Lecturer: Shaling LiAcc&Fin Dept, PBS

University of Portsmouth15 October, 2009

What is Finance?

Fin

an

ce

Investment

Corporate Finance

Financial Market

and Financial Institutio

ns

Real Investmen

t

Financial Investme

ntFinancin

g decision

Investment &

Dividend decisions

Global financial systems: banks,

equity/debt markets

Resources of money

Usage of money

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Why study Finance?Finance is important to economy

Economy allocates money to its highest valued use (e.g. stock market)

Good business get more money (e.g. bank lending & interests)

Finance is important to individualManage your money: borrow/debtDifferent needs for money in different life

stages: young, middle age, retired

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How to study finance?Finance as a subject in ScienceScience:

Science refers to a system of acquiring knowledge. This system uses observation and experimentation to describe and explain natural phenomena.

The purpose of science is to produce useful models of reality.

Scientific methods

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Theory and Practice

Theoretical world:

AssumptionsGeneral rules

Results

Real world: Full of myteries

ExpectedUnexpected

results

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The theoretical world in FinanceThe assumptions of the theoretical world of

Finance1. Rational self-interest2. Frictionless financial markets

No transactions costs. No public information costs

3. Financial markets are liquid4. Minimal role for government

Theoretical world:

Assumptions: IFGeneral

rules/models: THEN

Results: SO

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How realistic are the assumptions of the finance textbook world?UK London stock market

The FTSE 100 companies are the 100 biggest UK companies by market capitalisation

Checking the assumptions in the UK marketsAssumption1: Rational self-interest

Self-interest: only focus on and seek self benefits (egotism – altruism)

Rational: logic manner Professional investors: pension fund, insurance

company, investment companiesCheck: yes or no?

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How realistic are the assumptions of the finance textbook world?Checking the assumptions in the UK markets

Assumption 2: Frictionless financial markets No transaction cost: commission fee exists, 0.35%

of selling/buying No public information cost: internet, newspaper, TV

Check: yesAssumption 3: Financial markets are liquid

The total market capitalisation of all FTSE 100 stocks is well over £1,000 billion

The total daily trading volume runs into the millions of shares traded

Check: Yes

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How realistic are the assumptions of the finance textbook world?Checking the assumptions in the UK markets

Assumption 4: Minimal role for government Government: a ‘night watchman’. systems of internal controls: professional ethics, the

strict legal and regulatory framework Check: yes

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Theory and PracticeTheoretical

world:RationalityFrictionless

marketLiquidity

Government role+

Models, results

Real world:UK London exchange

What is that??

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Arguments on the assumptionsThe rationality assumption is the most

important assumption of our textbook world model

Three arguments challenging this assumptionArgument 1: the ‘blockheads’ argument: Question: Blockheads are many and not

rational Explanation: On average the blockheads

cancel each other out

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Arguments on the assumptionsArgument 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 argumentQuestion: Are there more blockheads than smart

guysExplanation: blockheads will tend to lose money

over time, and that smart investors will tend to make money

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Arguments on the assumptions

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

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

Theoretical world:

RationalityFrictionless

marketLiquidity

Government role+

Models, results

Real world:UK London exchange

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How closely does the real world resemble the world of theory?Whatever is thought and found in the theory

world has two types of results if matched/applied to the practical world: Yes, largely

The model (rules) can be applied to the practice with expected results most of time

However, this does not mean everyone gains in the market

There are always exceptions in the real worldNo, basically

If it does not work, why? Proper assumptions, models? However, this also does not mean there is no random

gain.

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How closely does the real world resemble the world of theory?Example: US market & Successful investors

A mutual fund, the Vanguard S&P500 Tracker In the early 1970s in America John Bogle decided to

apply the textbook world finance theory that was developed by finance scholars during the 1960s

looking at the thirty-year record, the investment returns on the Vanguard S&P500 Tracker fund have beaten those of every other stock market mutual fund in the United States.

Mr. Buffett’s personal wealth is around $40 billion and the funds he manages are far larger

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How closely does the real world resemble the world of theory?Russian market in 1990s

Investment model & investment results US/UK model likely to lose or does not work

Checking the assumptionsInformation was expensive Reliable information hardly existed Trading had to stopped during some period

(liquidity)Have a well-developed legal and regulatory

framework on paper, the lack of an enforced legal and regulatory framework

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The approach to studying finance1. We always start off with a problem, or a

question.2. Next we give the theoretically correct

solution to the problem3. The next step is empirical research

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SummaryFinance and its key elementsThe theoretical world in Finance + four

assumptionsThe realistic degree of the assumptions of the

finance textbook worldHow closely does the real world resemble the

world of theory (yes or no examples)Approach to study finance

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Seminar for next weekPlease see the attached.

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