Lecture 1: Money and capital markets, an overview
This course is about the places where money changes hands between people who have it and people who need it: the money and capital markets. This first lecture is a map of that world. It introduces the vocabulary (assets, securities, intermediaries, markets), the main players and the first two calculations of the course: the value of a fund share and the yield of a Treasury bill.
The summary assumes no prior knowledge. Every term is explained the first time it appears. If you have never had a finance course, read the blue box first.
- Saving and investing. If you spend less than you earn, you have money left over. You can keep it as cash, or hand it to someone who will use it and pay you for the privilege. That payment is the return on your investment. For a loan it is called interest; for a share in a company it is a dividend plus any rise in the share's price.
- Interest rate. The price of borrowing money, as a percentage per year. Borrow €100 at 5% and you pay back €105 after one year. The same number seen from the lender's side is the return on lending.
- Security. A tradable financial contract. The two basic kinds are debt (a bond or bill: "I lend you money, you pay it back with interest on fixed dates") and equity (a share: "I own a slice of the company and get a slice of its profits").
- Maturity. The date on which a debt security is paid back. "Short term" in this course means less than a year, "long term" more than a year.
- Liquidity. How easily and quickly you can turn something into cash without losing value. A share of Coca-Cola is very liquid (you can sell it in seconds at a known price); a house is not.
- Yield. Another word for the return on an investment, usually written as a percentage per year.
- Portfolio. The collection of all investments one person or fund holds.
About the course
- Instructor: Konstantinos Kassimatis (office: 2 Troias street, 5th floor). Textbook: Investments, 4th edition, by Zvi Bodie, Alex Kane and Alan J. Marcus.
- Topics: (1) money and capital markets, an overview; (2) compounding, present and future value; (3) bonds and interest rates; (4) stocks; (5) portfolio theory; (6) futures. The order of the lectures on e-class is slightly different: lecture 3 covers stocks and lecture 4 bonds.
- Assessment: a 2-hour final exam. Expect calculations like the examples and exercises in these chapters, so practise them with the calculation questions on this site.
The investment environment
Why invest at all? The timing of consumption. Investing is choosing when to consume. If you earn €2,000 and spend €1,500 now, you move €500 of consumption to the future. Investing it means the €500 can grow before you use it. The opposite also exists: borrowing moves future income to today (a student loan lets you consume now and pay later). Financial markets exist to make these shifts in time possible.
Real assets versus financial assets.
- Real assets are the things that actually produce goods and services: land, buildings, machinery, knowledge. They create the wealth of an economy.
- Financial assets are claims on real assets or on the income they produce: stocks, bonds, bank deposits. A share of Toyota does not build cars, but it gives you a right to part of the profit from the cars Toyota builds. Financial assets are just pieces of paper (today: entries in a computer), yet they decide who gets the income from the real assets.
Separation of ownership and management. A large company is owned by thousands of shareholders who cannot all run it. So they hire managers. This separation lets the company grow beyond what one family could own, but it creates a tension: the managers (the agents) may pursue their own interests (big offices, empire building) instead of the owners' interest (profit). Finance calls this the agency problem. Later in the course, the stock market is one of the mechanisms that disciplines managers: if they do a bad job, the share price falls and the company can be taken over.
The investment process
Building a portfolio happens in two steps, and two ideas run through both.
- Asset allocation: the big decision. How much of your money goes into each class of assets: stocks, bonds, cash, real estate? Research shows this decision explains most of the differences in returns between portfolios.
- Security selection: the small decision. Within each class, which individual securities do you buy? Which stocks, which bonds?
- Risk-return trade-off: the central idea of investing. Nobody pays you a high return for free. Assets that can lose a lot (stocks) offer a higher expected return than assets that are safe (government bills). If you want more return, you have to accept more risk; if you want safety, you give up return. There is no safe asset with a high return, and if someone offers you one, be suspicious.
- Active versus passive management: an active investor tries to beat the market by picking the right securities or timing the market. A passive investor just buys a broad, diversified portfolio (for example an index fund that holds all 500 stocks of the S&P 500) and holds it. Passive investing is cheap; active investing costs more and, on average, does not do better after costs.
First decide how much goes into stocks versus bonds versus cash (asset allocation). Then pick the specific securities (selection). Accept that more return always comes with more risk, and decide whether you want to try to beat the market (active) or simply own it (passive).
Trends in money and capital markets
- Technology. Computer advances made trading faster and cheaper, and information more timely and accurate. A price in Tokyo is known in Athens within a millisecond.
