Fundamentals of Finance

🧭 Overview

🧠 One-sentence thesis

Finance is fundamentally about allocating monetary capital and managing risks to maximize shareholder wealth through strategic investment, financing, and payout decisions.

📌 Key points (3–5)

• What finance studies: allocation and distribution of monetary capital and risks across individuals, businesses, and institutions, divided into four broad categories (Corporate Finance, Investments, Financial Markets & Institutions, Personal Finance).
• Corporate objective: managers should maximize the current market value of the firm to enhance shareholder wealth, not just short-term profit.
• Business structures matter: sole traders, partnerships, companies, and trusts each have different liability, tax, and complexity trade-offs.
• Common confusion: maximizing firm value vs. maximizing profit—profit is short-term and not cash; firm value considers future cash flows and risks over the long term.
• Three key corporate decisions: investment (capital budgeting), financing (capital structure), and payout (dividends/buybacks) all directly impact firm value.

💼 What is finance and why study it?

💼 Four categories of finance

Finance is concerned with the allocation and distribution of monetary capital and risks amongst various entities.

• Corporate Finance: how corporations make financial decisions to maximize shareholder wealth—investing in real assets, funding those assets, and distributing income.
• Investments: how individuals and managers allocate assets over time under certainty and uncertainty, balancing returns with risk tolerance through valuation, risk analysis, and portfolio construction.
• Financial Markets and Institutions: understanding how markets operate, types of financial instruments traded, and how institutions contribute to the broader financial system.
• Personal Finance: financial decisions of individuals or households, including retirement planning, insurance, saving, tax planning, and estate planning.

🎯 Why finance matters beyond careers

• Finance provides tools to understand market conditions and economic forces, not just manage money.
• It helps make critical decisions under uncertainty—e.g., understanding the risk-return trade-off: "no free lunch" means earning returns requires taking risk.
• Not all risks are equal; some risks enable higher returns, others do not.
• Finance offers insights into whether high-return, low-risk opportunities are real or repeatable, and what strategies successful investors follow.

🏢 Business structures in Australia

🏢 Four fundamental structures

When starting or expanding a business, you choose from four structures based on scale, nature, and management style:

Structure	Cost	Complexity	Liability	Tax	Owner	Decision-maker
Sole trader	Low	Simple	Unlimited (personal assets at risk)	Personal TFN	You	You
Partnership	Medium	Moderate	Joint liability (GP); limited for LP/ILP limited partners	Passed to partners	You and partners	You and partners
Company	Medium-High	Complex	Limited to shareholders; directors can face personal liability	Company tax	Shareholders	Director(s)
Trust	High	Highly complex	Trustee bears full responsibility	High	Trustee	Trustee

🔍 Sole trader

• Simplest setup with complete control over assets and decisions.
• Minimal reporting; cost-effective; use personal TFN for tax.
• Disadvantage: unlimited liability—personal assets at risk if business fails.

🤝 Partnership types

Three principal forms:

• General Partnership (GP): all partners manage and have joint unlimited liability.
• Limited Partnership (LP): general partners manage with unlimited liability; limited partners contribute capital, share profits, but liability is restricted to their investment.
• Incorporated Limited Partnership (ILP): similar to LP structure.

Partnerships need separate TFN and ABN; must register for GST if turnover ≥ $75,000; tax responsibility passes to individual partners.

🏛️ Company

• Independent legal entity, distinct from owners.
• Shareholders typically not personally liable; liability limited to unpaid amounts on shares.
• Directors can face personal liability if they fail legal duties.
• More complex and costly to set up; suited for fluctuating income, long-term investment, and reinvesting earnings.
• GST registration required if turnover ≥ $75,000 ($150,000 for non-profits).

🛡️ Trust

• Trustee (individual or company) manages business for beneficiaries.
• Trustee bears full responsibility for income and losses.
• Costly and complex; chosen to safeguard assets for beneficiaries.
• Trustee decides profit distribution among beneficiaries.

🎯 Corporate objective: maximizing shareholder wealth

🎯 The principle of shareholder wealth maximization

Shareholders want managers to maximize the market value of the firm.

• Smart managers make decisions that increase the current value of the company's shares, enhancing shareholder wealth.
• This is a long-term objective, not just short-term profit.

📊 Measuring firm value

• Market capitalization: current share price × total outstanding shares.
• Example: Telstra on 8/01/2023: 3.9050 × 11.55 billion = 45.1 billion dollars.
• Other methods: revenue multiples, earnings multiples, discounted cash flow analysis—each suited for different analyses.

💰 Maximizing value vs. maximizing profit

Don't confuse these two:

• Maximizing profit: short-term goal of increasing earnings by enhancing revenue and reducing costs, without considering risks to future cash flows.
• Maximizing firm value: broader, long-term objective that includes future cash flows and associated risks, not just current profits.
• Profit is not cash; firm value considers market expansion, innovation, customer loyalty, brand strength, sustainable business models, growth opportunities, risk management, and reputation.

⚠️ Agency problems

Managers may not always act in shareholders' best interests, leading to agency problems:

Why conflicts arise:

• Divergence of goals: managers may pursue personal power/status (e.g., expanding company size) over shareholder wealth.
• Risk preferences: shareholders (with diversified portfolios) may prefer riskier, higher-return strategies; managers (whose wealth is tied to the company) may prefer safer, less profitable strategies.
• Short-term focus: managers may chase short-term achievements for reputation or performance targets, while shareholders benefit from long-term planning.

Mitigation mechanisms:

• Performance-based incentives: stock options, bonuses tied to company performance.
• Corporate governance: strong, independent board oversight.
• Market discipline: threat of takeover or shareholder activism.
• Regulatory oversight: legal standards for managerial behavior and shareholder rights.

🌍 Shareholder wealth vs. social objectives

• Traditional view: maximizing shareholder value can conflict with social objectives (e.g., cost-cutting harms workforce welfare or environment).
• Modern approach: integrating social objectives (Corporate Social Responsibility, ESG criteria) can benefit long-term firm value—sustainable practices enhance reputation, improve stakeholder relations, and mitigate risks.
• Stakeholder theory: companies should serve all stakeholders (employees, customers, community), not just shareholders; addressing broader needs builds sustainable, ethical business models that can also maximize long-term shareholder value.
• Conclusion: short-term profit maximization can conflict with social goals, but long-term integration of social objectives is essential for sustainable profitability and resilience.

🔑 The big three corporate decisions

🔑 Three key policies that impact firm value

Managers maximize firm value through three key corporate policies:

💡 1. Investment decisions (capital budgeting/CAPEX)

• Involves acquisition, management, and disposal of real assets—assets that produce cash flows through productive use.
• Tangible assets: oil fields, land, factories.
• Intangible assets: R&D, advertising, computer software development—these build know-how, brand recognition, and reputation.

💵 2. Financing decisions (capital structure)

• How to obtain funds: from lenders (debt) or shareholders (equity).
• Debt: corporation receives cash, commits to repay with interest.
• Equity: shareholders provide funding without guaranteed return; they receive future dividends if distributed.
• Capital structure decision: choosing between debt and equity financing; "capital" denotes long-term financing sources.

💸 3. Payout decisions (payout policy)

• Should the company pay cash to shareholders, how much, and through what mechanisms?
• Mechanisms: dividends or share buybacks.
• Cash-rich companies: more inclined to pay dividends.
• Growth-oriented companies: less likely to initiate dividend payouts in the near future.

🧭 Overview

🧠 One-sentence thesis

The time value of money principle—that a dollar today is always worth more than a dollar in the future—underpins all financial valuation through compounding and discounting mechanisms that convert cash flows across different time periods.

📌 Key points (3–5)

• Core principle: Money available today can be invested and grow, making it more valuable than the same amount received later.
• Two directions of conversion: Compounding moves present value forward to future value; discounting brings future value back to present value.
• What drives returns: Total return compensates for three factors—deferred consumption (real interest), inflation, and risk.
• Common confusion: Simple vs. compound interest—compound interest earns "interest on interest" by reinvesting earnings, while simple interest calculates only on the original principal.
• Frequency matters: More frequent compounding (monthly vs. annually) increases the effective annual rate beyond the stated nominal rate.

💰 Why money has time value

💰 The three components of return

When investors put money into an investment, they expect compensation for three distinct factors:

Total Return = Inflation rate + Real interest rate + Risk premium

• Real interest rate: compensates for deferring consumption today to consume more in the future; the investment must grow in real terms.
• Inflation component: protects against erosion of purchasing power while money is tied up.
• Risk premium: compensates for uncertainty—future returns are not guaranteed, and there's a possibility of losing capital.

Example: An organization investing funds needs returns high enough to cover all three components, or the investment destroys value in real terms.

