BUSI3502: Investments

Sep 16, 2021

The Investment Environment

Course Professor: Dr. M. Al Guindy

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Course Structure Time Permitting

Return & Risk

1. Investment
Environment 4. Utility and 11. Derivatives
5. Risky
Probability
Portfolios
Theory

2. Financing
Vehicles Factor Models

12. Portfolio
6. CAPM 7. APT
Management

8. Market Efficiency &

Behvaioural Finance

Bonds
3. Trading 13. FinTech
9. Term 10. Duration/
Structure Convexity

3
 Overview

◼ Real Assets versus Financial Assets

◼ Risk-return trade-off and efficient pricing

◼ Financial crisis 2008

❑ Financial system → “Real” economy
❑ Systemic risk

INVESTMENTS | BODIE, KANE, MARCUS, SWITZER, BOYKO, PANASIAN, STAPLETON

Real Assets Versus Financial Assets

Real Assets Financial Assets

• Have productive capacity • Claims on real assets

• Do not contribute directly to

productive capacity

• Examples: Land, buildings,

machines, intellectual
property • Examples: Stocks, bonds

INVESTMENTS | BODIE, KANE, MARCUS, SWITZER, BOYKO, PANASIAN, STAPLETON

Financial Assets

Financial Assets: Claims on Real Assets

❑ Fixed-Income Securities: Promises a

fixed stream of income or a stream of
income determined by a specified
formula; debt
❑ Equity: Represents ownership share in a
corporation; Common stock
❑ Derivatives: Provide payoffs that are
determined by the prices of other assets

INVESTMENTS | BODIE, KANE, MARCUS, SWITZER, BOYKO, PANASIAN, STAPLETON

Other Types of Investments

◼ Investment in currency
❑ Cryptocurrencies!
https://inews.co.uk/news/politics/pound-dollar-yen-currency-reacts-brexit/

◼ Commodity futures
❑ Corporations invest in the commodity
futures to hedge the risk

INVESTMENTS | BODIE, KANE, MARCUS, SWITZER, BOYKO, PANASIAN, STAPLETON

https://www.forbes.com/sites/billybambrough/2019/06/16/bitcoin-hits-year-to-date-highs-as-litecoin-soars-
heres-why/#4c6b2bc8167d
The Role of Financial Markets

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 Firm Financial
Firm issues securities (A) markets

Invests
Retained
in assets cash flows (D)
(B)
Short-term debt
Current assets Cash flow Dividends and Long-term debt
Fixed assets from firm (C) debt payments (F)
Equity shares

Ultimately, the firm
must be a cash
generating activity.
Taxes (E)
The cash flows from
the firm must exceed
the cash flows from
Government the financial markets.

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Financial Market participants – the players!

◼ Firms: net borrowers

◼ Households: net savers
◼ Governments: can be both borrowers and
savers

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Financial Intermediaries

❑ Pool and invest funds

❑ Investment Companies
❑ Banks
❑ Insurance companies
❑ Credit unions

Investment Banking Commercial Banking

• Underwrite new securities issues • Take deposits and make loans

• Sell newly issued securities to

public in the primary market

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Financial Markets & the Economy

◼ The Informational Role

◼ Consumption Timing
◼ Allocation of Risk

INVESTMENTS | BODIE, KANE, MARCUS, SWITZER, BOYKO, PANASIAN, STAPLETON

Separation of Ownership & Control

❑ Agency Problems

◼ Mitigating Agency Problems:

❑ Tie managers' income to the success of the
firm
❑ Monitoring from the board of directors
❑ Monitoring by large investors and security
analysts
❑ Takeover threat

INVESTMENTS | BODIE, KANE, MARCUS, SWITZER, BOYKO, PANASIAN, STAPLETON

Corporate Governance & Corporate Ethics

❑ Accounting Scandals
▪ Enron, Nortel Networks, Parmalat

❑ Analyst Scandals
▪ Arthur Andersen

❑ Sarbanes-Oxley (SOX) Act

▪ Tighten the rules of corporate governance

INVESTMENTS | BODIE, KANE, MARCUS, SWITZER, BOYKO, PANASIAN, STAPLETON

The Investment Process

◼ Portfolio: Collection of investment

assets

◼ Asset allocation
❑ Choice among broad asset classes

◼ Security selection
❑ Choice of securities within each asset
class

INVESTMENTS | BODIE, KANE, MARCUS, SWITZER, BOYKO, PANASIAN, STAPLETON

Investment approaches

Top-down Asset allocation followed by security

approach analysis

Bottom-up Investment based solely on the price-

approach attractiveness

INVESTMENTS | BODIE, KANE, MARCUS, SWITZER, BOYKO, PANASIAN, STAPLETON

Risk-Return Trade-Off
◼ Higher-risk assets are priced to offer
higher returns than lower-risk assets
◼ Risk and expected return are positively
correlated
12.00

11.00 Common
10.00 Long Shares
Annual Return Average
9.00 Bonds
8.00
T-
7.00 Bills
6.00

5.00

4.00

3.00

2.00
INVESTMENTS | BODIE,0.00KANE, MARCUS,
5.00
SWITZER,
10.00
BOYKO,
15.00
PANASIAN,
20.00
STAPLETON
25.00

Annual Return Standard Deviation

Efficient Markets

◼ Prices adjust quickly to all relevant

information
❑ No free lunch!

