1 = $11,200
• Interest rate on 8/22/05: 4.30%
 Formula: NPV = – C0 + C1 / (1+r)
 Applying the formula
• NPV = – $10,000 + $11,200 / (1 + 0.043) =
– $10,000 + $10,738.26 = $738.26
Professor Ross Miller • Fall 2006
E=mc2
43
Excel and NPV
 The computation on the previous slide is difficult
to do automatically in Excel
 Minor problem: Excel has an NPV function, but it
makes no provision for the first cash flow to
occur right now
 The PV function can be coaxed to do this
Professor Ross Miller • Fall 2006
E=mc2
44
Summary of Bank Time Deposits
and Discounting
 Simple payment scheme from bank CDs
• Pay money in now
• Get more money out later
 The interest rate determines how much money is
paid out later relative to the amount paid in
 To get future value multiple by (1+r) to get
present value divide by (1+r), where r is the
interest rate for the period
Professor Ross Miller • Fall 2006
45
The Fundamental Relationship Between
Interest Rate (r) and Present Value (PV)
 Interest rates and the PV of any every financial
instrument with constant future cash flows (fixedincome securities like CDs and bonds) always
move in opposite directions
 Example: The PV of $10,000 at 4% interest in 1
year is $10,000/1.04 = $9,615.38
• If the interest rate goes up to 5%, the PV drops
to $10,000/1.05 = $9,523.81
• If the interest rate goes down to 3%, the PV rises
to $10,000/1.03 = $9,708.74
Professor Ross Miller • Fall 2006
E=mc2
46
More on the Fundamental Relationship
 We will examine the sensitivity of various fixedincome securities to interest rates before
midterm using a measurement called duration
 While the prices of stocks and some risky bonds
(both have very uncertain cash flows) tend to
move in the opposite direction of interest rates,
they sometimes move in the same direction
when the change in interest rates indicates
strength or weakness in the economy
Professor Ross Miller • Fall 2006
E=mc2
47
Converting Annual Interest Rates to Periods
Less Than One Year
 Obvious method
• Multiply rate by the appropriate fraction of a year
 Examples:
• 12% for 6 months (or ½ year) is ½ (12%) = 6%
• 8% for 3 months (or ¼ year) is ¼ (8%) = 2%
 Warning
• The financial world often does not conform to the
“obvious method” because annual rates can be
quoted oddly or based on a 360-day year
Professor Ross Miller • Fall 2006
E=mc2
48
FV and PV for Less Than a Year with
No Compounding
 Convert interest rate to new period length as
demonstrated earlier
 Apply the FV and PV formulas as before
• FV = C0 (1+r)
• PV = C1 / (1+r)
 FV of $10,000 paying 4% annual rate for 6
months ( ½ year)
• FV = $10,000 (1 + 0.04/2) = $10,200
Professor Ross Miller • Fall 2006
E=mc2
49
Suppose We Reinvest in an Identical CD
After 6 Months
 Now our outflow (initial investment) is $10,200
 The future value in six months is $10,200 (1.02)
= $10,404
 Notice that this is the same as investing for an
entire year at 4.04%
 4.04% is known as the APY (annual percentage
yield) or EAR (effective annual rate)
 Compounding accounts for the extra 0.04%,
commonly known as 4 basis points (b.p.) or
bips
Professor Ross Miller • Fall 2006
E=mc2
50
The General Formula for Future Value
with Compounding
 New parameters:
• m: Number of interest periods in a year
–
–
–
–
m = 2 means semi-annual interest
m = 4 means quarterly interest
m = 12 means monthly interest
m = 365 means daily interest
• T: Future time (in years or a fraction of a year)
when inflow of cash occurs
r

 Formula: FV  C0 1  
 m
Professor Ross Miller • Fall 2006
mT
E=mc2
51
Using the Compounding Formula
 Example: $10,000 at 4% annual rate for 6
months, compounded monthly
 Parameters:
•
•
•
•
C0 = $10,000
r = 4% = 0.04
m = 12
T = 0.5
 Plugging in: FV = $10,000 (1 + 0.04/12)0.5(12)
= $10,000 (1.0033…)6 =
$10,201.67
Professor Ross Miller • Fall 2006
E=mc2
52
APY (or Effective Annual Interest Rate)
Formula from RWJ p. 72
r m
