My name is James Thompson. I’m the Co-Director of the Computing and Financial Management program at the University of Waterloo and I am also a professor of finance here. I am here to talk to you today about what finance is. There’s a lot of misconceptions from high school students about what we do here. One of the problems is the courses that you’ve taken at high school, maybe economics, maybe accounting, they really give you an incomplete picture. Finance at its core is really mathematical. If you enjoy probability and statistics, calculus, then this field might be for you. Let’s take a look.
One of the most basic, yet powerful concepts in finance is called the Time Value of Money. Imagine that you’ve been potentially offered $100. Would you rather have that $100 now or in one year? Now some of you may say, “Well, I’d rather have it in a year because I don’t need it now and I might just waste it”. Well it turns out that it’s actually better to have it now. Why is that? Well, in reality, what we could do is we could take that $100 now and we could invest it. And in one year’s time, we could actually end up with more than $100. So now what we want to know is how much is $100 paid to you in one year actually worth? Well, we’re going to call that “P”. It’s the price of a contract which pays $100 in one year’s time. Over here, from $100 today to $102 in one year’s time, represented a rate of return of 2%. If we want to go the opposite way and bring it back in time, we do what’s called discounting. And so, I’m going to use this variable “r” to represent, what we call, a discount rate. If I want to bring $100 back to today, I’m going to divide by 1 + r. In the case of this example here, r would be 2%. So if I want to know the value of $100 in one year’s time, it’s 100 divided by 1.02 or approximately $98. That would represent our price.
There’s lots of areas to study within finance including financial markets, the value of assets and risk. A financial market is a market where items of value are traded. An asset is something that can be owned and has value such as a stock or a bond. A stock is an equity investment that represents part ownership in a firm or company and can allow you to share in the profits. A bond is a loan made by an investor to a borrower, for example a firm that promises a periodic fixed payment.
So let’s consider a stock on firm x. Let’s consider the firm having borrowed some money so they issued a bond. On average, the bond is going to return less to an investor than a stock will, so why would anyone purchase the bond? The answer comes down to risk and there’s an entire field in finance dedicated to studying risk, called Risk Management.
When millions of people come together to trade assets, they do so in financial markets. Financial markets can be very powerful at conveying information. Consider for example, an oil price shock, a nature disaster which effects oil fields. The first thing we’ll see if the price of oil spike up. The oil company’s stock prices will go down. But also, all of those stocks that rely on oil will also be affected. For example, trucking companies. They heavily rely on oil. Their stock prices will generally go down and so too will all of those companies that rely on trucking. All of these price adjustments will be done in an instant.
So now that we have an understanding of the time value of money and we know what a bond is, we can look at a very very simple example. Imagine a bond that will pay you $100 starting in one year’s time for three years. What would be the price “P”, of that bond be? Well, we’re going to have to use a discount rate “r”, which we saw earlier. Now the first $100 you get, it’s going to look exactly like before. To bring that back to today, it’s 100 over 1+ r. The second $100 that you’re going to get, you’re going to take $100 and you’re going to discount it back twice and you’re going to divide 1 + r squared. The third $100 that you’re going to get in three years, well, simple pattern here, 1 + r cubed. Add those three together and you get the value of the bond which pays $100 over three years.
So we’ve talked a lot about some interesting concepts in finance but there’s really much more to learn. Now that you’ve got some basic tools under your belt, we hope explore a lot more. Thanks for watching.
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