Investments Kapitel 1

Chapter
Investments:
1 Background and Issues
Bodie, Kane, and Marcus

Essentials of Investments
12th Edition
1.1 Real versus Financial Assets
• Real assets
• Assets used to produce goods and services.
• Financial assets
• Claims on real assets or the income generated

by them.
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1.1 Real versus Financial Assets
• Nature of Investment: Reduce current
consumption for greater future consumption
Real
Assets
Financial Assets:
Productive Claims on Real Assets or
Capacity Real Asset Income
Property,
plants and
equipment,
human
capital, etc.
Table 1.1 Balance Sheet, U.S. Households, 2019
1.1 Financial Assets = Financial Liabilities
• Financial Assets and Liabilities must balance
• Aggregated balance sheets à only real

assets remain
• Domestic Net Worth = Sum of real assets
1.1 Financial Assets = Financial Liabilities
• Financial Assets and Liabilities must balance.
Financial Assets
(Owner of the claim)
Financial Liability
(Issuer of the Claim)
• Thus, when all balance sheets are

aggregated, only real assets remain
• Domestic Net Worth = Sum of real assets
Table 1.2 Domestic Net Worth, 2019
CHECK
• Are the following assets real or financial?
a) Patent
b) Lease obligations
c) Customwer goodwill
d) A college education
e) A $5 dollar bill
1.2 Financial Assets
• Fixed-income (debt) securities

• Pay a specified cash flow over a specific period
• Equity
• An ownership share in a corporation
• Derivative securities
• Securities providing payoffs that depend on the
values of other assets
1.2 Financial Assets
Common Stock
Ownership stake in entity,
residual cash flow
Asset
Classes
Derivative Securities Fixed Income

Securities
Contract, value derived
from underlying market Money market instruments,
condition Bonds, Preferred stock
1.3 Financial Markets and the Economy
• Informational Role of Financial Markets
• Capital flow to companies with best prospects
• Market Price = Fair Value?
• Do markets allocate capital to best uses?
• Other mechanisms to allocate capital?
• Advantages/disadvantages of other systems?
• Consumption Timing
• Use securities to store wealth
• Transfer consumption to the future
• Risk Allocation
• Investors select desired risk level
•Bond vs. stock
•Bank CD vs. company bond
• Consumption Timing
• Consumption smoothes over time
• When current basic needs are met, shift

consumption through time by investing surplus
Dollars
Consumption
Savings
Dissavings
Dissavings
Income
Age
• Separation of Ownership and Management
• Separation à Agency Problems
• Mitigating Factors
•Performance-based compensation
•Boards of directors may fire managers
•Threat of takeovers
• Corporate Governance and Corporate Ethics
• Businesses and markets require trust
• No trust à additional costly laws and regulations
• Governance and ethics failures cost the economy
• Erodes public support and confidence
• Accounting scandals
• Enron, WorldCom, Rite-Aid, HealthSouth, Global

Crossing, Qwest
• Misleading research reports
• Citicorp, Merrill Lynch, others
• Auditors: Watchdogs or consultants?
• Arthur Andersen and Enron
• Sarbanes-Oxley Act (SOX):
• Requires more independent directors
• CFO personally verifies the financial statements
• Creates accounting/audit industry oversight board
• Charges board to maintain culture of high ethical

standards
1.4 The Investment Process: Asset Allocation
• Asset Allocation
• Allocation of an investment portfolio across
broad asset classes.
• Primary determinant of a portfolio's return
• Percentage of fund in asset classes
1.4 The Investment Process: Asset Allocation
• Asset Allocation
• Primary determinant of a portfolio's return
• Percentage of fund in asset classes, for example:
10%
Equity 25% 25%
30%
60% Bonds
50%
Bills
• Top Down Investment Strategies starts with Asset

