BAYONA, DELA CRUZ, SAN JUAN
(1BSA1C)
Economics of Finance
A study of the role of financial markets
in the efficient allocation of resources. We look
at how financial markets:
(1) enable the transfer of resources
across time and space;
(2) facilitate the reduction and
management of risk; and
(3) provide information about the future,
which is important to public policymakers as
well as private firms and individuals.
Two of the most important in economics
of finance are:
1. Discounting- Decision making over
time recognises the fact that the value of £1 in
ten years’ time is less than the value of £1 now.
The £1 ten years’ hence must be discounted to
allow for risk, inflation and the simple fact that
it is in the future. Failure to discount
appropriately has led to problems such as the
systematic underfunding of pension schemes
that we have seen in recent years.
2. Risk management and
diversification- Many advertisements for
financial products based on the stock market
remind potential buyers that the value of
investments may fall as well as rise. So although
stocks yield a return which is high on average,
this is largely to compensate for risk. Financial
institutions are always looking for ways of
insuring (or ‘hedging’) this risk. It is sometimes
possible to hold two highly risky assets but for
the overall risk to be low: if share A only
performs badly when share B performs well (and
vice versa) then the two shares perform a perfect
‘hedge’. An important part of finance is working
out the total risk of a portfolio of risky assets,
since the total risk may be less than the risk of
the individual components.
MANAGERIAL ECONOMICS
DR. CESAR C. EUSTAQUIO
Theoretical Framework
All analyses of financial theory rest on
initial assumptions about the environment in
which finance takes place and about the
participants in the finance process.
Three assumptions of financial theory:
1. Rationality – refers to the behavior
of individuals in firms in aiming to maximize
the satisfaction they derived from the
management of economic assets. It maximizing
the value of the firm to its stockholders
- can also be translated in terms of risk
and return. In other words, there is the move
towards maximizing returns and minimizing risk
and this behavior is universal.
2. Perfect Markets – refers to all
markets (for goods, for labor and especially for
capital), operating under a perfect competition
setting. Implies that:
(a) There is plurality of buyers and
sellers so that no one, on his own, can influence
the price level.
(b) There is full knowledge about prices
and all relevant information.
(c) There is full freedom of entry and
exit
(d) There is complete mobility of
resources.
3. Assumption of Certainty – means
that everybody has exact and complete
agreement on future events; in particular those
regarding future incomes, cash flows, dividends,
etc.
Two key concepts:
(a) Value – is worth on monetary terms.
Under perfect markets and certainty, the capital
market can have some unique rate of interest, i,
the price of capital. This basic interest rate or
“opportunity cost” i, establishes the time value
of money which can compare the present value
of amounts received at different times in the
future.
BAYONA, DELA CRUZ, SAN JUAN
(1BSA1C)
(b) Income – maybe defined as
additions to the personal wealth of the individual
for the owners of the firm for the specified
theory. Example, the return on an investment
must have a rate at least equal to the opportunity
cost, i.
Three basic decision areas in corporate
finance:
A. the investment decision
B. financing decision
C. dividend decision
Risk and the imperfect market
- It given a choice between two returns
with the same expected value, the individual or
firms chooses the less risky alternative. It can
means the “doubtfulness” of expected return.
- Business risk is inherent to the
physical operations of the firm; it arises simply
from the inability to ensure absolutely stable
sales, cost and profits as a consequence of
vicissitudes of the markets. Added to this are
financial risks. Investment risks occur because
of the uncertainty in the future cash flows.
Financing risk is due to the presence of debt
(instead of wholly equity) in the capital
structure.
- The usual rule is: the higher the risk,
the higher the return.
- In the real world, there are only
imperfect ones. The imperfections are structural,
institutional behavioral. In capital markets, as
when stock holders are “locked in” to their
holdings because of tax reasons; desire to
preserved voting rights; or fall prey to simple
inertia.
- Some would argue that a “satisfactory”
return is sufficient, and that the firm should be
concerned not only with the stock holders but
also the “stakeholders,” which include its
customers, employees, suppliers, creditors and
the community.
MANAGERIAL ECONOMICS
DR. CESAR C. EUSTAQUIO
Theories and concepts of economic of
finance
- specifically, in testing whether the
returns of financial asset are sufficient to cover
the inflation-find expression in the fact that the
Philippine capital market fails to account for the
impact of inflation.
Risk analysis
The capital asset pricing model
- A rational investor would normally
want to maximize his investment by minimizing
risk and optimizing returns. However, not all
people act rationally. Risk- lovers prefer to play
when ricks are greater, as it follows that the
returns will also be great. On the other hand
some investors are averse to taking big risks and
are content with a minimal return.
The Capital Asset Pricing Model
The CAPM makes the following
assumptions:
1. Investors are never satiated. When
given a choice between two otherwise identical
securities, a risk-averse investor will choose the
one with the higherexpected return, but will
choose a security with the lowest standard
deviation.
2. There is a risk- free rate at which an
investor may either lend money or borrow
money, which give them a choice whether to
invest in government securities or in the stock
market which is highly volatile compared to
government securities. This risk-free rate is
assumed to be the same for all investors.
3. Third, information is freely and
instantly available to all investors. It is assumed
that everyone possesses the same amount of
information and that investors analyze and
process information the same way.
BAYONA, DELA CRUZ, SAN JUAN MANAGERIAL ECONOMICS
(1BSA1C) DR. CESAR C. EUSTAQUIO

4. Lastly, markets for securities are

assumed to be perfect markets, meaning there
are no impediments to investments.

The Single Market Model

- defines the relationship between the

security return and the market return. It shows
how a certain market index that can be shown
through the formula:

𝑅𝑖 = 𝛼𝑖 + 𝛽𝑅𝑚 + 𝜖

Where:
𝑅𝑖 = return on security i
𝛼𝑖 = intercept term
𝛽 = slope term
𝑅𝑚 = return on market index
∈ = random error term

The formula for the single market model can be

written as:

𝑅𝑗 = 𝑅𝑓 + 𝛽(𝑅𝑚 − 𝑅𝑓) + 𝜖

Where:
𝑅𝑗 = return of a certain stock
𝑅𝑓 = risk free rate
𝛽 = Beta coefficient for security j, slope
term
𝑅𝑚 = the market index
∈ = random error term

Wherein the expected rate of return for a

stock is equal to the return required by the
market for a riskless investment are plus risk
premium𝛽(𝑅𝑚 − 𝑅𝑓) .

The formula simply states that the

greater the Beta of a security, the greater the risk
the higher the expected return. Conversely, the
lower the Beta the lower the risk and the lower
the expected return.

To summarize, the model implies that if

the market has gone up then it is likely the stock
prices has also gone up, and the market has gone
down, it is likely that stock prices have gone
down too.