- Globalization. Domestic firms compete in world markets and national economies affect each other. For an investor this brings foreign exchange risk (an investment in dollars can lose value for a euro investor if the dollar falls) but also the chance to diversify across countries to improve performance.
- Securitization. Bundling many small loans (for example 5,000 mortgages) into one security that is sold to investors. The bank that made the loans gets its money back immediately and can lend again; investors get a new asset to buy. It creates opportunities for innovators and investors and has forced changes in regulation and supervision (securitised mortgages were at the heart of the 2008 crisis).
- Financial engineering. Repackaging services and products, and "slicing and dicing" cash flows. Example: strips. A 10-year government bond pays 20 half-yearly coupons and the principal at the end. A bank can separate these 21 payments and sell each one as its own zero-coupon security. The same cash flows now serve 21 different investors with different needs.
Who meets whom: the structure of the markets
Money and capital markets match those who need capital with those who have it. The ones who have it are lenders (also called investors); the ones who need it are borrowers (also investors, when they invest the money in projects). Between them stand intermediaries and markets.
| Group | Who | What they do |
|---|---|---|
| Lenders | Individuals, companies, governments | Have money they do not need right now |
| Intermediaries | Banks, insurance companies, pension funds, mutual funds | Collect money from lenders and pass it on to borrowers, transforming it on the way |
| Markets | Interbank market, stock exchanges | Places where securities are traded directly between participants |
| Borrowers | Individuals, companies, governments | Need money now and promise to pay later |
Notice that individuals, companies and governments appear on both sides. A household can be a lender (savings account) and a borrower (mortgage) at the same time.
A lender with €10,000 rarely lends it directly to a company. Either a bank sits in between (the bank takes the deposit and makes the loan: an intermediary), or the lender buys a security the company issued on a market (a bond or a share). This chapter describes both routes.
Intermediaries 1: banks
The central bank is the bank of the banks and of the government. In Greece that is the Bank of Greece as part of the Eurosystem led by the ECB; in the US the Federal Reserve. Its tasks:
- Supervision of banks and deposits: checking that banks are safe, and protecting depositors.
- Issue of bank notes: it prints the cash.
- Currency reserves: it holds the country's reserves of foreign currencies and gold.
- Raising money for the government and acting as banker to the government: it runs the government's accounts and organises the auctions of government debt.
- Lender of last resort: when a healthy bank cannot borrow anywhere else (for example during a panic), the central bank lends to it so that it does not collapse.
- Setting monetary policy: deciding the short-term interest rate, which influences all other rates, inflation and the economy.
- Clearing: settling the payments between banks. When you pay €50 from your account at bank A to a shop at bank B, the two banks settle through their accounts at the central bank.
Commercial banks are the banks you know. They do retail banking (accounts and loans for households and small firms) and wholesale banking (large deals with big companies and other banks). Their economic role has three parts:
- Intermediation: they collect many small deposits and make loans with them. The depositor does not need to find a borrower, check them, or chase them for repayment: the bank does all of that.
- Maturity transformation: deposits can be withdrawn at any time (short maturity), but mortgages run for 30 years (long maturity). The bank turns short-term money into long-term loans. This is useful for everyone and is also the reason banks are fragile: if all depositors want their money on the same day, the bank cannot sell its 30-year mortgages fast enough (a bank run).
- Providers of liquidity: they give you the ability to pay anyone, anytime: cards, transfers, cash.
Investment banks do not take deposits from the public. They work for companies and large investors: corporate finance (advising on mergers and takeovers), accepting (guaranteeing a company's debt by "accepting" its bills), security trading (buying and selling for clients and for themselves), investment management (running portfolios for clients), loan arrangement (organising a large loan given by a group of banks, a syndicated loan), foreign exchange and miscellaneous activities.
Savings banks, cooperative banks and mortgage banks are specialised deposit-taking banks: savings banks for household savings, cooperative banks owned by their members (farmers, local businesses), mortgage banks for housing loans.
Intermediaries 2: investment companies (funds)
An investment company pools money from many investors and invests it as one large portfolio. Each investor owns a number of shares (also called units) of the fund. There are two legal forms.
| Open-end fund (mutual fund) | Closed-end fund |
|---|---|
| Invests funds provided by investors; the amount under management varies with supply: new investors bring money in, leavers take it out | Invests an amount that is pooled once, at the start; it does not accept additional funds |
| Has a specific investment policy (for example "European large-company stocks") | Has an expiration date, after which the fund is wound up and the money paid out |
| Investors may liquidate their shares: the fund itself buys them back at the net asset value | Investors who want out sell their shares to another investor on the stock exchange, at whatever price the market gives |
Why invest through a fund instead of directly?