💵 Interest as a form of return

Interest: the return on debt investment, where the investor lends money to an entity in exchange for future repayments, expressed as a percentage per annum.

• Interest is one specific type of return, applicable when lending money.
• Example: Investing $100 at 6% annual interest yields $6 in the first year, growing the investment to $106.

🔄 Compounding and discounting

🔄 Moving money through time

Two fundamental processes allow comparison of cash flows at different times:

Process	Direction	Purpose	Formula pattern
Compounding	Present → Future	Determine how much current money will grow	Multiply by (1 + interest rate) raised to number of periods
Discounting	Future → Present	Determine current worth of future money	Divide by (1 + discount rate) raised to number of periods

• Don't confuse: These are inverse operations—compounding grows money forward, discounting shrinks it backward.
• Example: With a 5% annual rate, you are indifferent between receiving $100 now or $105 one year from now; $100 is the present value of $105, and $105 is the future value of $100.

📈 Future value calculation

Future Value (FV): the value of a current asset at a specified future date, based on an assumed rate of return over time.

For compound interest: FV = PV × (1 + i)^n

For simple interest: FV = PV × (1 + i × n)

Where:

• PV = present value or original principal
• i = interest rate per period
• n = number of periods

Example: $100 invested at 6% for 2 years yields $112.36 with compound interest (earning interest on the $6 first-year interest) but only $112 with simple interest (earning interest only on the original $100).

📉 Present value calculation

Present Value (PV): the current worth of a future sum of money or stream of cash flows given a specific discount rate.

Formula: PV = FV ÷ (1 + i)^n

• As n increases (further in the future), PV decreases—future dollars are worth less today.
• As the discount rate i increases, PV decreases—higher opportunity cost makes future money less valuable.

Example: To have $10,000 in 5 years at 5% interest, you need to deposit $7,835 today.

Discount rate: the rate of return used to discount future amounts of money, converting them into their equivalent present value; reflects the opportunity cost of capital.

🔢 Simple vs. compound interest

🔢 How they differ

Feature	Simple Interest	Compound Interest
Calculation base	Always on original principal	On principal plus accumulated interest
Interest on interest	No	Yes
Principal over time	Unchanged	Grows each period
Typical use	Short-term (less than 1 year)	Longer-term investments

📊 The growing gap over time

Example: $100 at 6% over 5 years:

• Year 1: Both yield $106 (no difference yet)
• Year 2: Compound = $112.36; Simple = $112 (difference of $0.36 from interest on interest)
• Year 5: Compound = $133.82; Simple = $130 (difference of $3.82)

The difference widens because compound interest continuously earns returns on previously earned returns, creating exponential growth rather than linear growth.

⏱️ Compounding frequency

⏱️ How often interest is calculated

Compounding frequency: how often interest is calculated and added to the principal balance within a year.

Common frequencies:

• Annual: once per year (m = 1)
• Semi-annual: twice per year (m = 2)
• Quarterly: four times per year (m = 4)
• Monthly: twelve times per year (m = 12)

Formula with frequency: FV = PV × (1 + i/m)^(m×n)

Where m = number of compounding periods per year.

💡 More frequent = higher returns

Example: $1,000 invested at 5% for 10 years:

Frequency	Future Value
Annual	$1,628.89
Semi-annual	$1,638.62
Quarterly	$1,643.62
Monthly	$1,647.01

More frequent compounding leads to greater wealth accumulation due to the "interest on interest" effect being applied more often.

📊 Stated vs. effective rates

📊 APR vs. EAR

Annual Percentage Rate (APR): the stated interest rate assuming once-a-year compounding.

Effective Annual Rate (EAR): the actual yearly growth rate that includes the effects of multiple compounding periods within the year.

Formula: EAR = (1 + APR/m)^m - 1

Where m = compounding frequency per year.

🔍 Why the distinction matters

• APR doesn't reflect the true cost of borrowing or yield on investment when compounding occurs more than once per year.
• EAR provides the genuine annual rate accounting for compounding effects.

Example: An 8% APR mortgage with monthly payments has an EAR of approximately 8.3%—the true annual cost is higher than the stated rate.

Quoted Rate	Frequency	Effective Rate
10%	Annual	10.00%
10%	Semi-annual	10.25%
10%	Monthly	10.47%
10%	Daily	10.52%

🧮 Practical applications

🧮 Aggregating cash flows at different times

Due to time value of money, cash flows at different times cannot be simply added in nominal amounts:

• They must be adjusted to a common point in time—either all discounted to present value or all compounded to a future value.
• Example: Receiving $100 today and $100 in one year at 5% interest is not worth $200 today; the second $100 has a present value of only $95.24, totaling $195.24 in today's terms.

🔧 Solving for unknown variables

Knowing any three variables (PV, FV, interest rate, time) allows you to calculate the fourth:

Example: An investor bought shares at $38 in 2012 and they're worth $374 in 2024 (12 years later). What was the annual return?

Using FV = PV × (1 + r)^n:

• $374 = $38 × (1 + r)^12
• Solving: r = 21% per year

This demonstrates how the formulas can work backward to determine rates of return from observed price changes.

🧭 Overview

🧠 One-sentence thesis

Financial managers must convert cash flows to a common point in time—either future or present—to accurately evaluate their total value, using specialized formulas for regular payment patterns (annuities and perpetuities) to simplify calculations.

📌 Key points (3–5)

• Core principle: Future or present value of multiple cash flows cannot be found by simple addition; each cash flow must be converted to a common time point first.
• Annuities vs perpetuities: Annuities are equal periodic payments for a fixed duration; perpetuities continue indefinitely.
• Ordinary annuity vs annuity due: Ordinary annuity payments occur at the end of each period; annuity due payments occur at the beginning—annuity due always has higher value because each payment earns interest for one extra period.
• Common confusion: Don't confuse the timing—ordinary annuity (end of period) vs annuity due (beginning of period) affects the formula and final value.
• Practical flexibility: Annuity formulas contain four variables; knowing any three allows solving for the fourth (payment amount, interest rate, time, or present/future value).

💰 Valuing multiple cash flows

💰 Future value of cash flow streams

Future value (FV) of a series of cash flows: the total value at a future point in time when each individual cash flow is compounded forward to that common date.

• Why not just add them up? Cash flows occurring at different times have different values due to interest accumulation.
• The method: Bring each cash flow forward to the target future date using compound interest, then sum.
• Example: Mary deposits $500 in year 1, $900 in year 2, $400 in year 3, $700 in year 4, earning 9% annual interest. To find the balance at year 4:
  • Year 1 deposit grows for 3 years: 500 × (1 + 0.09) to the power of 3 = 647.51
  • Year 2 deposit grows for 2 years: 900 × (1 + 0.09) to the power of 2 = 1069.29
  • Year 3 deposit grows for 1 year: 400 × (1 + 0.09) = 436
  • Year 4 deposit: 700 (no growth)
  • Total FV = 2,852.8

💵 Present value of multiple cash flows

Present value (PV) of multiple cash flows: the total current worth when each future cash flow is discounted back to today.

• The method: Discount each future cash flow back to the present using the discount rate, then sum.
• Each cash flow is divided by (1 + discount rate) raised to the power of the number of periods.
• Example: Expecting to receive $100 in one year, $200 in two years, $300 in three years, with a 5% discount rate:
  • Year 3: 300 / (1 + 0.05) to the power of 3 = 285.71
  • Year 2: 200 / (1 + 0.05) to the power of 2 = 181.41
  • Year 1: 100 / (1 + 0.05) = 95.24
  • Total PV = 562.36

📅 Annuities: equal periodic payments

📅 What qualifies as an annuity

Annuity: a stream of equal periodic cash flows over a stated period of time.

Three conditions must be met:

• The amount of cash flows is the same each period
• The interval between each cash flow is the same
• The cash flows occur for a fixed amount of time (they do not go on forever)

Common examples: mortgage payments, insurance premiums, rent, lease payments, salaries, retirement income.

🔄 Two types of annuity

Type	Payment timing	Examples
Ordinary annuity	End of each period	Mortgage repayments, salaries, insurance premiums
Annuity due	Beginning of each period	Tuition payment, rent

Key distinction: The timing difference means annuity due always has higher present and future values because each payment earns interest for one additional period.

🔮 Future value of annuities

🔮 Future value of an ordinary annuity

Future value of an ordinary annuity: the accumulated amount when equal payments are made at the end of consecutive periods at a certain interest rate.

Formula structure: FVA = CF × [(1 + i) to the power of n - 1] / i

• FVA: future value of an annuity
• i: interest rate per period
• CF: cash flow each period
• n: number of periods

Why use the formula? For long periods, calculating each cash flow individually is time-consuming; the formula offers a far better alternative.

