Chapter 1

Investments:
Background and Issues
Chapter Contents

 1.1 Real Versus Financial Assets

 1.2 Financial Assets
 1.3 Financial Markets and the Economy
 1.4 The Investment Process
 1.5 Markets Are Competitive
 1.6 The Players
 1.7 Recent Trends
 Outline

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1.1 Real versus Financial Assets
Real versus Financial Assets
• Essential nature of investment
- Reduce current consumption in hopes of greater
future consumption.

• Real Assets
- Used to produce goods and services: Property,
plant & equipment, human capital, etc.

• Financial Assets
- Claims on real assets or claims on asset income
Table 1.1. Balance Sheet - U.S. Households
1.2 Financial Assets
Major Classes of Financial Assets or Securities
• Debt (fixed-income securities)
- Money market instruments
• Short-term, highly marketable, and very low risk
• Bank certificates of deposit, T-bills, commercial paper, etc.
- Capital market instruments
• Long-term and ranged from very safe to relatively risky
• Treasury bonds, bonds issued by various agencies
• Common stock
- Not promised any particular payment.
- Ownership stake in the entity, residual cash flow
- Tend to be risker than investments in debt securities.
• Derivative securities
- A contract whose value is derived from some underlying market condition.
- Provide payoffs that depend on the values of other assets.
• Options and Futures
- Primarily purposed for hedging risks.
1.3 Financial Markets
and the Economy

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The Informational Role
• Do market prices equal the fair value estimate of a security’s
expected future risky cash flows?
- Decide which companies will live and which will die.

• Can we rely on markets to allocate capital to the best uses?

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Consumption Timing
• People tend to smooth consumption over time.

• If one has more than enough cash to meet their basic needs in the
current time period, one might shift consumption through time by
investing the surplus.
- In high-earnings periods, invest in financial assets.
- In low-earnings periods, sell these assets.

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Allocation of Risk
• Investors can choose a desired risk level.

- Bonds versus stock of a given company

- Bank certificate of deposit (CD) versus company bond

- Tradeoff between risk and return?

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Separation of Ownership and Management
• Large size of firms requires separation of ownership and management
- In 2010, GE had over $750 billion in assets and over 600,000
stockholders.
- Owners (principals) ≠ Managers (agents)
- Agency costs: Owners’ interests may not align with managers’ interests.
- Mitigating factors:
• Performance based compensation
• Boards of Directors may fire managers
• Threat of takeovers

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Corporate Governance and Corporate Ethics
• Business and market require trust and transparency to operate
efficiently.
- Without trust, additional laws and regulations are required.
- All laws and regulations are costly.

• Governance and ethics failures have cost our economy billions.

- Erode public support and confidence in market based systems.

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Corporate Governance and Corporate Ethics (cont.)

• Accounting Scandals
Ex) Enron, WorldCom, Rite-Aid, HealthSouth, Global Crossing, Qwest
• Misleading Research Reports
Ex) Citicorp, Merrill Lynch, others
• Auditors: Watchdogs or Consultants?
Ex) Arthur Andersen and Enron

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Corporate Governance and Corporate Ethics (cont.)

• Sarbanes-Oxley Act (SOX)

- Increases the number of independent directors on company boards.
- Requires the CFO to personally verify the financial statements.
- Created a new oversight board to oversee the accounting/audit industry.
- Charged the board with maintaining a culture of high ethical standards.

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1.4 The Investment Process

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 Asset allocation
- Choosing the percentage of funds in asset classes.
Stocks 60%
Bonds 30%
Alternative Assets 6%
Money market securities 4%

 Security selection & analysis

- Choosing specific securities within an asset class

 The asset allocation decision is the primary

determinant of a portfolio’s return.

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1.5 Markets Are Competitive
(No Free-Lunch Propositions)

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 Risk-Return Trade-off:
- Assets with higher expected returns have higher risk.
Average Annual Minimum Maximum
Return (1931) (1933)
Stocks About 12% -46% 55%

A stock portfolio can be expected to lose money about

1 out of every 4 years.

