Finance Study Guide

📖 Core Concepts Finance – study of money, assets, liabilities and how they are managed to meet goals. Financial System – network of institutions, markets, and instruments that moves funds from savers to borrowers. Financial Intermediary – middle‑man (e.g., banks, mutual funds) that pools resources and reallocates them, earning a spread. Personal, Corporate, Public Finance – three main domains: budgeting & protection for individuals; value‑maximizing decisions for firms; revenue‑expenditure management for governments. Risk Types – Credit (default), Market (price/exchange‑rate moves), Operational (process or system failures). Hedging – using derivatives or other instruments to offset a specific risk exposure. Asset Allocation – dividing a portfolio among asset classes (stocks, bonds, real‑estate, etc.) according to risk profile and horizon. Value‑at‑Risk (VaR) – statistical measure of the maximum expected loss over a set time‑frame at a given confidence level. ESG / Sustainable Investing – integrating environmental, social, and governance factors into investment analysis. --- 📌 Must Remember Finance Goal: maximize value (shareholder wealth for corporations; financial security for individuals). Capital Budgeting: select projects that add net present value (NPV) – i.e., expected cash flows exceed cost of capital. Dividend Policy Decision: retain earnings for growth vs distribute to shareholders; reflects firm’s investment opportunities. Capital Structure Aim: choose debt‑equity mix that minimizes the weighted average cost of capital (WACC). Banks’ Income Model: earn interest spread = loan rate – deposit rate. Basel III: regulatory framework requiring banks to hold economic capital and regulatory capital against risk exposures. Modigliani‑Miller (MM) Theorem: in a perfect market, firm value is independent of capital structure (ignores taxes & bankruptcy costs). Behavioral Biases: investors often over‑react, herd, and suffer from loss aversion, which can misprice assets. --- 🔄 Key Processes Capital Flow in the Financial System Savers → financial intermediaries → borrowers (individuals, firms, governments). Intermediaries pay interest/dividends to savers and charge higher rates to borrowers. Corporate Capital‑Budgeting Cycle Identify potential projects → forecast cash flows → discount at cost of capital → compute NPV/IRR → accept if NPV > 0 (or IRR > cost of capital). Hedging a Market Risk Identify exposure (e.g., foreign‑exchange). Choose appropriate derivative (forward, futures, options). Take offsetting position equal in size but opposite in direction. Portfolio Optimization (Mean‑Variance) Define expected returns & covariance matrix. Solve for weights that minimize portfolio variance for a target return (or maximize return for a target risk). ESG Integration in Investment Process Screen securities for ESG criteria → adjust expected cash‑flow forecasts → incorporate into valuation/allocation decisions. --- 🔍 Key Comparisons Debt vs. Equity Financing Debt: fixed interest payments, tax‑deductible, increases financial leverage, higher bankruptcy risk. Equity: no mandatory payments, dilutes ownership, no tax shield, lower bankruptcy risk. Active vs. Passive Investment Active: frequent trading, seeks to beat benchmark, higher fees. Passive: tracks index, lower fees, relies on market efficiency. Fundamental vs. Technical Analysis Fundamental: values securities based on underlying cash‑flow/earnings. Technical: forecasts price movements from historical price/volume patterns. Value vs. Growth Investing Value: targets undervalued stocks (low price‑to‑earnings). Growth: targets firms with high earnings‑growth potential (often higher multiples). --- ⚠️ Common Misunderstandings “Higher returns always mean higher risk.” Risk must be measured (e.g., volatility, VaR); some low‑volatility assets can still have high expected returns if mispriced. “Dividends are always good for shareholders.” Paying dividends can signal limited growth opportunities; retaining earnings may create more value if profitable projects exist. “All banks make money only from interest spread.” Banks also earn fees, trading profits, and can suffer losses from credit risk; spread is just one component. “ESG investing sacrifices performance.” Empirical studies (outside the outline) show ESG can match or exceed traditional returns, especially over long horizons. --- 🧠 Mental Models / Intuition “Money flows like water.” Visualize savers as high‑land sources, borrowers as low‑land sinks; intermediaries are channels guiding the flow. “Capital structure as a lever.” Adding debt can magnify returns (leveraging) but also magnifies losses; the optimal point balances tax shield vs. bankruptcy cost. “Risk as a shield.” Hedging is like adding a protective layer; the cost of the shield (premium, spread) should be less than the expected loss it prevents. “Portfolio as a balanced diet.” Mix of asset “nutrients” (stocks, bonds, real estate) provides nutrition (return) while preventing “deficiencies” (over‑concentration risk). --- 🚩 Exceptions & Edge Cases Modigliani‑Miller assumptions break down when taxes, bankruptcy costs, agency problems, or information asymmetry are significant. VaR limitation: does not capture tail risk beyond the confidence level; can underestimate extreme losses. FinTech platforms may bypass traditional intermediation, but still subject to credit and operational risk. ESG scores differ across rating agencies; a security may be “green” under one methodology and not under another. --- 📍 When to Use Which Choose Debt vs. Equity: Use debt when tax shield benefits outweigh increased bankruptcy risk and cash flow is stable. Use equity when growth opportunities are high and cash flow is uncertain. Apply Hedging: Use forwards/futures for deterministic exposures (e.g., known future foreign‑currency payment). Use options when you need protection with upside participation. Select Investment Style: Active management when you believe markets are inefficient or have specialized information. Passive management for low‑cost, long‑term exposure to broad market returns. Risk Measurement Tool: Use VaR for regulatory reporting and quick loss estimate. Use stress testing and Greeks for scenario analysis and sensitivity to market moves. --- 👀 Patterns to Recognize “Spread” in banking questions → look for deposit rate vs. loan rate. “Trade‑off” language → signals a capital‑structure or dividend‑policy decision. “Screening” + “ESG” → indicates a sustainable‑investment valuation adjustment. “Option payoff” description → points to a hedging strategy (protective put, covered call). --- 🗂️ Exam Traps Confusing “cost of capital” with “interest expense.” Cost of capital is the required return for all financing sources; interest expense is only the debt component. Choosing VaR as the sole risk metric. Exams often penalize reliance on VaR without acknowledging its tail‑risk blind spot. Assuming “higher dividend yield = better stock.” High yields may reflect underlying distress; look for payout sustainability. Mix‑up between “financial risk” and “operational risk.” Credit/market risk = financial; failures of processes or systems = operational. Over‑applying MM theorem. Ignoring taxes or bankruptcy costs leads to incorrect capital‑structure conclusions. ---