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1. 15.401
15.401 Finance Theory
15.401 Finance Theory
MIT Sloan MBA Program
Andrew W. Lo
Andrew W. Lo
Harris & Harris Group Professor, MIT Sloan School
Harris & Harris Group Professor, MIT Sloan School
Lecture 1: Introduction and Course Overview
Lecture 1: Introduction and Course Overview
© 2007–2008 by Andrew W. Lo

2. © 2007–2008 by Andrew W. Lo
Lecture 1: Intro and Overview
15.401
Slide 2
Critical Concepts
Critical Concepts
ƒ Motivation
ƒ Dramatis Personae
ƒ Fundamental Challenges of Finance
ƒ Framework for Financial Analysis
ƒ Importance of Time and Risk
ƒ Six Principles of Finance
ƒ Course Overview
ƒ How to Get the Most Out of This Course
Readings:
ƒ Brealey, Myers, and Allen Chapters 1–2

3. © 2007–2008 by Andrew W. Lo
Lecture 1: Intro and Overview
15.401
Slide 3
Motivation
Motivation
Mathematics + $$$ = Finance
Warren Buffett
Berkshire Hathaway
James Simons
Renaissance Technologies
Jack Welch
General Electric
Photographs removed due to copyright restrictions.

4. © 2007–2008 by Andrew W. Lo
Lecture 1: Intro and Overview
15.401
Slide 4
Dramatis Personae
Dramatis Personae
Households
Nonfinancial
Corporations
Financial
Intermediaries
Capital Markets
Product
Markets
Labor
Markets
The Financial System
A Flow Model of the Economy

5. © 2007–2008 by Andrew W. Lo
Lecture 1: Intro and Overview
15.401
Slide 5
Fundamental Challenges of Finance
Fundamental Challenges of Finance
All Business Activities Reduce To Two Functions:
ƒ Valuation of assets (real/financial, tangible/intangible)
ƒ Management of assets (acquiring/selling)
Business Decisions Involve Valuation and Management
ƒ “You cannot manage what you cannot measure”
ƒ Valuation is the starting point for management
ƒ Once value is established, management is easier
Objectives + Valuations ⇒ Decisions
ƒ Valuation is generally independent of objectives (why?)
ƒ Role of financial markets and the “price discovery” process

6. © 2007–2008 by Andrew W. Lo
Lecture 1: Intro and Overview
15.401
Slide 6
Fundamental Challenges of Finance
Fundamental Challenges of Finance
Valuation
ƒ How are financial assets valued?
ƒ How should financial assets be valued?
ƒ How do financial markets determine asset values?
ƒ How well do financial markets work?
Management
ƒ How much should I save/spend?
ƒ What should I buy/sell?
ƒ When should I buy/sell?
ƒ How should I finance the transaction?
Applies To Both Personal and Corporate Financial Decisions (How?)

7. © 2007–2008 by Andrew W. Lo
Lecture 1: Intro and Overview
15.401
Slide 7
The Framework of Financial Analysis
The Framework of Financial Analysis
Accounting
ƒ The language of finance
ƒ Vocabulary, syntax, grammar, prose, and poetry!
ƒ Language frames and circumscribes the analysis
ƒ Basic concepts should be familiar to you by now
ƒ “Stock” (not equities) vs. “flow” variables
Balance Sheet and Income Statement Perspectives
ƒ Balance sheet: snapshot of financial status quo (stock)
ƒ Income statement: rate of change of the status quo (flow)
ƒ Financial status ⇔ balance sheet
ƒ Financial decisions ⇔ income statement
ƒ What about the “rate of change of the rate of change”?

8. © 2007–2008 by Andrew W. Lo
Lecture 1: Intro and Overview
15.401
Slide 8
The Framework of Financial Analysis
The Framework of Financial Analysis
Balance Sheet
Income Statement
Assets Liabilities
Value Value
Cash
Capital
Intangibles
Equity
Debt

9. © 2007–2008 by Andrew W. Lo
Lecture 1: Intro and Overview
15.401
Slide 9
The Framework of Financial Analysis
The Framework of Financial Analysis
Corporate Financial Decisions
1. Cash raised from investors (selling financial assets)
2. Cash invested in real assets (tangible and intangible)
3. Cash generated by operations
4. Cash reinvested
5. Cash returned to investors (debt payments, dividends, etc.)
Corporate
Operations
Financial
Manager
Individual
and
Institutional
Investors
2 1
4
5
3

10. © 2007–2008 by Andrew W. Lo
Lecture 1: Intro and Overview
15.401
Slide 10
The Framework of Financial Analysis
The Framework of Financial Analysis
Corporate Financial Decisions
1. Cash raised from investors (selling financial assets)
2. Cash invested in real assets (tangible and intangible)
3. Cash generated by operations
4. Cash reinvested
5. Cash returned to investors (debt payments, dividends, etc.)
Management
ƒ Real Investment: 2, 3
ƒ Financing: 1, 4
ƒ Payout: 5
ƒ Risk management: 1, 5
ƒ Objective: create and maximize shareholder value

11. © 2007–2008 by Andrew W. Lo
Lecture 1: Intro and Overview
15.401
Slide 11
The Framework of Financial Analysis
The Framework of Financial Analysis
Personal Financial Decisions
1. Cash raised from financial institutions (selling financial assets)
2. Cash invested in real assets (tangible and intangible)
3. Cash generated by labor supply
4. Cash consumed and reinvested in real assets
5. Cash invested in financial assets
Real
Economic
Activities
Household
Financial
Assets and
Liabilities
(stocks,
bonds,
mortgage,
etc.)
2 1
4
5
3