- Record keeping and administration: the fund handles dividends, tax forms, corporate actions.
- Diversification and divisibility: with €500 you cannot buy a piece of 200 different companies, but a fund can, and your €500 buys a slice of all of them.
- Professional management: full-time analysts choose the investments.
- Low transaction costs: the fund trades in large amounts and pays lower fees per euro than you would.
The value of a fund share: net asset value (NAV)
The net asset value is the market value of the fund's net assets (what it owns minus what it owes) divided by the number of shares outstanding. It is the price at which an open-end fund buys back and sells its shares.
A fund manages assets with a market value of €100 million. It owes €3 million to its investment advisors and €1 million for expenses. It has issued 20 million shares.
Step 1, net assets: 100 − 3 − 1 = €96 million. Step 2, divide by shares: 96 / 20 = €4.80 per share.
If you own 1,000 shares, your investment is worth 1,000 × 4.80 = €4,800. If the stocks in the fund rise by 10% tomorrow, assets become €110 million, net assets €106 million and the NAV 106 / 20 = €5.30.
What a fund costs: commissions and fees
- No-load funds charge no commission when you buy or sell.
- Load funds charge a commission (the load). A front-end load is paid when you buy: a 3% load means that of every €100 you pay, only €97 is invested. A back-end load is paid when you sell, often decreasing the longer you stay.
- Administration fees cover the fund's running costs (bookkeeping, custody); management fees pay the managers. Both are taken out of the fund's assets every year, typically 0.1% to 2% of assets. They lower the NAV a little every day, which is why cheap index funds beat most expensive active funds in the long run.
Fund categories
- Equity funds: mainly stocks.
- Money market funds: very short-term, very safe debt (Treasury bills, commercial paper). Almost like a bank account with a slightly higher interest rate.
- Fixed income funds: bonds.
- Balanced and income funds: a mix of stocks and bonds; income funds aim at regular payouts.
- Asset allocation funds: the manager moves between stocks, bonds and cash depending on the outlook.
- Index funds: passively copy an index such as the S&P 500 or the Athens General Index.
- Specialized sector funds: one industry only, such as technology or health care.
Markets 1: the interbank market
An electronic market where intermediaries trade with each other: banks lend each other money (often overnight), trade currencies and bonds. There is no exchange building; the trading platforms are provided by private companies such as Bloomberg and Reuters (now LSEG). The interest rates set here (for example EURIBOR, see below) are the reference for loans to everyone else.
Markets 2: the money market
The money market is the market for short-term debt securities: loans of less than a year, in large amounts, between governments, banks and large companies. The most important instrument is the Treasury bill.
Treasury bills (T-bills) are short-term government debt with a maturity of 91 days, 182 days or 52 weeks. They pay no interest coupons: you buy them below their face value and receive the full face value at maturity. The difference is your return. The government sells them in auctions with competitive bids (you state the price you are willing to pay; the highest bids win) or non-competitive bids (you accept whatever price the auction produces; used by small investors).
The yield of a T-bill: three ways to say the same thing
Because a T-bill has no coupon, its return is the discount at which you buy it. The slides compute this in three ways, and you should be able to do all three.
A T-bill is priced today at $9,600 and pays $10,000 in 182 days. You earn 10,000 − 9,600 = $400 on $9,600.
1. Holding-period yield (182-day yield): the return over the 182 days.
This is 4.17% for half a year, so the slides call it "semiannually".
2. Effective annual yield (EAY): what you would earn in a year if you could repeat this twice and reinvest the money. Compounding over two half-years:
(The slides treat 182 days as exactly half a year. Using 365/182 instead of 2 as the exponent gives 8.53%, a small difference.)
3. Bank discount yield (BDY): the old-fashioned way T-bills are quoted in the US. It divides the discount by the face value (not the price) and scales up with a 360-day year:
On the slides this is written as 400 × (360 / 182) = 791.21, then 791.21 / 10,000 = 7.912%.