- Bonds have a much lower average rate of return (under

6%) and have not lost more than 13% of their value in
any one year.
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 Risk-Return Trade-off (cont.)
- How do we measure risk?

- How does diversification affect risk?

- Discussed in Part 2.
Efficient Markets

 Market Efficiency

- Securities should be neither underpriced nor overpriced on average.

- Security prices should reflect all information available to investors.

- Whether we believe markets are efficient affects our choice of

appropriate investment management style.

- Discussed in Ch. 8.

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Active vs. Passive Management
Active Management (inefficient markets)
Finding undervalued securities Security selection
Timing the performance of asset classes Asset allocation

Passive Management (efficient markets)

No attempt to find undervalued securities
No attempt to time Indexing
Holding a diversified portfolio: Constructing an “efficient” portfolio

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1.6 The Players

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• Business Firms
- Net borrowers (i.e. net demanders of capital)
• Households
- Net savers (i.e. suppliers of capital)
• Governments
- Can be both borrowers and savers, depending on the
relationship between tax revenue and expenditures

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• Financial Intermediaries: “Connectors of borrowers and lenders”
- Commercial Banks
: Traditional line of business: Make loans funded by deposits

- Investment companies
: Pool and manage the money of many investors; e.g. mutual fund

- Insurance companies

- Pension funds

- Hedge funds
: Similar with mutual fund, but open only to institutional investors.
: Pursue complex and hither-risk strategies, and keep a portion of
trading profits as part of their fees.

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• Investment Bankers
- Firms that specialize in the sale of new securities to the public (in
primary market transactions).

- Primary market:
• A market where newly issued securities are offered to the public.
• The investment banker typically ‘underwrites’ the issue.

- Secondary market
• A market where pre-existing securities are traded among investors.

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• Venture Capital
- The equity investment in small and young companies such as start-up firms.

- Sources of VC are dedicated VC funds, wealthy individuals known as

angel investors, and institutions such as pension funds.

- Most venture capital funds are set up as limited partnerships.

• Private Equity
- Focus on firms that are in distress or firms that may be bought up,
improved, and sold for a profit.

- These investments in firms that do not trade on public stock exchanges

are known as private equity investments.

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1.7 Recent Trends

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• Globalization

• Securitization

• Financial Engineering

• Computer Networks

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Globalization
• Domestic firms compete in global markets

• Performance in one country or region depends on

other regions

• Opportunities for better returns & implications for risk

- Managing foreign exchange
- International diversification reduces risk.
- Instruments and vehicles continue to develop.
- Information and analysis improves.

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Securitization
• Loans of a given type such as mortgages are placed
into a ‘pool’ and new securities are issued that use
the loan payments as collateral.

• The securities are marketable and are purchased by

many institutions.

• End result is more investment opportunities for

purchasers, and spreading loan credit risk among
more institutions.

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Securitization

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Securitization
• Securitization has grown rapidly due to
- Changes in financial institutions and regulation permitting its growth,
particularly lower capital requirements on securitized loans.

- Improvement in information capabilities

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Financial Engineering
• Repackaging cash flows of a security to enhance marketability
• Bundling and unbundling of cash flows
- Bundling:
Combining more than one asset into a composite security, for
example securities sold backed by a pool of mortgages.
- Unbundling:
Selling separate claims to the cash flows of one security.

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Computer Networks
• Online trading connects a customer directly to a brokerage firm.
- Online brokerage firms can charge lower commissions.

• Cheaply and widely accessed to vast amounts of information via

Internet

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 Outline
• Part 1: Introduction to Financial Markets, Instruments and
Trading of Securities, and the Mutual Fund Industry

• Part 2: Modern Portfolio Theory

• Part 3: Debt Securities

• Part 4: Equity Security Analysis

• Part 5: Derivative Markets

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