Introduc)on

to Financial Economics
351473

Eugenia Andreasen

Contact informa)on
Professor: Eugenia Andreasen
Oce: 13

Phone: 2718-0752
Email: eugenia.andreasen@usach.cl
Oce hours: Thursday from 1pm to 3pm

Teaching Assistant: Cris)an Lagos Reyes

Course material
Courses web page (Intranet)

Lecture slides
Exercises and Problem sets
Ar)cles
Addi)onal material
Textbooks
Brealy, Myers, and Allen, Principles of Corporate Finance (10th edi)on).
Hull, Op5ons, Futures, and Other Deriva5ves (7th edi)on).
Bodie, Kane, and Marcus, Investments (10th edi)on).

How to get the best from this course?

AYend lectures and par)cipate
Study the slides
Read the textbooks and suggested ar)cles

Work on the exercises and problem sets

Grading

4 Controls (5% each).
Tenta)ve dates: 2/4, 23/4, 4/6 y 25/6
Either on the second part of the class or on the next Friday

Midterm (40%)
Date: 7/5

Final Exam (40%)
Date: 9/7

IMPORTANT: The grading of the controls will only be considered if the

average of the midterm and the nal exam is above 3.6. Otherwise, the
controls will not be considered and the student will disapprove the
course.

This course
The main goal of this course is to provide a market-oriented framework
for analyzing the major types of nancial decisions made by agents.

Valua%on of nancial assets: Here you will learn to value nancial assets
such as bonds, stocks, futures, and op)ons, and to evaluate investment
projects using a rigorous framework.
Diversica%on and risk: These classes provide a comprehensive
framework in the trade-o between risk and return given by modern
porholio theory.
Arbitrage and hedging: We will explore how to hedge stock and
commodity market risk, interest rate risk, and foreign exchange risk using
futures and op)ons.

Overview
Financial Systems and Capital Markets
Bonds
Stocks
Risk and Return
Asset Pricing Models

Forward and Futures Contracts
Swaps and Op)ons

Introduc)on

What is nance?
Finance is the study of how people allocate their assets over )me under
condi)ons of certainty and uncertainty.
A key point in nance, which aects decisions, is the )me value of money,
which states that a unit of currency today is worth more than the same
unit of currency tomorrow.
Finance aims to price assets based on their risk level, and expected rate of
return.
Finance can be broken into three dierent sub categories:
Public Finance
Corporate Finance
Personal (Household) Finance

Financial decisions

Corpora)ons face two principal nancial decisions:
Financing decisions
Investment decisions

The stockholders who own the corpora)on want its managers to

maximize its overall current value and the current price of its shares.
This can be achieved taking good nancing and investment decisions.
Investment decisions force a trade-o. The rm can either invest cash or
return it to shareholders, for example, as an extra dividend.
When the rm invest cash rather than paying it out, shareholders forgo
the opportunity to invest it for themselves in nancial markets.
The return that they are giving up is called the opportunity cost of capital.

Capital markets

Market Capitaliza)on

Source: Securi)es and Insurance Supervisor

Present Value

Learning Objec)ves

Review of Concepts
Compounding/discoun)ng
PV/FV
Real vs. nominal rate
Annui)es and perpetui)es

Examples
CD
Auto loan
Scholarship fund
Project planning

Review: Compounding / Discoun)ng

We can
move money forward in )me by compounding.
move money backward in )me by discoun%ng.





Note:
Only rela)ve )me maYers
Mul)plying by (1+r)m-n = dividing by (1+r)n-m

Review: Compounding / Discoun)ng

If we invest money for more than one period
at the interest rate r,
the investment grows at a compound rate; and
the interest rate you earn is called compound
interest

Review: APR vs. EAR

Annual percentage rate (APR) vs. equivalent annual
return (EAR):

Note:

always use the EAR when compounding and

discoun)ng
Due to interest compounding, the EAR is higher than
the APR whenever the compounding frequency is
higher than once a year.

Con)nuous Compounding
Given a xed APR, higher compounding
frequency leads to higher EAR.
Suppose we take compounding frequency to
innity, then

The con)nuously compounded EAR is the highest

possible EAR for a given APR.

Review: PV / FV

Cash ow:

Present value (PV):

Future value (FV) :

Which discount factor should we use?

To discount ows we need to consider the opportunity
cost
Which is the return that is foregone by inves)ng in the
project rather than inves)ng in the nancial market

So far we are assuming risk free ows, then we should

use the risk free rate of the market
Typically, the rate of return of some government bond

If we consider risky investments we need to use as

discount factor the return oered by a risk-equivalent
investment in nancial markets.

Net Present Value

Net Present Value Criterion: Undertake
investment if NPV is posi)ve:
Where C0 is usually nega)ve

Alterna)vely, invest if return is higher than

the opportunity cost of capital:

Review: Nominal vs. Real Interest Rate

Nominal-real interest rate conversion:
Nominal-real cash ow conversion:
When you discount or compound,

Either use the nominal cash ow and the nominal interest

rate
Or use the real cash ow and the real interest rate
Do not mix and match

Evalua)ng mul)ple cash ows

If you wish to value a stream of cash ows over a
number of years it is necessary to use the
discounted cash ow formula

To nd the NPV we add the usually nega)ve

ini)al value

Review: Annuity/Perpetuity

Annuity:

Perpetuity:

Note that both ows begin in period 1

Review: Growing Annuity/Perpetuity

Growing Annuity:

Growing Perpetuity (r > g):

Shortcut formulas for calcula)ng Present Values

Ar)cle
The discount rate illusion, The Economist,
May 23rd, 2013
hYp://www.economist.com/blogs/buYonwood/2013/05/inves)ng

Example 1: CD

You can invest $10,000 in a CD oered by your
bank.
The CD matures in 5 years and the bank quotes
you a rate of 4.5%.
How much will you have in 5 years, if the 4.5% is:
a) EAR
b) Quarterly APR
c) Monthly APR

Example 1: CD
Answer

Example 2: Auto Loan

You would like to buy a new car for $22,000.
The dealer requires:
a down payment of $10,000
and oers you 6% APR nancing (compounded
monthly) for 5 years for the remaining balance.

What is your monthly payment?

Example 2: Auto Loan

Answer
Let C be the monthly payment, then:

Example 3: Scholarship Fund

You would like to establish a scholarship fund that will
help outstanding students with nancial dicul)es pay
their college tui)on.

Star)ng today, you hope to give 50 students $20,000 each
in todays money (i.e., adjusted for ina)on) every year.
The eec)ve nominal interest rate is 5%/yr.
Ina)on is 2%/yr.

How much money do you need now if you want the

fund to last forever?

Example 4: Project Planning

GeneriCorp is considering whether or not to expand
into a new market.
The company faces the following cash ow (in
$million) if it decides to expand:

A commiYee appointed by the CEO determined that

the appropriate discount rate is 9%
Should the company take on the expansion project?