Example: Depositing $1,000 at the end of each year for 20 years at 5% annual interest:

• N = 20, i = 5%, CF = 1,000
• Future value factor = (1 + 0.05) to the power of 20 - 1 = 1.6533
• FV = 1,000 × 1.6533 / 0.05 = $33,066

🌅 Future value of an annuity due

Key insight: Each payment accrues interest for an additional period compared to an ordinary annuity because payments are made at the beginning rather than the end.

Formula: Future value of annuity due = Future value of ordinary annuity × (1 + i)

Example: Same scenario as above but deposits made at the beginning of each year:

• FV of ordinary annuity = $33,066
• FV of annuity due = 33,066 × (1 + 0.05) = $34,719.3

Don't confuse: Annuity due always exceeds ordinary annuity value when both have identical cash flows and duration.

🎯 Present value of annuities

🎯 Present value of an ordinary annuity

Present value of an ordinary annuity: the current worth of a series of future periodic payments at a given interest rate.

The question it answers: "How much would I have to invest today to receive a certain payment amount at regular intervals for a specified period, given a particular interest rate?"

Formula structure: PV = CF × [1 - 1/(1 + i) to the power of n] / i

Example: Needing $5,000 every month for the next 20 years starting next month, with 6% annual interest:

• Total periods = 240 (12 months × 20 years)
• Monthly interest = 0.5% (6% / 12)
• CF = $5,000
• (1 + 0.005) to the power of 240 = 0.3021
• PV = 5,000 × (1 - 0.3021) / 0.005 = $697,903.86

🌄 Present value of an annuity due

Formula: Present value of annuity due = Present value of ordinary annuity × (1 + i)

Why the adjustment? The present value is compounded forward by one additional period because the first payment is needed immediately.

Example: Same scenario but first payment needed immediately:

• PV of ordinary annuity = $697,903
• PV of annuity due = 697,903 × (1 + 0.005) = $701,595.38

Pattern: Similar to future value, the present value of an annuity due is always higher than the present value of an ordinary annuity.

🔧 Solving for other variables

🔧 Flexible applications of annuity formulas

Core principle: The annuity equation comprises four variables; by knowing any three, the remaining one can be deduced by rearranging the equation.

What you can solve for:

• Monthly payment amounts
• Growth or discount rate necessary to reach a specified future sum
• Duration required for an investment to mature to a desired lump sum
• Present or future value

⏱️ Solving for time periods

Example: Needing $200,000 as a home deposit, with 6% annual interest and $3,500 monthly savings starting in one month:

• Future Value = $200,000
• Interest per period = 0.06 / 12 = 0.005 (monthly)
• CF = $3,500
• This is an ordinary annuity (first payment one month from now)

Solution approach:

• Apply the future value formula and rearrange to solve for n
• Take logarithm on both sides: n × log(1.005) = log(1.2857)
• n = log(1.2857) / log(1.005) = 50.39 periods
• Result: 50.39 months or 4.2 years to reach $200,000

♾️ Perpetuities: infinite cash flows

♾️ Present value of a perpetuity

Perpetuity: a stream of equal cash flows that continue indefinitely, with no end, theoretically lasting forever.

Key characteristics:

• A type of annuity with no end
• Does not have a future value since its life is indefinite
• Only present value can be calculated

Formula: PV = CF / i

• CF: cash flow per period
• i: interest rate per period

Real-world example: Dividend distributions can be regarded as perpetuity since companies are assumed to operate on a going concern basis—in the investor's perspective, the lifespan is considered indefinite.

Example: Grandfather wants to ensure $11,309 annual payments forever, starting at retirement, with 9.9% annual interest:

• PV = 11,309 / 0.099 = $114,232.32
• This is the amount he needs to invest now

🌱 Growing perpetuities

Growing perpetuity: a series of cash flows that increase at a constant rate indefinitely.

Difference from standard perpetuity: Takes into account the growth of payments over time, not fixed cash flow.

Formula: PV = CF₁ / (i - g)

• CF₁: first cash flow
• i: interest rate
• g: constant growth rate

Don't confuse: The growth rate (g) must be less than the interest rate (i) for the formula to work.

Example: Establishing a scholarship with $50,000 first-year payment, growing at 3% inflation annually, with 7% interest rate:

• First year payment = $50,000
• Second year = 50,000 × (1 + 0.03) = $51,500
• Third year = 51,500 × 1.03, and so on
• PV = 50,000 / (0.07 - 0.03) = 50,000 / 0.04 = $1,250,000
• This is the amount needed today to sustain the scholarship indefinitely

🧭 Overview

🧠 One-sentence thesis

The financial system channels funds from savers to borrowers through markets and institutions, enabling productive investment and economic growth while regulators maintain stability and protect participants.

📌 Key points (3–5)

• Real vs financial assets: Real assets (property, equipment, patents) produce goods/services; financial assets (stocks, bonds) are legal claims on cash flows from real assets.
• Two funding pathways: Direct flow (primary/secondary markets) and indirect flow (through intermediaries like banks).
• Market classifications: Markets differ by maturity (money vs capital), issuance stage (primary vs secondary), organization (exchange vs OTC), and product type (equity, bond, FX, derivatives).
• Common confusion: Primary markets create new securities (issuer receives funds); secondary markets trade existing securities (money flows between investors, not to issuer).
• Three regulatory pillars: RBA (monetary policy, systemic stability), ASIC (consumer protection, market integrity), APRA (prudential oversight of institutions).

🏗️ Real vs financial assets

🏗️ Real assets: the productive foundation

Real assets: all elements required for production of goods and services; the essential building blocks of an economy's wealth and productive capacity.

• Tangible real assets: property, plant, equipment, land, buildings, machines.
• Intangible real assets: knowledge, intellectual property (patents, copyrights, trademarks, trade secrets).
• These assets directly contribute to output and determine a company's ability to create value.
• Investment decisions involve identifying which real assets yield favorable cash flows, considering acquisition, operation, maintenance, and upgrade costs throughout their lifecycle.

💼 Financial assets: claims on cash flows

Financial assets (financial securities): assets created by law outlining rights and obligations of holder and issuer; they represent claims over cash flows produced by real assets.

• Do not contribute directly to productive capacity.
• Created by financing decisions, not production decisions.
• Examples: stocks and bonds represent capital providers' claims on cash flows.
• Don't confuse: Real assets generate output; financial assets are legal instruments that allocate the income from that output.

🏦 The financial system architecture

🎯 Core purpose

The financial system efficiently directs funds from savers (surplus) to borrowers (deficit), facilitating investment in productive ventures critical for economic growth.

Four components:

1. Financial markets (venues for trading)
2. Financial institutions (intermediaries and managers)
3. Financial products (instruments traded)
4. Regulators (oversight bodies)

🔄 Two flow pathways

Pathway	How it works	Key feature
Direct flow	Savers buy securities directly from borrowers via markets	Investor has claim against issuer
Indirect flow	Savers deposit with intermediary (e.g., bank), who lends to borrowers	Investor's claim is only against intermediary, not borrower

Example (indirect): You deposit money in a bank (term deposit). The bank lends it as a housing loan. If the borrower defaults, the bank—not the borrower—is responsible to you.

🗺️ Financial markets: classifications

⏱️ By maturity: money vs capital markets

Money markets:

• Short-term securities (maturity < 12 months).
• Participants: institutional investors (banks, mutual funds, corporations), not retail.
• No physical location; trading over-the-counter, electronic, or by phone.
• Instruments: Treasury notes, certificates of deposit, commercial bills, promissory notes, inter-bank loans, repurchase agreements (repos).
• Purpose: liquidity management.

Capital markets:

• Long-term funds.
• Equity market: ownership stakes (shares) traded, often on exchanges like ASX.
• Corporate debt market: corporate bonds (companies borrow).
• Government debt market: government bonds/treasury bills (governments finance deficits).
• Foreign exchange (FX) market: global, decentralized currency trading; operates 24/5; enables international trade and investment.
• Derivatives market: instruments (options, futures, forwards, swaps) whose value derives from underlying assets; used for hedging or speculation.

🆕 By issuance stage: primary vs secondary markets

Primary markets:

• New securities created and sold for the first time.
• Issuers (corporations, governments) raise capital directly from investors.
• Investment banks facilitate: determine price, market, and sell securities.
• Example: Initial Public Offering (IPO)—company offers shares to public for the first time.
• Money flows from investor to issuer.

Secondary markets:

• Existing securities traded between investors.
• No new assets created; ownership changes hands.
• Money flows from buyer to seller, not to issuing company.
• Role: provides liquidity—investors can convert assets to cash, reducing investment risk and encouraging primary market participation.

Don't confuse: Primary = issuer gets funds; secondary = investors trade among themselves.

