FINM7008 Applied Investments

Lecture 1

INVESTMENTS | BODIE, KANE, MARCUS

 Administration
• Lecturer:
• Daruo Xie 谢大若
PhD in Finance, Arizona State University;
PhD in Physics, University of Virginia;
• daruo.xie@anu.edu.au
• Office: 4.40, CBE Building 26C
• Office Hours: Monday 10am-12pm

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 Administration
• Your undergraduate major?
• I - Natural Science or Engineering (Chemistry,
Physics, Biology, Computer Science, Mathematics,
…, etc.)
• II - Business related (Economics, Finance,
Accounting, Management, Trade, … , etc.)
• III - Social Science or Humanities (Foreign
Language, History, Psychology, Sociology, Arts, … )
• Have you learned “Utility Function”?

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 Administration
• Lecture Arrangements:
• 2-hour lecture, Thursday 1pm-3pm;
• 1-hour lecture, Friday 1pm-2pm;
• 1-hour tutorial each week;
• Need to register in a tutorial this week;
• Tutorials start from week 2;
• You can only attend your registered tutorial;
(*If you have difficulties to register a tutorial, please go to
the 4th floor of CBE, and ask a lady in the main office for
help)
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 Administration
• Your Final Grade:
• Mid-term Exam(optional; 25% or 0%);
• 25%, if you take it, and your MARKMid > MARKFinal
• 0%, if you don’t take it, or your MARKMid <= MARKFinal
• Final exam (65% or 90%);
• 65% if your Mid-term counts; 90% otherwise;
• Individual/group assignment (10%);
• Due after the teaching break;
• A group of 2 people; or individual;
• Homework (0%);
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 Administration
• Textbooks (required):
• Bodie, Kane and Marcus, 2014, Investments; 10th
Edition
• Solution Manual to accompany the textbook
• This course sorts the textbook materials into two parts:
An Example: Charpter#1 - 1.1, 1.2, 1.3, 1.4, 1.5, 1.6, 1.7
• Required (red)
• Not required (grey)

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 Administration
• How to get the most out of this course:
• Review the lecture notes;
• Review the textbook (required parts);
• Participate in the tutorials;
• Do your homework;

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 Administration
• Your tutors:
• Bardia Khorsand, bardia.khorsand@anu.edu.au
• Ameer Sultan, ameer.sultan@anu.edu.au
• Sheetal Gupta, sheetal.gupta@anu.edu.au

• Tutors’ consultation hours

• Time and locations will be posted;
• For tutorial related questions, seek help from tutors;

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 Chapter One

The Investment Environment

INVESTMENTS | BODIE, KANE, MARCUS

Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
 What is an investment?

• What is an investment?
An investment is the current commitment of
money or other resources in the expectation
of reaping future benefits.
• Timing - Current vs. Future;
• Other resources, e.g. time, land, labor, affection…;
• Expectation - a certain level of uncertainty (risk);
• Future benefits - monetary or nonmonetary;

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 What is an investment?
• Investors?

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 What is an investment?
An investment is the current commitment of money or other
resources in the expectation of reaping future benefits.
• Investors, an example:

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 Good investors vs Lucky investors
• Flipping a fair coin: Returns:
t0 t1
$2𝑀 − $1𝑀
HEAD $2Million 𝑟𝐻 = =1
50% $1𝑀
$1Million

50% $0𝑀 − $1𝑀

TAIL $0 𝑟𝑇 = = −1
$1𝑀

• E r = 0.5𝑟ℎ + 0.5𝑟𝑡 = 0

• σ= 0.5 × (𝑟ℎ − E r ) 2 + 0.5 × (𝑟𝑡 − E r ) 2 = 1

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 Good investors vs lucky investors
• Flipping a fair coin:
t0 t1
HEAD $2Million
50%
$1Million

50% TAIL $0

• Good Investors - Reject this investment (Expected return

is 0);
• Lucky Investors - Do this investment and win (Realized
return is 100%);
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 Good investors vs. lucky investors

