Finance

Introduction
• Finance is a crucial component of modern economies,
allowing for the allocation of resources and the
management of risk.
• However, finance can also lead to market failures, such as
information asymmetry, externalities, and systemic risk.
• To mitigate these market failures, the domain of finance
relies on a variety of tools, including financial
intermediaries, financial regulation, and financial
innovation.
• Financial intermediaries, such as banks and insurance
companies, help to pool and allocate risk across different
actors in the economy.
• Financial regulation, such as capital requirements and
stress tests, helps to ensure the stability of financial
institutions and prevent financial crises.
• Financial innovation, such as securitization and
derivatives, can help to improve the efficiency of
financial markets, but can also lead to new forms of risk.
 Functions of Financial Markets
• Capital Allocation: Financial markets efficiently allocate
capital to its most productive uses. They channel funds
from savers to borrowers, enabling businesses to expand,
create jobs, and invest in research and development.
• Facilitating Investment: Financial markets provide
investors with an array of investment options, from low-
risk to high-risk assets, catering to various risk appetites
and investment objectives.
• Risk Management: Financial markets offer instruments like
derivatives that allow investors to hedge against risks, such
as price fluctuations, interest rate changes, and currency
volatility.
 Challenges in Finance
• One key challenge in finance is the problem of moral
hazard, where actors take on excessive risk because they
are protected from the consequences of their actions.
• Another challenge is the problem of adverse selection,
where actors with better information are more likely to
engage in risky behavior.
• Behavioral economics has shown that individuals often
make irrational decisions when it comes to finance, such
as overconfidence and loss aversion.
• Financial literacy and education can help to mitigate these
behavioral biases and improve financial decision-making.
 Housekeeping

• Instructor: Tanmoy Majilla

Ph.D. in Economics from Erasmus University Rotterdam
M.A. Delhi School of Economics
Assistant Professor of Economics, IIM Lucknow
• Email: [email protected]

• Office: 1206 Bharti Block

• Office hours: tbc

• TA: Saurabh Shukla

[email protected]
 Course Outcome
• At the end of the course, we expect the students to be able to:

• Comprehend Financial Markets: Understand equity, bond, and money markets,

enabling informed investment decisions.
• Analyze Financial Statements: Evaluate balance sheets, income statements, and
flow statements for effective business decision-making.
• Apply Time Value of Money: Utilize time value of money principles to assess
project viability and investment choices.
• Explore Financial Models: Examine cost of capital and Capital Asset Pricing
Model (CAPM) for optimal financing and risk assessment.
• Integrate Data Science in Finance: Leverage Python and data science tools to
analyze financial data, culminating in a practical group project.
 Course Materials
• Textbooks: 
• Brealey, R. A., Myers, S. C., & Allen, F. Principles of Corporate Finance (Edition 12
or higher). McGraw-Hill. BMA
• Libby, R., Libby, P., & Hodge, F., Financial Accounting (Edition 9 or higher).
McGraw Hill. LLH

• Recommended Books (optional) 

• Mishkin, F. S., & Eakins, S. G. Financial Markets and Institutions (Edition 8 or
higher). Pearson Education. ME.

• Case Studies:  
• We will be working through a number of case studies during many of our class
sessions. These situations are based on actual businesses. Please read the case text
prior to class so that you are familiar with the setup, questions, and provided
information.
 First Case Study
• Gone Rural – this Friday.

• Volunteer?
 Data Science Incorporation
• We will analyze and discuss several applications of data science in finance and
accounting. I will also provide several suggestions on how to effectively apply
your data science training. In your group assignment, you are expected to
analyze financial data using data science tools. Please bring your laptop to the
sessions on data science incorporation. Our preferred programming language is
Python. Feel free to utilize any language with which you are comfortable.

• You will also have the Tutorial sessions with the TA:
• Week 3: Analyzing Financial Data using Python (1).
• Week 4: Analyzing Financial Data using Python (2).
• Week 7: Analyzing accounting data using Python.
• Week 12: Analyzing CAPM using Python.
 Class Etiquette
• Please turn off and put away your phones.
• Do not use any electronic devices.
• Please respect the classroom as an inclusive learning
environment in which diverse perspectives and
experiences can be shared to facilitate the education
of all students.
• Students are expected to attend all sessions.
Participation in class is weighed with a grade.
• Do not discuss among yourselves during the class.
 Grading Policy
• Final grades will be determined using the following weights:
• Class Participation – 10%
• Attendance– 10%
• Assignment – 20%
• Quiz – 20%
• Group Data Science Project – 40%

• Attendance Policy:
• 95% and above: 10 marks
• 91-94: 9 marks
• 81-89: 8 marks
• 71-80: 7 marks
• 65-70: 6 marks
• 60-64: 5 marks
• Below 60%: 0 marks
 Detailed Course Schedule (Tentative)
• Week 1
• Topic – 1 Introduction to Finance
• 2 Time Value of Money and Calculating Present Values

• Week 2
• Topic – 1 Introduction to Bond and Equity Markets
2 Valuing Bonds

• Week 3
• Topic – 1 Valuing stocks
2 Net Present Value and Other Investment Criteria 
• Tutorial – Analyzing Financial Data using Python (1).
• Week 4
• Topic – 1 Investment Decisions using the Net Present Value Rule
• Tutorial – Analyzing Financial Data using Python (2).