🏛️ By organization: exchange vs OTC

Exchange-traded markets:

• Structured, regulated venues (e.g., ASX, NYSE).
• High transparency: all orders, prices, transactions visible to participants.
• Strict disclosure requirements for issuers (financial health, performance).
• Regulatory oversight ensures fair practices and investor protection.

Over-the-counter (OTC) markets:

• Decentralized; no physical location.
• Trading via dealer networks (phone, electronic).
• Less regulatory oversight; more flexibility.
• Terms not standardized; customizable agreements.
• Dealers act as market makers, quoting bid/ask prices and holding inventory.
• Prices often negotiable; trades are private.

📦 By product type

Market	What trades	Typical venue
Equity	Shares (ordinary, preference, hybrids)	Exchanges (ASX)
Bond	Long-term debt (corporate, government bonds)	OTC (large trades) or exchanges
FX	Currencies	Global, decentralized; 24/5
Derivatives	Options, futures, forwards, swaps	Exchanges or OTC

🏢 Financial institutions: three categories

🏦 Financial intermediaries (ADIs)

Authorised Deposit-taking Institutions (ADIs): institutions authorized to accept deposits from the public (banks, credit unions, building societies).

How they work:

• Supplier of funds (investor) deposits money (e.g., term deposit).
• Intermediary pools deposits and lends to borrowers (e.g., housing loan).
• Investor's claim is only against the intermediary, not the borrower.
• If borrower defaults, the intermediary compensates the investor.

Revenue model: Interest spread—difference between loan interest charged and deposit interest paid.

• Example: Bank pays 1% on savings, charges 4% on loans → 3% spread.

💰 Investing institutions

These pool funds from many investors and invest in diversified portfolios.

Types:

Institution	What they do	Investment focus
Superannuation funds	Collect employer/member contributions for retirement	Equities, debt, real estate, cash
Managed funds	Pool money for diversified portfolios managed by professionals	Financial assets
Private equity (PE)	Invest in private (unlisted) companies; long-term, high-risk	Venture capital (start-ups) or buyouts/growth capital
Hedge funds	Sophisticated strategies (leverage, short-selling, derivatives); higher risk	Various; less regulated; for accredited investors only
General insurance	Collect premiums; cover property, motor, liability risks	Short-term, liquid securities (deposits, government bonds, liquid equities)
Life insurance	Life, accident, disability insurance; also investment/annuity products	Mix of equities and debt; long-term liabilities

Don't confuse: General insurance invests short-term (unpredictable claims); life insurance invests long-term (predictable liabilities).

🏛️ Financial agency institutions

(Not detailed in this excerpt; typically brokers, advisors, underwriters.)

🛡️ Financial regulators: three pillars

🎯 Regulatory objectives

Systemic stability:

• Ensure the financial system is resilient to shocks.
• Prevent crises like bank runs (mass withdrawals due to insolvency fears) or widespread failures.

Deposit protection:

• Safeguard small depositors who lack expertise to assess bank health.
• Address asymmetric information (banks know more than depositors).
• Mechanisms: deposit insurance schemes guarantee deposits up to a limit.

Social objectives:

• Incentivize institutions to serve public interest (not just profit).
• Keep fees low, support sectors with social value (small businesses, employment-generating industries).
• Promote economic inclusion and equitable growth.

🏦 Reserve Bank of Australia (RBA)

Role: Australia's central bank.

Key functions:

1. Monetary policy: Sets the cash rate (overnight loan interest rate) to influence inflation and economic activity. Board meets first Tuesday of every month (except January) to review and announce changes.
2. Payment systems oversight: Ensures safety and efficiency.
3. Banking services: Provides services to government and financial institutions.
4. Financial system stability: Monitors systemic risks, works with other regulators to prevent crises.

🛡️ Australian Securities and Investments Commission (ASIC)

Role: Corporate and financial services regulator.

Key functions:

• Enforce company and financial services laws.
• Protect consumers, investors, creditors.
• Oversee corporate governance (rules/processes for company direction and control; mitigate fraud risk).
• Regulate insurance, banking, superannuation sectors for efficiency, honesty, fairness.
• Promote transparency and market integrity.

🏛️ Australian Prudential Regulation Authority (APRA)

Role: Prudential oversight of financial institutions.

Key functions:

• Supervise banks, credit unions, building societies, insurance companies, superannuation funds.
• Ensure institutions meet financial promises to consumers under all reasonable circumstances.
• Set standards for risk management and capital adequacy.
• Plan for and respond to financial crises; can take control of threatened institutions and manage restructure or exit.

Distinction: ASIC focuses on consumer protection and market conduct; APRA focuses on institutional solvency and systemic risk.

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Key Takeaway: The financial system is a network of markets (venues), institutions (intermediaries and managers), and regulators (overseers) that together allocate capital from savers to productive uses, with checks to ensure stability, fairness, and public benefit.

🧭 Overview

🧠 One-sentence thesis

Bonds are debt instruments whose prices move inversely with market interest rates, and their value depends on the present value of future coupon payments and principal repayment discounted at the yield to maturity.

📌 Key points (3–5)

• What a bond is: a formal debt contract specifying par value, coupon rate, payment dates, and maturity date; the issuer pays whoever holds the bond at payment time.
• Coupon rate vs yield to maturity: coupon rate is the fixed interest rate on face value stated in the contract; yield to maturity (YTM) is the market-determined discount rate that reflects investor expectations and changes with market conditions.
• Bond pricing principle: bond price equals the present value of all future cash flows (coupons + par value) discounted at the YTM; when coupon rate equals YTM the bond trades at par, when coupon rate is lower the bond trades at a discount, when higher it trades at a premium.
• Common confusion—interest rate risk: longer-maturity bonds experience much larger price drops than shorter-maturity bonds for the same increase in market interest rates, because investors are locked into lower coupons for a longer period.
• Default risk premium: bonds with default risk must pay a higher yield than risk-free government bonds; credit ratings (AAA to D) indicate the likelihood of default and help investors assess this risk.

🧩 What bonds are and how they work

📜 Definition and key components

A bond is essentially a form of debt instrument, which can be likened to an "I owe you" note. It represents a formal and enforceable contract between the issuer (borrower) and the investor (lender).

Every bond contract specifies:

• Par value (face value): the principal amount repaid at maturity.
• Coupon rate: the annual interest rate paid on the face value, usually fixed.
• Coupon payment dates: scheduled interest payment dates, typically quarterly or semi-annual.
• Maturity date: the date when the bond expires and the par value is repaid.

The issuer does not need to know the bondholder's identity; payments go to whoever holds the bond at the due date, making bonds easily tradable.

🧾 Types of corporate bonds

Type	Description	Key feature
Coupon bonds	Pay fixed periodic interest (coupons) until maturity, then repay principal	Often include call provisions allowing early repayment
Zero coupon bonds	Pay no periodic interest; sold at a discount to face value	Single payment at maturity; the discount represents accumulated interest
Convertible bonds	Can be converted into a predetermined number of the issuer's common shares	Conversion at bondholder's discretion at specific times

🇦🇺 Australian bond market landscape

The excerpt references an RBA graph showing Australian financial markets as a percentage of GDP over time:

• Government bonds have generally decreased as a share of GDP.
• Equity markets have grown significantly, especially from the 1980s onward.
• Corporate bonds have grown but remain smaller than equities and government bonds.
• Overall trend: shift from heavy reliance on government bonds in the early 20th century to a more diversified structure with significant equity and corporate bond markets.

Trading structure:

• Most Australian corporate bonds trade over-the-counter (OTC) through broker-dealer networks, not on the ASX.
• OTC trading is less transparent; prices and availability vary more.
• Exchange-traded Treasury Bonds (eTBs) are government bonds listed on the ASX, offering individual investors easier access, transparency, and liquidity similar to stocks.

💰 Bond valuation: the present value approach

🧮 The valuation principle

The value of a financial asset is equal to the present value of all expected future cash flows, discounted at an appropriate discount rate.

Formula (Equation 1):

• Price (P) at time 0 = sum of each future cash flow (CF_t) divided by (1 + discount rate i) raised to the power of the period t, for all periods from 1 to n.
• P = present value of the stream of cash flows.
• i = market interest rate (discount rate).
• n = number of discounting periods.

This principle applies to all financial assets; for bonds, forecast the coupons and principal, then discount them to present value.

🎯 Pricing a coupon bond

A coupon bond's cash flows have two components:

1. Coupon payments: a series of equal periodic payments (an ordinary annuity).
2. Par value: a lump sum paid at maturity (a single cash flow).

Formula (Equation 2 and 3):

• Bond price = present value of coupon annuity + present value of par value.
• Use the annuity formula for the coupons and the single cash flow formula for the par value.
• The discount rate is the yield to maturity (YTM), which reflects the opportunity cost of capital—the return investors expect.

