1.5 Six Important Ideas in Finance

The value of a dollar depends upon when it is received. A dollar today is worth more than the promise of a dollar next year. Human mortality makes us prefer current consumption over future consumption. When we evaluate securities or projects that generate cash over time, we have to be careful to discount the future. This concept is captured by the time value of money, which is studied in Chapter 3 “Introduction to the Time Value of Money” and Chapter 4 “Annuities and Loans”.

The concept of risk and return is the finance equivalent of no pain, no gain. We should not expect to earn high returns without taking high risks. This derives from our natural aversion to uncertainty. Investors pay less for investments that have greater uncertainty, and so those investments generate higher returns (on average).

Investors are not stupid. The competition to find cheap securities and earn high returns is fierce. Thus, we should not expect to find mispriced securities. This idea is central to an understanding of the efficient markets hypothesis (EMH)A hypothesis that states that all relevant information is fully and immediately reflected in a security's market price. .

Driving the efficient markets hypothesis is the law of one priceA law that says that two equivalent investments that trade in different markets must have the same price.. The law of one price states that, if two identical assets are traded in two different markets, then they must trade at the same price. For example, if the price of a six-pack of Coors is $4 at the Quick-E-Mart, but it is $5 at Safeway, then that is a violation of the law of one price.

The law of one price is enforced by arbitrageA trading strategy that involves the simultaneous purchase and sale of an identical security in two different markets at two different prices. Ideally, it should involve no investment and no risk.. Arbitrage is the practice of taking advantage of violations of the law of one price. In this situation, you should buy a six-pack for $4 at the Quick-E-Mart and then sell the beer for $5 outside of Safeway. If you repeat this transaction many times, then the excess demand will raise the price at the Quick-E-Mart and the excess supply will lower the price at Safeway. You will stop trading when the two prices are equal and the law of one price is restored.

We will return to this concept in more detail when we study stock pricing in Chapter 8 “Stock Valuation and Market Efficiency”.

You cannot spend net income. It is an accounting number meant to represent the average profit available to shareholders. Net income is reduced by depreciation that is not an actual cash outlay, so net income is not equal to the amount of cash that owners actually have at the end of the year. In finance, we focus on actual cash receipts and disbursements. We use accounting numbers in our calculations, but we often have to make adjustments to get closer to an actual cash value.

In some financial models, we assume that markets are perfect, that contracts are costless to enforce, and that everyone has the same information. Reality is different. In reality, transaction costs make contracts work imperfectly and undermine the incentives of the transacting parties. One example is the agency problem previously described. When principals cannot monitor their agents, then the agents can take advantage of the principal.

Information asymmetryWhen information is not spread evenly among all participants and some know more than others. is another feature of reality. Information is not distributed evenly across economic agents (i.e., shareholders, bondholders, bankers, and managers). Information is the lifeblood of financial markets, so many institutions have arisen to signal information and to protect uninformed agents from exploitation. One example is the moral hazard problem with insurance. Once you insure your car against damage, you have less interest in avoiding accidents. This affects the likelihood of a claim and the pricing and features of the insurance contract.

When we study financial institutions and contracts, we must realise that they occur in a world with transaction costs and information asymmetries. Sometimes, we observe arrangements that seem peculiar. That perception is usually the result of our failure to understand the particular costs and information problems encountered by the economic agents involved.

Throughout this book we calculate rates of return. We do it for loans, bonds, projects, and stocks. In finance, the return is the profitAny change in value in the asset that was purchased plus interest, dividends, or other cash flows that the investor receives from owning the asset. earned on an investment. The rate of return expresses the profit as a proportion of the original investment. The profit comprises any change in the value of the asset that was purchased plus interest, dividends, or other cash flows that the investor receives as a result of owning the asset. The investment is the amount of money paid by the investor to initiate the investment. Usually it is the cost of purchasing an asset, but in a loan it is the amount loaned (the principal). For example, say you give a friend $100 today and they repay you $120 in one year. First let’s make a picture, called a timelineA horizontal line on which time 0 is the leftmost end and future periods are shown as you move from left to right; can be used to depict investment cash flows., that shows the information in the problem.

At the beginning of the year (time 0) you give your friend $100. That is the investment.  We show it on the timeline as a negative number because it is a cash outflow. At the end of the year (time 1) you get $125. Your profit is the difference between what you received and what you invested:

Your rate of return is given by:

or

The default unit of time is a year. If the time span is shorter or longer than a year, then we convert the return to an annual return using methods you will encounter later in the book.