Allocation
1.4 The Investment Process: Security Selection
• Security Selection
• Choice of particular securities within asset class
• Bottom up Investment strategies
• Security Analysis
• Analysis of the value of securities
1.5 Markets Are Competitive
• Risk-Return Trade-Off
• Higher expected returns ßà Higher risk
• Stock portfolios lose money an average of 25%
• Bonds
• Lower average rates of return (under 6%)
• Not lost more than 13% of value in any one year
• Assets with higher expected returns have higher
risk
Average Annual Return Minimum (1931) Maximum (1933)
Stocks About 12% −46% 55%
• Stock portfolio loses money 1 of 4 years on

average
• Bonds
• Have lower average rates of return (under 6%)
• Have not lost more than 13% of their value in any one
year
• How do we measure risk?
• How does diversification affect risk?
• In Efficient Markets Securities should
• be neither underpriced nor overpriced on

average
• reflect all information available to investors
Choice of
Your Belief in
Investment-
Market Management
Efficiency
Style
• Efficient Markets
• Passive management
• Buying and holding a diversified portfolio
• No attempt to identify mispriced securities
• Active management
• Identify mispriced securities
• or Forecast broad market trends
Active Passive
Management Management
Markets are… Inefficient Efficient
Actively Seeking No Attempt to Find

Security Selection: Undervalued Undervalued
Stocks Securities
No Attempt to
Asset Allocation Market Timing
Time Market
1.6 The Players
• Business Firms (net borrowers)
• Raise capital now to pay for investments
• Households (net savers)
• Purchase securities issued by firms
• Governments (can be both borrowers and

savers)
• Depends on the relationship between tax
revenue and government expenditures
1.6 The Players
• Financial Intermediaries
• Connectors of borrowers and lenders
• Commercial banks
• Investment companies
• Insurance companies
• Pension funds
• Hedge funds
1.6 The Players
• Investment Bankers
• Specialize in primary market transactions
• Primary market
• Newly issued securities offered to public
• Investment banker “underwrites” issue
• Secondary market
• Preexisting securities traded among investors
1.6 The Players
• Glass Steagall Act: Separate from commercial banks'
functions by law (1933-1999)
• Post-1999: Large commercial banks increased
investment-banking activities, transforming in universal
banks and pressuring investment banks’ profit margins.
• Some commercial banks started their own investment
division from scratch, but more commonly they expanded
through merger.
• September 2008: Mortgage-market collapse
• Major investment banks bankrupt; purchased/reorganized
1.6 The Players
• Investment banks might become commercial

banks
• Obtain deposit funding
• Have access to government assistance
• Major banks now under stricter regulations. In

fact, banks that enjoy federal guarantees should
be subject to limits on the sorts of activities in
which they can engage.
Investment bankers
• With the passage of the Dodd-Frank Wall Street Reform
and Consumer Protection Act in 2010, Glass Steagall was
partially restored via the Volcher rule (which generally
prohibits commercial banks from conducting certain
investment activities with their own accounts – proprietary
trading - and investing in hedge funds and private equity
funds).
• In 2018, Congress passed the Economic Growth,
Regulatory Relief and Consumer Protection Act which
established a threshold ($10 billion in assets) for banks to
be exempt from the Volcher rule.
Table 1.3 Balance Sheet of Commercial Banks, 2019
Table 1.4 Balance Sheet of Nonfinancial U.S. Business, 2019
1.6 The Players
• Venture Capital and Private Equity
• Venture capital
• Equity Investment to finance new firm. Sources come from

venture capital funds, wealthy individuals and institutions.
• Investors commonly take an active part in the management of

the firm
• Private equity
• Investments in privately-held companies that are in distress or

may be bought up, “improved” and sold for profit.
1.6 The players
• Private equity is capital invested in a company or
other entity that is not publicly listed or traded.
• Venture capital is funding given to startups or
other young businesses that show potential for
long-term growth.
• Private equity and venture capital buy different
types of companies, invest different amounts of
money, and claim different amounts of equity in
the companies in which they invest.
Fintech and Financial Innovation
• Sometimes innovations are spurred by technological
advances that make possible previously infeasible
products.
• FinTech: Application of technology to financial markets
- Ex: Cryptocurrencies and blockchain technology
• Bitcoin and ethereum allow for payment system that
bypass traditional channels such as credit cards, debit
cards or checks.
• The blockchain technology used by these currencies can
offer greater security and anonimity for financial
transactions.
1.7 The Financial Crisis of 2008-2009
Changes in Housing Finance
Old Way New Way
• Local thrift institution made • Securitization: Fannie Mae
mortgage loans to and Freddie Mac bought
homeowners mortgage loans, bundled
• Thrift’s possessed a them into large pools
portfolio of long-term • Mortgage-backed securities
mortgage loans are tradable claims against
• Thrift’s main liability: the underlying mortgage
Deposits pool
• “Originate to hold” • “Originate to distribute”
1.7 Changes in Housing Finance
• Securitization
• Pooling loans into standardized securities back
by loans
• Can be traded like any other security
1.7 Changes in Housing Finance (Continued)
• Inclusion of nonconforming “subprime”