Example: AR Ltd issues a 10-year bond with 8.89% coupon rate, face value $1000, and market interest rate (YTM) 5.97%.

• Coupon payment per year = 0.0889 × 1000 = 88.9.
• Cash flows: 88.9 per year for 10 years, plus 1000 at year 10.
• Discount at i = 0.0597 for n = 10 periods.
• (The excerpt shows the setup but does not provide the final calculated price.)

📅 Semi-annual coupon bonds

Most corporate bonds pay coupons semi-annually, but coupon rates are quoted annually.

• If annual coupon rate is 4%, the bond pays 2% every six months.
• Formula (Equation 4): adjust the number of periods to 2n (twice the number of years) and the discount rate to i/2 (half the annual rate).

Example: 3-year bond, face value $1000, 6.3% annual coupon (semi-annual payments), required return 6.6% p.a.

• Coupon per period = 0.063 × 1000 / 2 = 31.50.
• Number of periods = 3 × 2 = 6.
• Discount rate per period = 0.066 / 2 = 0.033.
• (The excerpt shows the setup but does not provide the final price.)

🚫 Zero coupon bonds

Zero coupon bonds pay no periodic interest; the only cash flow is the par value at maturity.

• Formula (Equation 5): Bond price = par value / (1 + i)^n.

Example: Zero coupon bond, 6 years to maturity, face value $100,000, market rate 6% p.a.

• Price = 100,000 / (1.06)^6.
• (The excerpt shows the formula but does not provide the final calculated price.)

📊 Par, premium, and discount bonds

🎚️ How coupon rate and market rate determine price

Bond type	Relationship	Why	Price relative to par
Par bond	Coupon rate = market rate (YTM)	Bond offers exactly what investors expect	Trades at face value
Discount bond	Coupon rate < market rate	Bond offers less than investors expect; price must fall to raise effective return	Below face value
Premium bond	Coupon rate > market rate	Bond offers more than investors expect; investors pay more	Above face value

Don't confuse: the coupon rate is fixed in the contract; the market rate (YTM) changes with market conditions, causing the bond price to adjust.

Example: If investors expect 10% return and the bond pays exactly 10% coupon, it sells at par. If the bond pays only 8% coupon when the market expects 10%, the bond must sell below par so the total return (coupon plus capital gain at maturity) equals 10%.

🔄 Coupon rate versus yield to maturity

📐 Definitions and key differences

Coupon rate: determines the annual interest rate that the issuer promises to pay the bondholder on the bond's face value, expressed as a percentage.

Coupon yield (Yield to Maturity, YTM): is the return that an investor can expect to receive from the bond if it is held until maturity, assuming all the coupon payments are reinvested at the same rate.

• Coupon rate is stated in the bond contract and is often fixed for the life of the bond.
• YTM is the market-determined discount rate that equates the present value of all bond cash flows to the current bond price; it changes over time as market conditions change.
• YTM reflects the opportunity cost of capital: if market interest rates rise, investors expect higher returns, so YTM increases and bond prices fall.

🔍 How to find YTM

When the bond price is known, you can invert the valuation formula to solve for the discount rate (YTM).

Example: Westpac 3-year bond, 7% annual coupon (semi-annual payments), par $1000, current price $913.88.

• Number of periods = 2 × 3 = 6.
• Coupon per period = 0.07 × 1000 / 2 = 35.
• Use the bond price formula (Equation 4) and solve for the discount rate y per period.
• Using Excel, y = 5.21% per six-month period, so annual YTM = 2 × 5.21% = 10.42%.

Once YTM is obtained from one bond, it can be used to price similar bonds.

⚠️ Risks of investing in bonds

📉 Interest rate risk

Interest rate risk refers to the possibility of incurring losses on investments due to a rise in market interest rates.

How it works:

• When market interest rates rise, the YTM of existing bonds increases (because YTM reflects opportunity cost).
• Higher YTM means investors discount future cash flows at a higher rate, lowering the present value (price) of the bond.
• New bonds issued at higher rates offer better coupons, making existing bonds with lower coupons less attractive.

Key insight: Bonds with longer maturities are more sensitive to interest rate changes and experience greater price declines than shorter-maturity bonds for the same change in YTM.

• Longer maturity = longer period locked into lower coupons relative to the market = higher interest rate risk.

Example from the excerpt: A graph compares a 1-year bond and a 10-year bond when interest rates increase. Both prices fall, but the 10-year bond's price drops much more sharply than the 1-year bond's price.

Don't confuse: All bonds lose value when rates rise, but the magnitude differs—long-term bonds suffer much larger losses.

💥 Default (credit) risk

Default risk: the probability that the bond issuer will be unable to fulfill the debt payment obligations as they fall due.

• This is the risk of losing not just the return on capital but the return of capital (the principal).
• Government bonds generally have lower default risk than corporate bonds.
• To compensate for default risk, investors demand a default risk premium (DRP).

Default risk premium formula:

• DRP = interest rate on a security with default risk (i_dr) − interest rate on a risk-free security (i_rf).
• The DRP is the extra return a risky bond pays over a risk-free security like an Australian Government Bond.

🏅 Bond ratings

Credit rating agencies (Moody's, S&P, Fitch) evaluate the creditworthiness of bond issuers and assign ratings.

• Highest quality: Aaa (Moody's) or AAA (S&P/Fitch)—minimal default risk.
• Investment-grade: rated between Aaa/AAA and Baa/BBB—lower default risk, sought by conservative investors.
• Non-investment grade (junk/speculative/high-yield): rated below Baa/BBB—higher default risk, higher returns to compensate.

Rating scale summary (from the excerpt table):

Category	S&P	Moody's	Fitch	Description
Investment grade	AAA to BBB−	Aaa to Baa3	AAA to BBB−	Prime to lower medium grade, low to moderate credit risk
Non-investment grade	BB+ to D	Ba1 to D	BB+ to D	Speculative to default, substantial to extremely high credit risk

Don't confuse: A bond rated BBB is still investment-grade (moderate risk); a bond rated BB is junk (substantial risk). The boundary is at BBB/Baa.

🔗 Putting it all together: bond pricing and market dynamics

🔄 The inverse relationship between price and yield

• Bond prices and yields move in opposite directions.
• When market interest rates (and thus YTM) rise, bond prices fall.
• When market interest rates fall, bond prices rise.
• This inverse relationship is a fundamental principle of bond investing.

📏 Maturity and price sensitivity

• Longer-maturity bonds have greater price fluctuations for the same change in YTM.
• Shorter-maturity bonds are less sensitive to interest rate changes.
• This is because the longer the maturity, the longer the investor is exposed to the risk of being locked into below-market coupons.

🧩 Valuation in practice

Since bond cash flows are predetermined, the bond price depends primarily on the discount rate (YTM).

• To price a bond: forecast cash flows (coupons + par value), choose the appropriate YTM (reflecting market rates and credit risk), and discount to present value.
• To find YTM: observe the market price of a bond, use the valuation formula, and solve for the discount rate.
• YTM obtained from one bond can be used to price similar bonds (same maturity, credit quality, etc.).

Example workflow:

1. Identify the bond's coupon rate, par value, maturity, and payment frequency.
2. Determine the market interest rate (YTM) for similar bonds (or solve for it if price is known).
3. Calculate the present value of the coupon annuity and the par value.
4. Sum these present values to get the bond price.

Don't confuse: The coupon rate is a contract term and does not change; the YTM is a market variable that changes constantly, driving bond price movements.

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Note: The excerpt includes learning objectives, references, and a brief forward-looking paragraph about equity (the next chapter), which are not substantive content for bond valuation and have been omitted or summarized minimally. The core content focuses on bond definitions, types, valuation formulas, the distinction between coupon rate and YTM, interest rate risk, default risk, credit ratings, and the Australian bond market structure.

🧭 Overview

🧠 One-sentence thesis

Stocks represent ownership stakes in companies that can be valued through dividend-based models or market comparables, with ordinary shares offering higher risk and potential returns than preference shares due to their residual claim status.

📌 Key points (3–5)

• Two main equity types: ordinary shares (ownership with voting rights and residual claims) vs. preference shares (fixed dividends, bond-like features, priority over ordinary shareholders).
• Valuation principle: the value of any stock equals the present value of all future cash flows (dividends) discounted at the appropriate rate.
• Growth assumptions matter: constant growth (Gordon Growth Model) vs. variable growth (two-stage model) dramatically affect valuation outcomes.
• Common confusion: dollar returns vs. percentage returns—dollar amounts depend on initial investment size, making percentage returns essential for comparing performance across stocks.
• Market structure: not all stocks or markets are equal; larger companies and markets receive higher weights and disproportionately influence overall market performance.