APY  (1  )  1
m
Professor Ross Miller • Fall 2006
E=mc2
53
The Difference a Bip (or a Few Bips) Makes
 At current interest rates, APY tends to be only a
few bips (hundredths of a percentage point, also
known as basis points or b.p.) higher than the
simple interest rate
 It is important to keep interest rates straight
because although they low small, every bip
matters when you invest millions of dollars
 Professional bond traders and investors look at
“spreads” (the interest rate relative to other
securities) and these are measured in bips
Professor Ross Miller • Fall 2006
E=mc2
54
A Note on Use of the Compounding Formula
by Ross/Westerfield/Jaffe (RWJ) on page 73
 For the moment this course is focused on
financial instruments that take one year or less to
mature
 The RWJ formula states it is for multiple years,
but it also works for fractions of a year as we
saw in the previous slide
 Similarly, the Excel FV function can deal with
both fractional and whole years though you have
to adjust the interest rate and number of periods
manually, which is not very convenient
Professor Ross Miller • Fall 2006
E=mc2
55
Three Important Points Worth Mentioning Now
 Compounding is “magic” because the interest on
interest (and interest on interest on interest…) adds
up over time
 Over long periods of time (10 years or more
depending on interest rates), a small difference in the
interest rate can make a large difference in the future
value of the investment
 Note that compounding only works if we do not
withdraw the interest at the time that it is paid
• We will not consider the receipt of more than one
cash flow from a financial instrument until we get to
Treasury notes and bonds in a few weeks
Professor Ross Miller • Fall 2006
E=mc2
56
Assignment For Week 2
 Check out the links in the slides covered in class
 Read RWJ Ch. 4, pp. 60-73
 Do the problems on the 4 slides that follow this
one
• Justify each True-False answer
• For the CD problems 1-3, use a calculator for
one of the CDs and a calculator or spreadsheet
for the rest
Professor Ross Miller • Fall 2006
57
True-False Statements
(Page 1 of 2)
1. One can make the annual percentage yield from
a CD as high as one wants by choosing a short
enough compounding interval.
2. At higher stated yields, the compounding
interval will make more of a difference to the
annual percentage yield.
3. In general, a $1,000 6-month bank CD should
cost less to purchase now than it did at this time
last year (September 2005).
Professor Ross Miller • Fall 2006
58
True-False Statements
(Page 2 of 2)
4. Doubling the interest rate on a CD will double its
APY
5. If two one-year CDs both pay $10,000 at
maturity, then the one with the lower APY will
cost more to purchase now
6. The financial markets expect that the U.S. will
grow faster in the second half of 2006 than it did
in the first quarter of 2006.
Professor Ross Miller • Fall 2006
59
Questions about the Next Slide
1. Compute the APY (known in the textbook as Effective
Annual Interest Rate) for each CD.
2. Compute the future value at maturity for each CD for an
investment of $10,000 today.
3. Compute the present value of $10,000 received at
maturity from each CD.
4. You are considering the 3-month and 12-month (1 year)
CDs offered by Beal bank. Bank of Miller (BoM) is willing
to guarantee you a 9-month when the 3-month Beal CD
matures if you sign with them now. What APY must BoM
provide you so that after a year you will have the same
amount you would have buying Beal’s 12-month CD.
Professor Ross Miller • Fall 2006
60
CD Interest Rates Compiled on
September 6, 2005
Bank
Imperial Capital Bank
Beal Bank
Mybankingdirect.com
Ascencia Bank
Beal Bank
Months to Interest Compounding
Maturity
Rate
Method
3
3
9
12
12
3.44
3.41
3.88
4.31
4.14
M
Q
Q
M
Q
M is monthly compounding (m=12)
and
Q is quarterly compounding (m=4)
Professor Ross Miller • Fall 2006
61