Introduction of Financial Management Lecture 2: Finance and Science

1. Introduction of Financial ManagementLecture 2: Finance and Science Lecturer: Shaling Li Acc&Fin Dept, PBS University of Portsmouth 15 October, 2009

2. What is Finance? Real Investment Investment Financial Investment Financing decision Finance Resources of money Corporate Finance Investment & Dividend decisions Usage of money Financial Market and Financial Institutions Global financial systems: banks, equity/debt markets S Li, Acc&Fin, PBS, UoP

3. Why study Finance? • Finance is important to economy • Economy allocates money to its highest valued use (e.g. stock market) • Good business get more money (e.g. bank lending & interests) • Finance is important to individual • Manage your money: borrow/debt • Different needs for money in different life stages: young, middle age, retired S Li, Acc&Fin, PBS, UoP

4. How to study finance? • Finance as a subject in Science • Science: • Science refers to a system of acquiring knowledge. This system uses observation and experimentation to describe and explain natural phenomena. • The purpose of science is to produce useful models of reality. • Scientific methods S Li, Acc&Fin, PBS, UoP

5. Theory and Practice Real world: Full of myteries Expected Unexpected results Theoretical world: Assumptions General rules Results S Li, Acc&Fin, PBS, UoP

6. The theoretical world in Finance • The assumptions of the theoretical world of Finance • Rational self-interest • Frictionless financial markets • No transactions costs. • No public information costs • Financial markets are liquid • Minimal role for government Theoretical world: Assumptions: IF General rules/models: THEN Results: SO S Li, Acc&Fin, PBS, UoP

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

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

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

10. Theory and Practice What is that?? Real world: UK London exchange Theoretical world: Rationality Frictionless market Liquidity Government role + Models, results S Li, Acc&Fin, PBS, UoP

11. Arguments on the assumptions • The rationality assumption is the most important assumption of our textbook world model • Three arguments challenging this assumption Argument 1: the ‘blockheads’ argument: • Question: Blockheads are many and not rational • Explanation: On average the blockheads cancel each other out S Li, Acc&Fin, PBS, UoP

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

13. Arguments on the assumptions Conclusions: The existing of blockheads does not influence the market and the assumption of rationality. S Li, Acc&Fin, PBS, UoP

14. How closely does the real world resemble the world of theory? Real world: UK London exchange Theoretical world: Rationality Frictionless market Liquidity Government role + Models, results S Li, Acc&Fin, PBS, UoP

15. How closely does the real world resemble the world of theory? • Whatever is thought and found in the theory world has two types of results if matched/applied to the practical world: • Yes, largely • The model (rules) can be applied to the practice with expected results most of time • However, this does not mean everyone gains in the market • There are always exceptions in the real world • No, basically • If it does not work, why? Proper assumptions, models? • However, this also does not mean there is no random gain. S Li, Acc&Fin, PBS, UoP

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

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

18. The approach to studying finance • We always start off with a problem, or a question. • Next we give the theoretically correct solution to the problem • The next step is empirical research S Li, Acc&Fin, PBS, UoP

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

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