📊 Stock ownership fundamentals

📊 Ordinary shares (common stock)

Ordinary shares: ownership stakes in a corporation representing residual claims on earnings and assets after all other obligations are met.

Key characteristics:

• Residual claimants: shareholders receive profits only after debt holders and other obligations are satisfied
• Voting rights: ability to influence corporate governance (mergers, executive pay, board elections)—something debt holders lack
• Limited liability: maximum loss is limited to the investment amount; personal assets are protected
• Infinite life: shares remain valid as long as the company operates; no maturity date

Risk-return trade-off:

• Higher risk than debt holders (last in line during liquidation)
• Cannot force company into liquidation (unlike debt holders)
• Potential for higher long-term returns compensates for increased risk

Example: If a company fails, debt holders can seize assets to recover funds, but ordinary shareholders only receive residual value after all debts are paid—often nothing.

🎯 Preference shares (preferred stock)

Preference shares: hybrid securities exhibiting characteristics of both bonds and common stocks, typically offering fixed dividends without a maturity date.

Distinctive features:

• Fixed income stream: regular dividends (set amount or fixed percentage), similar to bond coupons
• No maturity: dividends continue indefinitely as long as shares are held
• Priority ranking: higher than ordinary shareholders but lower than debt holders for dividends and liquidation claims
• Perpetuity nature: constant dividend stream allows valuation using perpetuity formula

Valuation formula (Equation 1):

• Price of preference share = Next period's dividend ÷ Discount rate
• PS₀ = Dₚ ÷ rₚ

Example: ABC Corp. issues preference shares paying $5 annual dividend; if market rate is 6%, the share price = $5 ÷ 0.06 = $83.33.

🔍 Comparing the two types

Feature	Ordinary Shares	Preference Shares
Dividend type	Variable, not guaranteed	Fixed, more predictable
Priority in liquidation	Lowest (residual)	Higher than ordinary, lower than debt
Voting rights	Yes	Typically no
Maturity	Infinite	Infinite
Valuation approach	Dividend discount models	Perpetuity formula

💰 Measuring stock returns

💰 Total return components

Two sources of return:

1. Income component: dividends received during the holding period
2. Capital gains/losses: change in share price (selling price minus purchase price)

Total dollar return = Dividend + (Ending price − Beginning price)

📏 Why percentage returns matter

The problem with dollar returns:

• Dollar returns depend on initial capital invested
• Cannot compare performance across different stocks fairly

Example: Share A costs $50, sells for $55 (dollar return = $5). Share B costs $10, sells for $12 (dollar return = $2). Which is better? With $50, you could buy 5 shares of B, ending with $60—better than A's $55. Dollar returns alone are misleading.

Rate of return formula (Equation 2):

• Rate of return = [Dividend + (Ending price − Beginning price)] ÷ Beginning price
• Expressed as a percentage, enabling fair comparisons

🧮 Present value perspective (Equation 3)

Rearranging the return formula gives the current stock price:

• P₀ = (D₁ + P₁) ÷ (1 + r)
• Current price = (Next dividend + Future price) ÷ (1 + Required return)

Example: XYZ Manufacturing expects $2.5 dividend and $30 sale price in one year; required return is 8%. Maximum price to pay today = ($2.5 + $30) ÷ 1.08 = $30.09.

Multi-period extension:

• For a 2-year horizon with growing dividends, discount each year's dividend and the final sale price separately
• The valuation principle holds regardless of time horizon: value = present value of all future cash flows

🌱 Dividend discount models

🌱 Core DDM concept

Dividend Discount Model (DDM): the fair price of a stock equals the present value of all anticipated future dividend payments.

Fundamental insight:

• Stock price today = sum of all future dividends discounted to present value
• Requires projections about future dividends (inherently uncertain)
• Different growth assumptions lead to different models

🔄 Constant growth: Gordon Growth Model

Assumptions:

• Dividends grow at a constant rate (g) forever
• Growth rate is less than the discount rate (g < r)

Formula (Equation 4):

• P₀ = D₁ ÷ (r − g)
• Or: P₀ = [D₀ × (1 + g)] ÷ (r − g)

Critical constraints:

1. g must be < r: if g = r, division by zero (undefined); if g > r, negative price (impossible due to limited liability)
2. Forward-looking: price depends on future dividends (D₁ onward), not past payments

Example: XYZ Corp. just paid $3.00 dividend, expected to grow at 4% forever; required return is 15%. D₁ = $3 × 1.04 = $3.12. Price = $3.12 ÷ (0.15 − 0.04) = $28.36.

Limitations:

• Unrealistic to assume constant growth forever (would eventually exceed global GDP growth)
• Ignores company life cycle (rapid early growth → mature steady growth)

📈 Two-stage variable growth model

More realistic approach:

• Stage 1: rapid growth for initial years (e.g., 20%, 15%)
• Stage 2: stable, lower growth rate forever (e.g., 5%)

Valuation process:

1. Calculate dividends for each high-growth year individually
2. Find the stock price at the end of the high-growth stage using Gordon model (with stable growth rate)
3. Discount all cash flows (individual dividends + terminal price) back to present

Example: Last dividend $1; Year 1 growth 20%, Year 2 growth 15%, then 5% forever; required return 20%.

• D₁ = $1 × 1.20 = $1.20
• D₂ = $1.20 × 1.15 = $1.38
• D₃ = $1.38 × 1.05 = $1.449
• P₂ (price at end of year 2) = $1.449 ÷ (0.20 − 0.05) = $9.66
• P₀ = ($1.20 ÷ 1.20) + ($1.38 ÷ 1.20²) + ($9.66 ÷ 1.20²) = $1.00 + $0.96 + $6.71 = $8.67

Don't confuse: The terminal price (P₂) is based on D₃ (the first dividend in the constant-growth phase), not D₂.

🔧 Alternative valuation approaches

🔧 Market comparables method

Why use comparables:

• DDM limitations: not applicable for non-dividend-paying companies; heavily dependent on accurate projections of dividends, growth rates, and discount rates
• Inaccurate inputs → significantly erroneous valuations

Common metrics:

• P/E ratio (Price-to-Earnings): compares stock price to earnings per share
• P/S ratio (Price-to-Sales): compares stock price to sales per share

Underlying principle:

• Comparable firms in the same industry should exhibit similar ratios
• If you know the target company's earnings and the peer group's average P/E ratio, estimate value = Earnings × Peer P/E ratio

Example: If similar companies trade at P/E = 15 and your target company has earnings of $2 per share, estimated price = $2 × 15 = $30.

🏛️ Australian share market structure

🏛️ ASX overview

Key statistics (as of 2024):

• 2,200 listed companies
• Total market capitalization: $2.6 trillion
• Average daily turnover: ~$6 billion

Market concentration insight:

• Not all stocks or markets are created equal
• Larger companies (by market cap) receive higher weights
• Performance of the overall market depends disproportionately on a few large companies
• Australian market tracks global trends closely; has outperformed global market since 2002

🔄 Primary vs. secondary markets

Aspect	Primary Market	Secondary Market
Purpose	New securities issued for the first time	Existing securities traded among investors
Participants	Issuing company + initial investors	Investors trading with each other
Capital flow	Funds go to issuing company	Funds stay between investors; no new capital to company
Role	Raise capital for expansion/operations	Provide liquidity; enable price discovery
Key process	IPOs, new bond issues (via investment banks)	Stock exchange trading (via brokers)

Primary market characteristics:

• Companies, governments, or institutions sell new financial assets
• Investment banks underwrite and facilitate IPOs
• Involves regulatory approval, due diligence, pricing stages
• Funds raised used for expansion, development, operations

Secondary market characteristics:

• Provides liquidity: investors can quickly convert holdings to cash
• Enables portfolio diversification and risk management
• Crucial for primary market functionality: investors buy new issues knowing they can later sell
• Transactions facilitated by brokerage firms, not issuing companies

🏦 Investment banking role

Core functions:

• Capital raising: assist companies in issuing bonds (debt) and conducting IPOs (equity)
• M&A advisory: facilitate mergers and acquisitions—negotiate deals, structure transactions, arrange financing

Investment banks vs. commercial banks:

Investment Banks	Commercial Banks
Long-term financing for corporations	Day-to-day banking for individuals/businesses
IPOs, bond issuance, M&A advisory	Savings accounts, mortgages, personal loans
Strategic advisory services	Accept deposits, lend to facilitate growth
Serve corporate clients	Serve retail and business clients

Don't confuse: Investment banks help companies access capital markets; commercial banks provide deposit and lending services to the general public.

🧭 Overview

🧠 One-sentence thesis

Investors demand higher expected returns for riskier investments, and by diversifying portfolios to eliminate firm-specific risk, only systematic risk (measured by beta) determines the expected return according to the Capital Asset Pricing Model.