2015

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 Good investors vs Lucky investors
• A simple question:
Suppose a nation has 10 million investors and no investor
has any “super skills”.
Q: How many of them can win the market each year?
1
10,000,000 × ≈ 5,000,000
2
Q: How many of them can consistently win the market
over 10 years?
1
10,000,000 × 10 ≈ 10,000
2
Are they super-investors?
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 Nonmonetary Benefit
• What if just a one-dollar game?
$2 − $1
HEAD $2 𝑟ℎ = =1
50% $1
$1

50% $0 − $1
TAIL $0 𝑟𝑡 = = −1
$1

• E r = 0.5𝑟ℎ + 0.5𝑟𝑡 = 0
• σ= 0.5 × (𝑟ℎ − E r ) 2 + 0.5 × (𝑟𝑡 − E r ) 2 = 1

• Nonmonetary Benefit, e.g. for fun, for satisfying an

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 Nonmonetary Benefit

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 Why do people invest?

• Why do people invest?

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 Real Assets vs. Financial Assets

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 Why do people invest?

• Why do people invest?

– A simple example: Mr. Wang’s lifetime income and consumption
Age
0 10 20 30 40 50 60 70 80 90 100
10
9 Salary
8
7
6
Consumption
5
4
3
2
1
0

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 Why do people invest?

• Why do people invest?

– Mr. Wang’s lifetime income and consumption
Age
0 10 20 30 40 50 60 70 80 90 100
10
9 Salary
8
7
6
Consumption
5
4
3
2
1
0

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 Example: Mortgage-Backed Securities (MBS)

• Example: Mortgage-backed securities (in chapter 1.7)

Mr. Wang A Local Bank Fannie Mae Investors

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 Example: Mortgage-Backed Securities (MBS)

The Size of MBS market (US):

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 Real Assets vs. Financial Assets
Financial Assets:
• Claims on real assets, do not contribute directly to the
productive capacity of the economy.
• Examples: Stocks, Bonds

Real Assets:
• Determine the productive capacity and generate net
income of the economy;
• Examples: Land, buildings, transportations, machines,
knowledge used to produce goods and services.

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 Real Assets vs. Financial Assets

• Example:
– Is Patent a real asset, or financial asset?

Recall:
Real asset - Determine the productive capacity and generate net
income of the economy.

Financial asset - Claims on real assets, do not contribute directly to

the productive capacity of the economy.

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 Real Assets vs. Financial Assets

• Example:
– Is GuanXi (personalized networks) an asset for
investment?
• Current vs Future;
• Expectation (risk);
Is it a real asset, or a financial asset?
Real asset: Determine the productive capacity and generate net income of the
economy.
Financial asset: Claims on real assets, do not contribute directly to the productive
capacity of the economy.

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 Real Assets vs. Financial Assets

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 Financial Assets

Three types of financial assets:

• Fixed income (or debt)
• Promise either a fixed stream of income, or a stream of
income determined by a specified formula;
• Common stock (or equity)
• Represent an ownership share in a corporation;
• Derivative securities
• Provide payoffs that are determined by the prices of
other assets;
• This course doesn't cover derivatives.
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 The Investment Process

An investor's Portfolio: her/his collection of

assets.
Investment Process = Portfolio construction
• Asset allocation
• Choice among asset classes
• Security selection
• Choice of securities within each asset class

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 The Investment Process

• An example:
Harvard Management Company

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 Portfolio construction

• “Top-down” approach
• Portfolio construction starts with asset allocation,
followed by security analysis to evaluate which
particular securities to be held;
• “Bottom-up” approach
• Investment based solely on securities' price-
attractiveness.

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 Financial Markets and the Economy
Financial markets play crucial roles:

• The Informational Role of Prices

• Capital flows to companies with best prospects
• Evaluate CEO performance

• Consumption Timing
• Use securities to store wealth and transfer consumption
across lifetime

• Allocation of Risk
• Investors can select securities consistent with their tastes
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 Chapter One

• Chapter 1:
• 1.1, 1.2, 1.3, 1.4, 1.5, 1.6, 1.7

• Red: required
• Grey: Not required

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