• Weak 5
• Topic – 1 The economics of financial reporting and disclosure
• 2 Financial Statements and Business Decisions

• Week 6
• Topic – 1 Investing and Financing Decisions and the Accounting System
• 2 Operating Decisions and the Accounting System
• Week 7
• Topic - Reporting and Interpreting Sales Revenue, Receivables, and Cash
• Reading: LLH Chapter 6.
• Tutorial – Analyzing accounting data using Python.

• Week 8
• Mid-term break

• Week 9
• Topic – 1 Reporting and Interpreting Cost of Goods Sold and Inventory
• 2 Reporting and Interpreting Liabilities
• Week 10
• Topic – 1 Reporting and Interpreting Stockholders’ Equity
• 2 Statement of Cash Flows

• Week 11
• Topic - Introduction to Risk and Return
• Research in focus – Relative Valuation Using Machine Learning.

• Week 12
• Topic - Capital Asset Pricing Model
• Tutorial – Analyzing CAPM using Python.
• Week 13
• Topic - Cost of Capital

• Week 14
• Topic - Special Topic
• We will introduce one of the following topics based on mutual interest. This list is
incomplete and not exhaustive.
• Fintech
• ESG and Climate Finance
• Algorithmic Trading
• Entrepreneurial Finance

• Week 15
• Topic - Group Presentation
 Group Project (Tentative)
• Groups of 4 will be formed.
• Each group will be assigned a Data Science Project
related to the course. For example:
• Banking (Risk Analysis)
• Option/Derivatives
• ESG
• Fintech
• Bond Market Forecast
• The list is not exhaustive.
• Details will be provided in upcoming classes.
 Financial market
• Financial market refer to platforms where individuals,
institutions, and governments buy and sell financial
assets, facilitating the transfer of funds between savers
and borrowers. These markets play a crucial role in
allocating capital efficiently in an economy.
• Financial markets are the backbone of a modern
economy. They promote economic growth by providing
funding for businesses, governments, and individuals,
enabling investments and driving entrepreneurship.
 Types of Financial markets
Financial markets can be broadly categorized into two
main types:
• Money Market: Deals with short-term debt instruments
and assets with maturities of one year or less. It includes
instruments like Treasury bills, commercial paper, and
certificates of deposit.
• Capital Market: Deals with long-term financial assets and
instruments with maturities exceeding one year. It
includes instruments like stocks, bonds, and mutual
funds.
 Participants
• Investors: Investors are individuals or entities that have surplus
funds they want to invest to earn returns. They can be retail
investors, high-net-worth individuals, pension funds, insurance
companies, or mutual funds.
• Borrowers: Borrowers are entities, such as corporations or
governments, seeking funds to finance their projects or operations.
They issue financial instruments like stocks or bonds to raise
capital.
• Intermediaries: Intermediaries act as facilitators between investors
and borrowers. They include banks, brokerage firms, and mutual
fund companies. Intermediaries provide various services, such as
investment advice, asset management, and market liquidity.
 Financial Flow
Upstream Financial Flow:
• Upstream Financial Flow refers to the movement
of money or funds in the opposite direction of the
regular supply chain, moving from the point of
consumption or sale back to the producer or
manufacturer.
• Example: In the context of supply chain finance, a
retailer may use upstream financial flow to
provide early payments to its suppliers, helping
them with working capital needs.
 Downstream Financial Flow
• Downstream Financial Flow is the conventional
movement of money or funds in the direction of the
regular supply chain, moving from the producer or
manufacturer to the distributor, retailer, and eventually to
the end consumer.
• Example: When a consumer purchases a product from a
retailer, the downstream financial flow involves the
payment made by the consumer to the retailer for the
product.
 Functions of Financial Markets
• Capital Allocation: Financial markets efficiently allocate
capital to its most productive uses. They channel funds
from savers to borrowers, enabling businesses to expand,
create jobs, and invest in research and development.
• Facilitating Investment: Financial markets provide
investors with an array of investment options, from low-
risk to high-risk assets, catering to various risk appetites
and investment objectives.
• Risk Management: Financial markets offer instruments like
derivatives that allow investors to hedge against risks, such
as price fluctuations, interest rate changes, and currency
volatility.
 Financial Instruments
• Financial instruments refer to tradable assets or contracts
that represent a legally enforceable claim to future cash
flows or financial assets.
• These instruments are used by individuals, businesses,
and governments to raise capital, manage risks, and invest
in various financial markets.
• Financial instruments can be categorized into two main
types: cash instruments and derivative instruments.
 Cash Instruments
Cash instruments are financial instruments that have
intrinsic value and can be settled in cash or cash
equivalents. They include:
• Stocks (Equity Securities): Represent ownership in a
company and provide shareholders with a proportional
claim to the company's assets and earnings.
• Bonds (Debt Securities): Represent loans or debt
obligations issued by governments or corporations.
Bondholders receive periodic interest payments and the
return of the principal amount at maturity.
• Money Market Instruments: Short-term debt securities