📌 Key points (3–5)

• Return components: Total return consists of income (dividends, interest, rent) plus capital gains or losses from price changes.
• Risk measurement: Risk is quantified as the standard deviation of returns, which measures volatility around the expected return.
• Diversification limits: Portfolio diversification can eliminate unsystematic (firm-specific) risk but cannot remove systematic (market-wide) risk.
• Common confusion: Expected return vs. realised return—expected return is forward-looking (what you require for the future), while realised return is backward-looking (what actually happened in the past).
• Beta as the relevant risk measure: Since diversification removes firm-specific risk, only systematic risk (beta) matters for determining expected returns in a well-diversified portfolio.

💰 Understanding investment returns

💰 What constitutes return

The return on an investment measures the performance of the investment over a certain period, capturing the gain and loss that the investor experienced.

Two components make up total return:

• Income component: dividends from stocks, coupon (interest) payments from bonds, or rental income from properties.
• Capital gain (loss): the increase or decrease in the value of the investment asset itself, reflecting price changes during the holding period.

📊 Realised vs. expected return

Type	Time orientation	Definition
Realised return	Past	Return from an asset that has been realised; measures actual performance during a given period
Expected return	Future	Rate of return expected to be earned; also called required rate of return—the minimum return investors require to justify the risk

• Realised return formula: (Asset Price at end of period - Asset Price at end of previous period + Cash Flow received) / Asset Price at end of previous period
• Don't confuse: Realised return is about what happened; expected return is about what you demand going forward.

🧮 Calculating expected return

Two methodologies:

Historical data average: Calculate the average return over a past period by adding up each return observation and dividing by the number of periods (simple arithmetic average).

Probability distribution method: When potential outcomes and their probabilities are known, calculate expected return as a weighted average where each potential return is weighted by its likelihood. This method accommodates complex scenarios where returns depend on specific events or conditions.

⚠️ Measuring and understanding risk

⚠️ Definition of risk

Risk refers to the likelihood that an investment's actual return will fall short of its anticipated return.

• In a broader sense, risk is the potential for an asset to decrease in value.
• Since investors dislike risks while preferring high expected returns, they typically require higher expected returns as compensation for greater risk.
• Fundamental principle: the more substantial the risk one takes, the greater the return they will demand to justify the possibility of loss.

📏 Standard deviation as risk measure

Harry Markowitz in his 1952 "Portfolio Selection" paper measured risk as the standard deviation of an investment's returns.

• Standard deviation: a statistical measure that gauges the range of possible outcomes, indicating volatility of returns.
• To find standard deviation, first compute variance, then take the square root.
• Variance: measures the "average" squared distance from expected value (what you expect to get compared to what you might get).
• The wider the deviation from expected value—or the greater the standard deviation—the higher the risk.

😰 Risk aversion

Risk aversion: the phenomenon where most investors dislike risks or have an aversion to risk.

• Investors typically demand higher expected returns from investments perceived to be riskier.
• How large these compensations should be depends on individual risk preferences, which vary significantly among investors.
• Risk aversion for a given investor can change over time, affected by:
  • Personal financial situations
  • Life stages
  • Past investment experiences
  • Broader economic conditions

💎 Risk premium

Risk-free asset: an investment with zero risk. Risky asset: an investment with a risk element; the higher the risk, the higher the expected return.

• Risk premium: the additional returns that riskier investments provide over safer alternatives (such as government bonds).
• Serves as compensation for investors who tolerate increased uncertainty in riskier assets compared to more secure ones.
• Example: An investor chooses the stock market over a bank account because, although the stock market involves more risk, it typically offers higher return as a reward for bearing that risk.
• Historical data shows stocks have yielded a risk premium of approximately 4-6% over Treasury bonds on average.

🎯 Portfolio theory and diversification

🎯 Modern Portfolio Theory (MPT)

Introduced by Harry Markowitz in 1952, MPT is a revolutionary approach extending beyond individual asset selection to portfolio composition dynamics.

• It's not solely about identifying a good investment but about creating the optimal mix of assets to balance overall portfolio risk and return.
• At the heart of MPT is diversification.
• Core assertion: a portfolio composed of various investments will bear less risk than the sum of the risks of its individual components.
• Risk reduction is achieved because the price movements of different assets are not perfectly correlated.

📦 What is a portfolio

A portfolio is a collection of assets formed to reduce risk.

• The weight of all securities that make up the portfolio must equal 1.
• Expected return of the portfolio: the weighted average of the expected returns of the assets that make up the portfolio.
• Example: You invest $3,000 in stock A (7% expected return) and $7,000 in stock B (10% expected return). Stock A weight = 3,000/10,000 = 0.3; Stock B weight = 0.7. Portfolio expected return = (0.3 × 0.07) + (0.7 × 0.10) = 0.091 or 9.1%.

🔀 How diversification reduces risk

Portfolio volatility can be reduced if the assets do not perfectly move in the same direction.

• Example: If asset X goes up 10% and asset Y goes down 10%, investing in both can achieve a portfolio with zero risk.
• Conversely, if X goes up 10% and Y also goes up 10%, putting both in the same portfolio will not eliminate any risk.
• Correlation coefficient: a statistical measure dictating the relationship between two variables, fluctuating between -1 and 1.
• The lower the correlation coefficient, the greater the diversification benefits.
• If correlation is 1, there is no diversification benefit.

🔢 Limits of diversification

Since every company is different, their correlation is not 1, so the more companies in a portfolio, the greater the diversification benefits.

• However, there is a limit to diversification.
• As the number of companies increases, some risk still remains: systematic risk.
• Assets tend to move positively with each other because they are affected by macroeconomic factors with pervasive impacts on the whole economy.

🧬 Systematic vs. unsystematic risk

🧬 Risk decomposition

Total risk = Systematic Risk + Firm Specific Risk

Risk type	Also known as	Definition	Can be diversified?	Examples
Systematic risk	Market risk	Risk affecting the entire market or economy	No	Interest rate changes, inflation, recessions, wars
Firm-specific risk	Unsystematic risk	Risk affecting only a specific company or industry	Yes	Poor management decisions, production capabilities, changes in consumer demand

🎯 Relevant measure of risk

• Through diversification, unsystematic risk (specific to individual companies) can be reduced.
• Market-wide factors affecting all risky assets cannot be diversified away.
• Since unsystematic risks can be eliminated, the relevant measure of risk should only be systematic risk.
• If investors hold an undiversified portfolio and are exposed to unsystematic risk, that is purely their decision, which the market will not compensate for.

📐 Beta: quantifying systematic risk

Beta captures the proportionate movement in the stock returns relative to the returns on the market as a whole.

• Example: A stock with beta of 1.5 means if the market return increases by 2%, the stock's return is expected to increase by 3% (1.5 times the market movement).
• Example: A stock with beta of 0.5 means if the market return rises by 2%, the stock's return would likely increase by just 1%, showing less sensitivity.

Interpreting beta values:

• Beta > 1: more volatile than the entire market
• Beta = 1: volatility mirrors the market average (the market itself has beta fixed at 1.0)
• Beta < 1: less volatile than the market
• Typically, a stock's beta is between 0 and 2, although negative betas can occur
• Over time, betas generally gravitate toward the mean value of 1.0

🧮 Portfolio beta

Once you know the betas of individual assets, you can calculate the portfolio beta as a weighted average.

Example: You invest $10,000 in stock A (beta 0.8), $15,000 in stock B (beta 1.2), and $25,000 in stock C (beta 1.5).

• Total portfolio value = $50,000
• Weight of A = 10,000/50,000 = 0.2
• Weight of B = 15,000/50,000 = 0.3
• Weight of C = 25,000/50,000 = 0.5
• Portfolio beta = (0.8 × 0.2) + (1.2 × 0.3) + (1.5 × 0.5) = 1.27

📈 The Capital Asset Pricing Model (CAPM)

📈 CAPM framework

Developed by William Sharpe (1964), CAPM describes the relationship between expected return and risk of an asset.

Expected return = Risk-free rate + Risk premium

• According to CAPM, the only relevant measure of risk is not the variance or total risk but only the systematic risk component (covariance with the market portfolio), known as beta.
• The higher the beta, the higher the expected return.
• The risk premium is determined by the beta of the security, reflecting how much risk the investment adds to a diversified portfolio.

🌐 Market portfolio

The market portfolio is a portfolio that includes all securities in the market.

• Since constructing such a portfolio is typically costly and not feasible, we use proxies.
• In Australia: All Ordinaries Index or S&P/ASX 200 Index
• In the U.S.: S&P500 index or Russell 2000
• Beta is computed based on the covariance with the market portfolio.