◼ There should be neither underpriced nor

overpriced securities

INVESTMENTS | BODIE, KANE, MARCUS, SWITZER, BOYKO, PANASIAN, STAPLETON

Passive vs Active Management

◼ Passive Management
❑ Holding a highly diversified portfolio
❑ No attempt to find undervalued
securities
❑ No attempt to time the market

◼ Active Management
❑ Finding mispriced securities
❑ Timing the market

INVESTMENTS | BODIE, KANE, MARCUS, SWITZER, BOYKO, PANASIAN, STAPLETON

The Financial Crisis

INVESTMENTS | BODIE, KANE, MARCUS, SWITZER, BOYKO, PANASIAN, STAPLETON

Changes in Housing Market

Old Way New Way

• Local thrift institution made • Securitization: Fannie Mae and Freddie

mortgage loans to
homeowners
• Thrift possessed a portfolio
of long-term mortgage loans
• Thrift’s main liability:
Deposits
• “Originate to hold”
Mac bought mortgage loans and bundled
them into large pools
• Mortgage-backed securities are tradable
claims against the underlying mortgage
pool
• “Originate to distribute”

INVESTMENTS | BODIE, KANE, MARCUS, SWITZER, BOYKO, PANASIAN, STAPLETON

Securitization

◼ Inclusion of nonconforming “subprime”

loans
◼ Low/No-documentation loans
◼ Rising loan-to-value ratio

INVESTMENTS | BODIE, KANE, MARCUS, SWITZER, BOYKO, PANASIAN, STAPLETON

Mortgage Derivatives: Collateralized Debt Obligations (CDOs)

◼ Mortgage pool divided into tranches to

concentrate default risk:
❑ Senior tranches
❑ Junior tranches
◼ Ratings significantly underestimated risk

Why Was Credit Risk Underestimated?

◼ Default probabilities were misestimated

◼ Geographic diversification did not reduce risk
sufficiently
◼ Agency problems with rating agencies
INVESTMENTS | BODIE, KANE, MARCUS, SWITZER, BOYKO, PANASIAN, STAPLETON
Credit Default Swap (CDS)

◼ A CDS is an insurance contract against

borrower default
❑ Investors bought sub-prime loans and CDSs
❑ Some big swap issuers did not have enough
capital to back their CDSs
❑ This lack of capital resulted in the failure of
CDO insurance

INVESTMENTS | BODIE, KANE, MARCUS, SWITZER, BOYKO, PANASIAN, STAPLETON

Rise of Systemic Risk

◼ One default triggers further defaults

◼ Waves of selling → downward spiral as asset
prices drop
◼ Banks: highly leveraged → no margin of
safety
◼ Investors relied too much on credit
enhancement through structured products

INVESTMENTS | BODIE, KANE, MARCUS, SWITZER, BOYKO, PANASIAN, STAPLETON

The Dodd-Frank Act

◼ Stricter rules for bank capital, liquidity, and

risk management practices

◼ Increased transparency, especially in

derivatives markets

◼ Office of Credit Ratings within the

Securities and Exchange Commission (SEC)
to oversee the credit rating agencies

INVESTMENTS | BODIE, KANE, MARCUS, SWITZER, BOYKO, PANASIAN, STAPLETON

The Canadian Experience

Less severe in Canada due to:

◼ the characteristics of the banking industry:

❑ “universal” banks benefit from the stable
funding provided by bank deposits

◼ conservative mortgage lending practices:

❑ limited Subprime mortgage lending
❑ mandatory default insurance for mortgages
with less than 20% equity

INVESTMENTS | BODIE, KANE, MARCUS, SWITZER, BOYKO, PANASIAN, STAPLETON

Next Week: Time Permitting

Return & Risk

1. Investment
Environment 4. Utility and 11. Derivatives
5. Risky
Probability
Portfolios
Theory

2. Financing
Vehicles Factor Models

12. Portfolio
6. CAPM 7. APT
Management

8. Market Efficiency &

Behvaioural Finance

Bonds
3. Trading 13. FinTech
9. Term 10. Duration/
Structure Convexity

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