with maturities of one year or less, such as Treasury bills,
commercial paper, and certificates of deposit.
• Bank Deposits: Funds deposited in banks, including
savings accounts, checking accounts, and certificates of
deposit.
• Cash Equivalents: Highly liquid investments with short-
term maturities, typically three months or less, that are
easily convertible into known amounts of cash, such as
Treasury bills.
 Derivative Instruments
• Derivative instruments derive their value from an
underlying asset or benchmark, such as stocks, bonds,
commodities, currencies, or interest rates.
• They are used for risk management, speculation, and
hedging purposes.
• Common types of derivative instruments include:
• Futures Contracts: Agreements to buy or sell an asset at a
specified price on a future date. They are commonly used
to hedge against price fluctuations.
• Options Contracts: Provide the right (but not the
obligation) to buy (call option) or sell (put option) an
asset at a predetermined price within a specified time.
• Swaps: Financial agreements where two parties exchange
cash flows based on different financial instruments, such
as interest rates or currencies.
• Forwards: Similar to futures contracts but customized
between two parties and not traded on a centralized
exchange.
 Understanding the Stock Market
• Stock Exchanges: Stock exchanges, such as the New York
Stock Exchange (NYSE) and NASDAQ, provide platforms
where stocks are bought and sold. They offer transparency,
liquidity, and price discovery.
• Stock Indices: Stock indices, like the S&P 500 and Dow
Jones Industrial Average, track the performance of a
selected group of stocks. They serve as benchmarks for
overall market performance.
• Trading Mechanism: The stock market operates through
brokers and electronic trading platforms. Investors place
buy or sell orders, and trades are executed based on market
demand and supply.
 Understanding the Bond Market
• Bondholders receive fixed interest payments (coupons) until
maturity.
• Bond prices fluctuate based on market interest rates. When interest
rates rise, bond prices fall, and vice versa.
• Yield: Yield is the total return an investor can expect from holding
a bond until maturity.
• Government bonds are considered low-risk, as governments rarely
default on their debt.
• Corporate bonds carry higher risk but offer potentially higher
returns.
• Bonds are assigned credit ratings by rating agencies (e.g., Standard
& Poor's, Moody's) to indicate their creditworthiness. Higher-rated
bonds are considered safer investments.
 Risk-Return Tradeoff
• In general, higher-risk investments have the potential for
higher returns, but they also carry a higher chance of loss.
Lower-risk investments typically offer lower returns but
greater stability.
• Diversification: Diversification involves spreading
investments across different assets to reduce overall risk. A
well-diversified portfolio can help mitigate the impact of
individual asset fluctuations.
• Efficient Market Hypothesis: The Efficient Market
Hypothesis suggests that financial markets quickly
incorporate all available information into asset prices. As a
result, it is difficult to consistently outperform the market.
 Financial Analysis
Horizontal Analysis:
• Horizontal Analysis, also known as trend analysis, is a
financial analysis method that compares financial data
over multiple periods. It evaluates the percentage changes
in financial statement items, such as revenue, expenses,
or net income, to identify trends and patterns.
• Purpose: Horizontal Analysis helps assess the company's
performance over time, identify growth or decline in
specific areas, and spot potential financial challenges.
Vertical Analysis:
• Vertical Analysis, also called common-size analysis, is a
financial analysis technique that expresses each line item
in the financial statements as a percentage of a common
base. For example, in the income statement, each expense
is presented as a percentage of total revenue.
• Purpose: Vertical Analysis allows for a better
understanding of the composition of financial statements,
highlighting the relative importance of each item and
revealing potential cost drivers.
 2008 Financial Crisis
• The 2008 financial crisis was caused by a combination of
factors, including lax regulation, excessive risk-taking,
and a housing bubble.
• The crisis led to a wave of financial regulation, including
the Dodd-Frank Act in the United States and the Basel III
accords internationally.
• However, some argue that these regulations have gone
too far and are stifling economic growth.
• In addition to financial regulation, there are also calls for
greater corporate social responsibility in finance, such as
through sustainable investing and impact investing.
• Finance can also have important distributional effects,
such as exacerbating income inequality and contributing
to the concentration of wealth.
• There are debates about the optimal level of
financialization in the economy, with some arguing that
too much finance can lead to instability and inequality.
• Finance can also have important geopolitical
implications, such as through the rise of China as a
financial superpower.
• The future of finance is likely to be shaped by a variety of
factors, including technological innovation, changing
demographics, and shifting geopolitical dynamics.

• As such, it is important for policymakers, investors, and

individuals to stay informed about the latest
developments in finance and to think critically about its
role in our economies and societies.