Why do the three numbers differ? The holding-period yield is the only "true" return over 182 days. The EAY converts it to an annual rate with compounding, so it is the highest. The BDY understates the real return for two reasons: it uses the face value (10,000) as the base instead of the smaller amount you actually paid (9,600), and it uses a 360-day year. The BDY is a quoting convention, not a return you can actually earn. On an exam, read carefully which one is asked.
"Yield" always means: what you earn divided by what you put in, per period. For the T-bill you put in 9,600 and earn 400, so 400 / 9,600 = 0.0417 = 4.17%. To write a decimal as a percentage, multiply by 100. To turn a half-year rate into an annual rate with compounding, you do not simply double it: after half a year you have 1.0417 times your money, after a full year 1.0417 × 1.0417 = 1.0851, so you gained 8.51%, not 8.34%. Compounding is the topic of lecture 2.
Other money market instruments
- Certificates of deposit (CDs): a bank deposit for a fixed term (for example 3 months) with a fixed rate, in a form that can be sold to someone else before the term ends.
- Commercial paper: short-term IOUs issued by large, creditworthy companies to borrow for a few weeks or months without going through a bank.
- Bankers' acceptances: an order to a bank to pay a given amount on a given date, which the bank has "accepted" (guaranteed). Used in international trade: the exporter can sell the acceptance immediately for cash.
- Eurodollars: dollar deposits held in banks outside the United States (the prefix "Euro" is historical and has nothing to do with the euro).
- Repos and reverse repos: a repurchase agreement is a very short loan secured by a bond: the borrower sells the bond today and agrees to buy it back tomorrow at a slightly higher price; the price difference is the interest. Seen from the lender's side the same deal is a reverse repo.
- Federal funds: in the US, the overnight loans of reserves between banks; the federal funds rate is the Fed's policy rate.
- LIBOR and EURIBOR: benchmark interest rates at which banks lend to each other in the interbank market (London Interbank Offered Rate; Euro Interbank Offered Rate). Many loans and derivatives are priced as "EURIBOR plus a margin". LIBOR was discontinued in 2023 after a manipulation scandal; EURIBOR still exists.
Markets 3: the fixed income (bond) market
The market for long-term debt. A bond pays fixed interest (the coupon) on fixed dates and the principal at maturity, hence "fixed income". Lecture 4 is about how to price bonds; here you only need the types of issuers:
- Treasury notes and bonds: government debt with maturities above a year (in the US, notes up to 10 years, bonds up to 30 years).
- Federal agency debt (USA): issued by government-sponsored agencies such as Fannie Mae, which finance mortgages.
- Municipal bonds: issued by cities, states and regions.
- Corporate bonds: issued by companies; riskier than government bonds, so they pay a higher yield.
- Mortgages and mortgage-backed securities (MBS): bundles of home loans sold to investors (the product of securitization).
Markets 4: stock exchanges
A stock exchange is an organized secondary market for securities. Primary market: the company sells new shares to investors and receives the money (an initial public offering, IPO). Secondary market: investors trade existing shares among themselves; the company receives nothing, but without this market nobody would buy in the primary market, because they could never get out.
Why create a stock market?
- Price discovery: thousands of buyers and sellers produce a price that reflects all available information about the company.
- Raise capital: companies can finance growth by selling shares to the public.
- Acquisitions and market discipline: a badly run company has a low share price and can be bought cheaply by someone who will run it better; the threat keeps managers on their toes.
- Choice of investment: investors can pick exactly the risk and industry they want.
- Liquidity: you can sell at any moment.
- Motive to save money: because savings can earn a return and remain accessible, people save more, which finances more investment.
Participants in the stock market
- Brokers: execute orders for clients and charge a commission; they do not take positions themselves.
- Market makers: stand ready to buy and sell a stock at all times, quoting a bid (what they pay) and an ask (what they charge). They earn the spread between the two and provide liquidity.
- Institutional and individual investors: institutions (pension funds, insurers, mutual funds) manage other people's money in large amounts; individuals invest their own.
- Arbitrageurs: look for the same asset at two different prices, buy the cheap one and sell the expensive one, and so push prices back in line. Risk-free in theory.
- Hedgers: use the market to reduce a risk they already have (an airline buying fuel futures to fix its fuel cost).
- Speculators: take on risk on purpose, betting on the direction of prices, in exchange for the chance of a profit.
Lecture 1 in one breath: savers hand money to borrowers either through intermediaries (banks, funds) or through markets (money market for short loans, bond market for long loans, stock exchange for ownership). Two numbers to master: NAV = net assets / shares, and the three yields of a T-bill.