12. © 2007–2008 by Andrew W. Lo
Lecture 1: Intro and Overview
15.401
Slide 12
The Framework of Financial Analysis
The Framework of Financial Analysis
Personal Financial Decisions
1. Cash raised from financial institutions (selling financial assets)
2. Cash invested in real assets (tangible and intangible)
3. Cash generated by labor supply
4. Cash consumed and reinvested in real assets
5. Cash invested in financial assets
Management
ƒ Real investment: 2, 3
ƒ Consumption/financing: 1, 4
ƒ Saving/investment: 5
ƒ Risk management: 1, 5
ƒ Objective: maximize lifetime “happiness” or expected utility

13. © 2007–2008 by Andrew W. Lo
Lecture 1: Intro and Overview
15.401
Slide 13
Time and Risk
Time and Risk
Two Other Factors That Make Finance Challenging
1. Time
ƒ Cashflows now are different from cashflows later
ƒ Time flows in only one direction (as far as we know)
ƒ How should we model temporal differences?
2. Risk
ƒ Under perfect certainty, finance theory is complete
ƒ Risk creates significant challenges
ƒ How should we model the unknown?
To Address These Two Issues:
ƒ Use historical data
ƒ Use mathematics (probability and statistics)
ƒ Challenges can easily overwhelm current mathematical abilities

14. © 2007–2008 by Andrew W. Lo
Lecture 1: Intro and Overview
15.401
Slide 14
Six Fundamental Principles of Finance
Six Fundamental Principles of Finance
P1: There Is No Such Thing As A Free Lunch
P2: Other Things Equal, Individuals :
ƒ Prefer more money to less (non-satiation)
ƒ Prefer money now to later (impatience)
ƒ Prefer to avoid risk (risk aversion)
P3: All Agents Act To Further Their Own Self-Interest
P4: Financial Market Prices Shift to Equalize Supply and Demand
P5: Financial Markets Are Highly Adaptive and Competitive
P6: Risk-Sharing and Frictions Are Central to Financial Innovation

15. © 2007–2008 by Andrew W. Lo
Lecture 1: Intro and Overview
15.401
Slide 15
Course Overview
Course Overview
Four Sections
A. Introduction
ƒ Fundamental challenges of finance
ƒ A framework for financial analysis
ƒ Six principles of finance
ƒ Cashflows and the time-value of money
B. Valuation
ƒ Discounting and the mathematics of net present value
ƒ Pricing stocks, bonds, futures, forwards, and options
C. Risk
ƒ Measuring risk
ƒ Managing risk (portfolio theory)
ƒ Incorporating risk into valuation methods

16. © 2007–2008 by Andrew W. Lo
Lecture 1: Intro and Overview
15.401
Slide 16
Course Overview
Course Overview
Four Sections
D. Corporate Finance
ƒ Capital budgeting and project finance
Final Lecture: Market Efficiency (putting it all together)
ƒ Do financial markets always work well in discovering prices?
ƒ What about behavioral biases and human psychology?
ƒ How should finance theory be used in practice?

17. © 2007–2008 by Andrew W. Lo
Lecture 1: Intro and Overview
15.401
Slide 17
Course Overview
Course Overview
Course Requirements
ƒ Lectures and Readings (attendance and participation, 10%)
ƒ Acid Rain Case Study (10%)
ƒ Mid-Term (25%) and Final (55%) Examinations
Implicit Contract
ƒ Faculty should
– Come to class on time and be well prepared
– Provide clear and time-appropriate exposition of material
– Manage class discussions effectively
ƒ Students should
– Come to class on time and be well prepared
– Contribute to class discussions
– Refrain from non-class activities (email, newspapers, etc.)

18. © 2007–2008 by Andrew W. Lo
Lecture 1: Intro and Overview
15.401
Slide 18
How to Get the Most Out of This Course
How to Get the Most Out of This Course
Theory vs. Practice
ƒ Most of this course will be devoted to theory
ƒ What about practice?
ƒ The origins of theory is common elements deduced from practice!
Some Helpful Hints
ƒ Do readings ahead of time (skim textbook chapters in advance)
ƒ Take copious notes during lectures (lecture notes are not complete)
ƒ Review the lectures afterwards with your study group
ƒ Work on assignments in groups and alone
ƒ “Finance is not a spectator sport”
ƒ Ask Ask Ask Questions!
Finance Is One of The Most Difficult Subjects You Will Ever Love!

19. © 2007–2008 by Andrew W. Lo
Lecture 1: Intro and Overview
15.401
Slide 19
Critical Concepts
Critical Concepts
ƒ Motivation
ƒ Dramatis Personae
ƒ Fundamental Challenges of Finance
ƒ Framework for Financial Analysis
ƒ Importance of Time and Risk
ƒ Six Principles of Finance
ƒ Course Overview
ƒ How to Get the Most Out of This Course

20. © 2007–2008 by Andrew W. Lo
Lecture 1: Intro and Overview
15.401
Slide 20
Additional References
Additional References
ƒ Bernstein, P., 1993, Capital Ideas. New York: Free Press.
ƒ Lo, A., 1999, “The Three P’s of Total Risk Management”, Financial Analysts Journal 55, 13–26.
ƒ Malkiel, B., 1996, A Random Walk Down Wall Street. New York: W. W. Norton and Company.

21. MIT OpenCourseWare
http://ocw.mit.edu
15.401 Finance Theory I
Fall 2008
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