• Chapter 1

Chapter Title
The
Investment
Environment

Slides Prepared
INVESTMENTS by Cagdas
| BODIE, Tahaoglu,
KANE, MARCUS, Concordia
SWITZER, University
BOYKO, PANASIAN, STAPLETON

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 Chapter Overview
• Real Assets versus Financial Assets
• Risk-return trade-off and efficient pricing
• Financial crisis 2008
– Financial system  “Real” economy
– Systemic risk

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 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

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 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

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 Other Types of Investment
• Investment in currency
• Commodity futures
– Corporations invest in the commodity futures to
hedge the risk

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 Financial Markets and the
Economy (1 of 4)
• The Informational Role
• Consumption Timing
• Allocation of Risk

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 Financial Markets and the
Economy (2 of 4)
• Separation of Ownership and Management
– Agency Problems

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 Financial Markets and the
Economy (3 of 4)
• Mechanisms to mitigate 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

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 Financial Markets and the
Economy (4 of 4)
• Corporate Governance and Corporate Ethics
– Accounting Scandals
 Enron, Nortel Networks, Parmalat
– Auditors: Watchdogs
– Analyst Scandals
 Arthur Andersen
– Sarbanes-Oxley Act
 Tighten the rules of corporate governance

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The Investment Process (1 of 2)
• Portfolio: Collection of investment assets
• Asset allocation
– Choice among broad asset classes
• Security selection
– Choice of securities within each asset class

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The Investment Process (2 of 2)
• “Top-down” approach
– Asset allocation followed by security analysis
• “Bottom-up” approach
– Investment based solely on the price-
attractiveness

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Markets Are Competitive (1 of 3)
Risk-Return Trade-Off
• Higher-risk assets are priced to offer higher
expected returns than lower-risk assets
• Risk and expected return are positively
correlated

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Markets Are Competitive (2 of 3)
Efficient Markets
• Efficient markets: prices quickly adjust to all
relevant information
• There should be neither underpriced nor
overpriced securities

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Markets Are Competitive (3 of 3)
• 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

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 The Players (1 of 2)
• Firms – net borrowers
• Households – net savers
• Governments – can be both borrowers and
savers

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 The Players (2 of 2)
• Financial Intermediaries: Pool and invest
funds
– Investment Companies
– Banks
– Insurance companies
– Credit unions

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 Universal Bank Activities

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 Crisis of 2008 (1 of 3)
• Antecedents of the Crisis:
– “The Great Moderation”
– Historic boom in housing market

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Financial Crisis of 2008 (2 of 3)
“The Great Moderation”

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Financial Crisis of 2008 (3 of 3)
Historic boom in U.S. housing market

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Antecedents of the Crisis

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 Changes in Housing Finance
(1 of 3)
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”

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 Changes in Housing Finance
(2 of 3)
• Securitization
• Inclusion of nonconforming “subprime” loans
• Low/No-documentation loans
• Rising loan-to-value ratio
• Adjustable-Rate Mortgages

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Changes in Housing Finance
(3 of 3)

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 Mortgage Derivatives
• Collateralized Debt Obligations (CDOs)
– Mortgage pool divided into tranches to
concentrate default risk:
 Senior tranches
 Junior tranches
– Ratings significantly underestimated risk

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 Why Was Credit Risk
Underestimated?
• Default probabilities were misestimated
• Geographic diversification did not reduce risk
sufficiently
• Agency problems with rating agencies

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 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

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 Rise of Systemic Risk (1 of 3)
• Systemic Risk:
– One default triggers further defaults
– Waves of selling  downward spiral as asset
prices drop
– Potential contagion

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 Rise of Systemic Risk (2 of 3)
• Banks mismatched maturity/liquidity of their
assets and liabilities:
– Liabilities were short and liquid
– Assets were long and illiquid
– Constant need to refinance
• Banks: highly leveraged  no margin of
safety

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 Rise of Systemic Risk (3 of 3)
• Investors relied too much on credit
enhancement through structured products
• CDS traded mostly over-the-counter
– No posted margin requirements
– Little transparency
• Opaque linkages between instruments and
institutions

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 The Shoe Drops (1 of 2)
• 2004: Interest rates began rising
• 2006: Home prices peaked
• 2007: Housing defaults and losses on
mortgage-backed securities surged

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 The Shoe Drops (2 of 2)
• 2008: Troubled firms include Bear Stearns,
Fannie Mae, Freddie Mac, Merrill Lynch,
Lehman Brothers, and AIG
– Money market breaks down
– Credit markets freeze up
– Federal bailout to stabilize financial system

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The Dodd-Frank Reform Act

Mechanisms to mitigate systemic risk

– 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

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 The Canadian Experience
of the Financial Crisis

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

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