!Week7:FinanceDrChristopherPokarier|EB202IntroductiontoBusiness

Rolesofthefinancialsystem

! Paymentsmechanism

! Aggregation–gatherlotsofsmallsavingstogetherforlargerinvestments

! Disaggregation–thereverse–eg.largeinvestmentsaredividedintosmallpersonalloans

! Facilitation–bringinvestors&capitalneedytogether(eg.stockbrokers)

! Intermediation-bringinvestorsandborrowerstogetherthroughthebalancesheetsoftheintermediatingfinancialinstitution(eg.bank)

! Reconciledifferenceintimingpreferences-maturities

Risk&financialmarkets

! Whenfinancialmarketsworkwelltheyassess,price,andsharerisk

! Thatis,riskisshifted(forapremium)fromthosewhocannotaffordtobeartothosewhocan–eginsurance

! Considerableefficienciesfrompoolingrisk

! Worksbestrelowprobabilityeventswithseriousdownside(negativeconsequences)–egfire,shipwreck,severeillness

! Littlelogicwheneventsarecommon&haveminordownside

! Problemsarisewhentheinsuredcaninfluencetheprobabilityoftheeventarising

!Raisingcapital..MoneyforabusinessprojectdoesnotcomelikepresentsfromSanta

Basicchallengesingettingcapital

! Needtocommunicatetheviabilityoftheprojecttopotentialinvestors(shareholders)orbankers(loanproviders)

! Needtocommunicateyourowntrustworthiness

! Capitalprovidersassessprobabilityofyourproject’ssuccess

! Ifbankers,theymustchargeaninterestratewhichrepresentstheriskofloandefault(yourfailuretorepay)&theirabilitytobearthatrisk(reflectingthestructureoftheir‘loanbook’)

! Ifinvestors,theprojectmustcomplementtheirportfolio

!KeyconceptsinfinancialcontractingADVERSESELECTION|MORALHAZARD

AdverseSelection

! Arisesbecausepeoplehidenegativeinformationaboutthemselves

! (applyingforaloan,insurance,orajob)

! Highriskpeopleoftenmostwanttosharetherisk

! Butitisdifficulttoknowwhothosepeopleare(nervouscautiouspeoplealsowantinsurance..Idealcustomers!)

! Forloancustomers–higherriskcustomersarepreparedtopayahigherinterestrateBUTbringmuchhigherriskstolenders

! Asimplelesson–bewaryofthosewhoaretooeager!….Theyknowmoreaboutthemselves,theirriskprofilesandtheiroptionsthanyou.

MoralHazard

! Theborrower’s/insurancecustomer’sbehaviourchangesonceyouhaveprovidedtheloan/insurance

! Becauseyouhavetakenresponsibilityfortheriskfromthemtheycanaffordtotakemorerisks

! Givingguaranteestopeoplecanchangetheirbehaviour..

! Hencegovernmentbankbail-outsmayincreaserisk-takingbybankersafterwards

! Moralhazardarisesinmanyspheresofsociallife

Attenuatingmoralhazard

! Needtobeconsciousofyoursignallingeffects

! Thatis,ifyousignalanunconditionalcommitmenttosupportingtheotherpartyyouarevulnerabletoselfishbehaviorbythem

! Youshouldcrediblycommunicateacapacity&preparednesstoendabusinessrelationshipiftheotherpartyactsirresponsiblyortheirconditionschange

! Eg.loancovenants(conditionsappliedtoloansthat,ifbreached,aregroundsfordemandingrepayment)

Abanker’sdilemma

! Oncealoanisprovidedbankersarevulnerable

! Ifaclientloanisverylarge,andtheclientisintrouble,loanrecoverymightbepossibleonlybyforegoingsomeofthemoney(debtforgiveness),orextendingnewfinance

! Banksmaygetheldupbylarge(notsmall!)clients

Debt-equitymix

! Debt(loans)haveafixedservicingcost(interest)

! Equity(issuingsharestoinvestors)reduceinitialdebtservicingcosts&shareriskswithinvestors

! Equityrequiresanentrepreneurtosharecontrol

! butalsoreducesrisksfromover-relianceondebt(interestondebtmustbepaidevenifthebusinessislosingmoneybutdividendstoshareholdersareoption)

! also,intimesofcrisissometimeslenderswillnotrenew(‘rollover’)loanstoexistingborrowers-riskingacashcrisisforthefirm

‘equitypremium’forinvestors

! Overtime,ingeneral,shareinvestorsdemandahigherreturnforthevolatility(&entailedshorttermrisk)ofreturnsinashareportfolio–the‘EquityPremium’

! Thismakesequityfinancingmoreexpensivetothefirmovertime(apremiumforsharingrisk)

! risk/return(andhigherreturnforhigherrisk)isfundamentaltofinance

Diversification

! Diversificationmeansholdingarangeofinvestments(inshares,oractivities/productswithinabusiness)toreduceoverallrisk

! Theassets’returnshouldshowlowor,better,negativecovariance

! Eg.sellbothsunscreenforaniceday,andumbrellasforarainyday.

! Over-diversificationincreasestransactioncosts

! Diversificationwon’tfullyprotectfromsomegeneralsystemicshocks(eg.GFCwhenallsharepricesfell,intheshortterm)

! Markovitz&portfoliotheory:createdhopeinthefinanceindustrythatdiversificationmightincreasereturnsatlowerrisk.

Portfolionotioninbroaderapplication

! Manybusinessesarecharacterisedbyuncertainty&risk

! Eg.creativeindustries(suchasfilm)facesthe‘nobodyknows’[whatmakesahit]problem

! Thereforefirms/studioshaveaportfolioofprojects

! Somefail,some‘breakeven’,othersmakebigmoney(old80/20rule–80%ofprofitsfrom20%ofprojects!)

! Entrepreneurialfirmsthereforedevelopa‘pipeline’ofprojects