🎓 Key takeaway

CAPM provides a useful concept for evaluating investment risks and returns:

• The expected return on a security equals the risk-free rate plus a risk premium.
• When investors hold a well-diversified portfolio, what matters is the systematic risk component.
• A security's expected return depends only on the systematic risk and market risk premium.
• Don't confuse: Total risk includes both systematic and unsystematic components, but only systematic risk (beta) is compensated in a diversified portfolio.

🧭 Overview

🧠 One-sentence thesis

Foreign exchange markets enable currency conversion and price discovery while allowing participants to hedge currency risk, with exchange rates determined by supply and demand in floating-rate systems or managed through pegs in other regimes.

📌 Key points (3–5)

• Purpose of FX markets: enable cross-border transaction settlement, establish relative currency prices, and provide hedging platforms against currency fluctuations.
• Exchange rate regimes: most developed countries use floating rates (market-determined), while some developing countries use managed floats or pegs.
• Who is affected: exporters prefer low exchange rates, importers prefer high rates, investors and borrowers face valuation and debt-servicing risks.
• Common confusion: direct quotes vs cross rates—direct quotes express foreign currency in domestic terms; cross rates calculate one currency pair through an intermediary currency.
• Rate movements are unpredictable: multiple interacting factors (interest rates, terms of trade, purchasing power parity, current account) make forecasting difficult.

🌐 What FX markets do

🌐 Core functions

The foreign exchange market is a global venue for the trading of currencies, allowing participants to convert one type of currency into another.

The excerpt identifies three primary purposes:

• Settlement: enable cross-border transactions from international trade, investment, and financing operations.
• Price discovery: establish the relative prices of different currencies (exchange rates are vital economic indicators).
• Risk management: provide a platform for hedging against potential losses due to currency value fluctuations.

These markets support international business by ensuring entities can transact in the appropriate currency for their needs and manage exposure to foreign exchange risk so currency volatility does not adversely impact financial strategies.

💵 The role of the US dollar

The USD plays a pivotal role in global exchange rates:

Role	Description
Reserve currency	Widely held by governments and institutions as part of foreign exchange reserves
Benchmark currency	Many commodities (oil, gold, raw materials) are priced in USD globally
Global trade medium	Primary medium of exchange in international trade; serves as intermediary for countries with less-traded currencies
Financial markets	The US hosts the world's largest and most liquid financial markets, making USD dominant for international borrowing and investing

📊 Trade Weighted Index (TWI)

The TWI evaluates the Australian Dollar against a portfolio of various international currencies selected based on their significance in international trade with Australia, with different weights reflecting the proportion of trade Australia conducts with each currency's country of origin.

🔄 Exchange rate systems

🔄 What is an exchange rate?

An exchange rate is the price at which one currency can be exchanged for another. It's an expression of the value of one currency in terms of another.

• Example: if USD/EUR = 1.2, one USD can be exchanged for 1.2 euros.
• Influenced by economic indicators, market speculation, political stability, and interest rates.

🏛️ Historical shift: Bretton Woods to floating rates

Bretton Woods System (mid-1940s to early 1970s):

• 44 Allied nations cooperated to manage currency exchange and foster financial stability.
• Countries pegged their currencies to the US dollar.
• The US dollar was linked to gold at $35 per ounce (gold standard).

Collapse in 1971:

• The US did not possess sufficient gold reserves to support the worldwide supply of dollars.
• Countries doubted sustainability and sought to exchange dollars for gold ("run on the gold reserve").
• Developed countries shifted to floating exchange rate systems.

Floating rates:

• Currency values fluctuate according to supply and demand in the foreign exchange market.
• No longer fixed to gold or pegged to the dollar.
• Influenced by interest rates, economic performance, and geopolitical events.
• This transition marked the beginning of modern foreign exchange markets.

⚖️ Floating vs managed systems today

Floating exchange rates (most currencies):

• Values determined by market supply and demand.
• Greater short-term fluctuations but prevent build-up of imbalances requiring large, disruptive adjustments.
• Example: Australia allowed the AUD to float on December 12, 1983, giving the economy greater flexibility to absorb external shocks and align with global conditions.

Managed floating rates (some developing countries):

• Currency floats in markets, but the central bank intervenes to stabilize or adjust value.
• Example: Chinese Yuan (CNY) is loosely pegged to a basket of currencies, allowing the People's Bank of China to guide valuation while market dynamics play a role.

💼 Economic impact of exchange rates

💼 Who is affected and how

Exchange rates are the determining prices at which a country values its international transactions, affecting the local cost of goods and services traded in foreign currencies and the domestic valuation of foreign assets and liabilities.

Group	Impact	Preference
Exporters	AUD appreciation makes products more expensive and less competitive globally	Favour low exchange rate
Importers	AUD appreciation means the same AUD buys more foreign goods; AUD depreciation increases costs	Favour high exchange rate
Investors	AUD depreciation increases the AUD value of foreign investments; appreciation decreases it	Depends on position
Borrowers	AUD weakening against the loan currency increases debt servicing costs when converted to AUD	Prefer stable or appreciating AUD

The influence extends to tourism operators, multinational corporations, pricing strategies, budget forecasting, international expansions, and hedging policies.

📐 Reading exchange rate quotes

📐 Direct quotes

A direct quote in the context of foreign exchange (forex) is the price of one unit of a foreign currency expressed in terms of the local or domestic currency.

In Australia:

• AUD/USD measures the value of 1 AUD relative to the US Dollar.
• Example: AUD/USD = 0.68 means 1 AUD = 0.68 USD (or 68 US cents).
• An increase in AUD/USD reflects AUD appreciation; a decrease reflects AUD depreciation.

🔀 Cross rates

Cross rates are exchange rates between two currencies calculated from their common relationships with a third currency, often known as the intermediary currency.

Example: Calculate EUR/AUD using USD as intermediary when no direct EUR/AUD quote is available.

• Given: EUR/USD = 1.15 (1 EUR = 1.15 USD) and AUD/USD = 0.77 (1 AUD = 0.77 USD).
• Need USD/AUD: USD/AUD = 1 / 0.77 = 1.3.
• EUR/AUD = EUR/USD × USD/AUD = 1.15 × 1.3 = 1.495.
• So 1 EUR = 1.495 AUD.

Don't confuse: cross rates are not direct market quotes; they are calculated through an intermediary currency.

🔮 Factors influencing exchange rate movements

🔮 Why movements are hard to predict

Exchange rate movements are very difficult to predict because multiple factors influence fluctuations and these factors do not happen in isolation—they often interact with each other.

🛒 Purchasing Power Parity (PPP)

• Based on the law of one price: in the absence of transaction costs and trade barriers, identical goods and services should have equal prices across countries when expressed in a common currency.
• Price differences would be eliminated through arbitrage (buying in a cheaper market to sell in a more expensive one).

Why PPP does not hold in practice:

• Transaction costs, tariffs, and other trade barriers exist and prevent price equalization.
• PPP only applies to tradable goods, not to services (e.g., haircuts).

💹 Expected Interest Rate Parity (EIRP)

Interest rate parity suggests the difference in interest rates between two countries will equal the differential between the forward exchange rate and the spot exchange rate.

Carry trade:

• Investors borrow in a low-interest-rate currency and invest in a high-interest-rate currency.
• Goal: profit from the interest rate differential as long as the exchange rate does not offset the profit.

Why carry trades are not reliable predictors:

• Currency values are influenced by many factors beyond interest rates (economic data, political events, market sentiment).
• Central banks can change interest rates unexpectedly.
• High-interest-rate currencies often come with higher risk, leading to sudden "unwinding" of carry trades if market sentiment changes.

📈 Expected interest rates

When a country is expected to raise interest rates:

• Foreign capital inflows increase as investors seek higher returns.
• Increased demand for the country's currency (needed to purchase local assets) drives up its value.

🏭 Terms of trade

The terms of trade measure the rate at which a country's exports can be exchanged for imports (ratio of export prices to import prices).

• Improvement (export prices rise relative to import prices): generates more revenue from exports; international buyers need the country's currency to pay for exports, increasing demand and causing appreciation.
• Deterioration (export prices fall or import prices rise): demand for the currency weakens, leading to depreciation.

Example: Australia is a major exporter of commodities (iron ore, coal, natural gas). When commodity prices are high, Australia's terms of trade improve, strengthening the AUD.

🧾 Current account balance

The current account includes:

• Trade balance (exports and imports of goods and services).
• Net income from abroad (dividends, interest).
• Net current transfers (foreign aid, remittances).

When exports exceed imports (trade surplus):

• Higher demand for the country's currency because foreign buyers need to exchange their currency to pay for exports.
• This increased demand typically leads to currency appreciation.