loans
• Low/No-documentation loans
• Rising loan-to-value ratio
• Adjustable-Rate Mortgages
• Mortgage Derivatives
• CDOs: Consolidated default risk of loans

onto one class of investor, divided payment
into tranches
• Ratings agencies paid by issuers; pressured
to give high ratings
• Credit Default Swaps
• Insurance contract against the default of

borrowers
• Issuers ramped up risk to unsupportable
levels
• AIG sold $400 billion in CDS contracts
• Systemic Risk
• Risk of breakdown in financial system —

spillover effects from one market into others
• Banks highly leveraged; assets less liquid
• Formal exchange trading replaced by over-

the-counter markets — no margin for
insolvency protection
• The Shoe Drops
• September 7: Fannie Mae and Freddie Mac

put into conservatorship
• Lehman Brothers and Merrill Lynch verged
on bankruptcy
• September 17: Government lends $85 billion
to AIG
• Money market panic freezes short-term
financing market
Figure 1.1 LIBOR, T-Bill Rates and the TED Spread
Figure 1.2 Cumulative Returns
Cumulative returns on a $1 investment in the S&P 500 index
Figure 1.3 Case-Shiller Index of U.S. Housing Prices
• Dodd-Frank Reform Act
• Stricter rules for bank capital, liquidity, risk

management
• Mandated increased transparency
• Clarified regulatory system
• Volcker Rule:
1.8 Text Outline
• Part One: Introduction to Financial Markets,
Securities, and Trading Methods
• Part Two: Modern Portfolio Theory
• Part Three: Debt Securities
• Part Four: Equity Security Analysis
• Part Five: Derivative Markets
• Part Six: Active Investment Management

Strategies

Investments Kapitel 1

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Chapter

Bodie, Kane, and Marcus

• Assets used to produce goods and services.

• Claims on real assets or the income generated

• Financial Assets and Liabilities must balance

• Aggregated balance sheets à only real

• Thus, when all balance sheets are

• Fixed-income (debt) securities

Derivative Securities Fixed Income

• Capital flow to companies with best prospects

• Market Price = Fair Value?

• Do markets allocate capital to best uses?

• Other mechanisms to allocate capital?

• Advantages/disadvantages of other systems?

• Use securities to store wealth

• Transfer consumption to the future

•Bond vs. stock

•Bank CD vs. company bond

• Consumption smoothes over time

• When current basic needs are met, shift

• Separation of Ownership and Management

• Separation à Agency Problems

•Boards of directors may fire managers

• Corporate Governance and Corporate Ethics

• Businesses and markets require trust

• No trust à additional costly laws and regulations

• Governance and ethics failures cost the economy

• Erodes public support and confidence

• Enron, WorldCom, Rite-Aid, HealthSouth, Global

• Misleading research reports

• Citicorp, Merrill Lynch, others

• Auditors: Watchdogs or consultants?

• Arthur Andersen and Enron

• Corporate Governance and Corporate Ethics

• Sarbanes-Oxley Act (SOX):

• Requires more independent directors

• CFO personally verifies the financial statements

• Creates accounting/audit industry oversight board

• Charges board to maintain culture of high ethical

• Top Down Investment Strategies starts with Asset

• Stock portfolio loses money 1 of 4 years on

• How do we measure risk?

• How does diversification affect risk?

• be neither underpriced nor overpriced on

• Buying and holding a diversified portfolio

• No attempt to identify mispriced securities

• Identify mispriced securities

• or Forecast broad market trends

Markets are… Inefficient Efficient

Actively Seeking No Attempt to Find

• Raise capital now to pay for investments

• Households (net savers)

• Purchase securities issued by firms

• Governments (can be both borrowers and

• Connectors of borrowers and lenders

• Specialize in primary market transactions

• Newly issued securities offered to public

• Investment banker “underwrites” issue

• Preexisting securities traded among investors

• Investment banks might become commercial

• Have access to government assistance

• Major banks now under stricter regulations. In

• Equity Investment to finance new firm. Sources come from