Lecture 1:

Investments: Introduction

Investment Analysis
Spring 2018

Rutgers Business School

Outline
 Practical Information about the class
(see also the syllabus)
 Overview of class
 Outline of topics covered
 First topic of the class: The Investment Environment

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Course Material
 Required Textbook: Investments by Bodie, Kane and Marcus
10th Edition,2013, Irwing-McGraw Hill
 Blackboard: Assignments, Additional Reading,
Announcements etc
 Recommended Readings:
A Random Walk down the Wall Street by Burton Malkiel
Stocks for the Long Run by Jeremy Siegel
Irrational Exuberance by Robert Shiller
 Light Readings:
When Genius Failed: The Rise and Fall of LTCM
The Big Short: Inside the Doomsday Machine
 Recommended: Wall Street Journal, Financial Times
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Calculator

 You need a calculator for problems and exams.

 Having a Financial calculator is an advantage but
not a requirement.
 Standard Financial calculators include: Hewlett
Packard 10B II or 12 C, Texas Instruments BA II +
 Knowledge of Excel Spreadsheets is a requirement.

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Grading

 Mid-Term Exam 35%

 Final Exam 30%
 Pre-Final Assessment 5%
 Problem Sets 15%
 Portfolio Management Project 15%
(2 Bonus % points for finishing in Top 10%)
 Exams are non-cumulative

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Portfolio Management Project

 Goal is to build and manage a simulated portfolio of

US stocks and Exchange Traded Funds (ETFs).
 Marketwatch- Virtual Stock Exchange platform.
 Well-diversified portfolio- exposure to a single asset
limited.
 Limits on cash holdings, short-selling allowed.
 An individual write-up with details of the investment
strategies and performance evaluation due before
the Final Exam.

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Contact Information

 Office: Room 5127, 100 RR

 Email: apareek@business.rutgers.edu
 Office Hours:
 Monday 2:30 PM to 3:30 PM

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The Course Outline
 Introduction to Investments: Asset Classes, Markets and
Investment Companies
 Efficient Diversification: Portfolio Theory
 Risk and Returns: CAPM and APT
 Efficient Markets, Behavioral Finance and Stock Return
Anomalies
 Bond Pricing and Managing Bond Portfolios
 Security Analysis: Equity Valuation and Financial
Statement Analysis
 Evaluating Fund Managers: Portfolio Performance
Evaluation
 Options Markets and Valuation
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 Ethics in Investment Management
Investments

 What is an investment?

 Current commitment of money (or other resources)

Expect to reap future benefits

 Current vs. future:

Sacrifice now and get something back later
 Expectation:
The future benefits are uncertain

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The Foundations of Investments: 4 Nobel-Prize winning
insights
 Harry Markowitz: 1990
Optimal Portfolio Selection
“Don’t put all your eggs in one basket”.
 William Sharpe : 1990
Capital Asset Pricing Model (CAPM)
In equilibrium, risky assets have higher returns.
 Robert Merton , Myron Scholes: 1997
No arbitrage pricing of derivatives (options).
 Eugene Fama, Lars Hansen , Robert Shiller: 2013
Empirical Analysis of Asset Prices: Rational vs Behavioral Models

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Finance is Based on Simple Axioms

 Investors prefer more to less.

 Investors are Risk Averse.

 Money paid in the future is worth less than the same

amount today.

 Financial markets are competitive

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Investment Decisions

 Savings versus consumption decision

 Families save money for child’s college education
 College students have low income now, but
(hopefully) high future income
 Student loans allow them to smooth consumption
intertemporally
 Investment decisions: how to allocate your savings
 Asset allocation: choice among broad asset classes
(bonds versus stocks versus cash versus real estate)
 Security selection: within each asset class, choice of
the particular securities to hold in your portfolio

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Asset classes

Real assets

Assets which generate net income to the economy,

i.e., ultimately determine its ability to produce goods
and services

 Natural resources: land, oil,

 Physical capital: machinery, buildings, factories

 Intangibles: human & “cultural” capital like technical

expertise, trademarks, patents

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Asset classes

Financial assets (or securities):

Assets which specify level, timing, and condition for
the payment of cash, goods, or other financial assets

 Debt: a claim to a predetermined payment stream

 Equity: residual claim to a set of real assets (usually

of a corporation)

 Derivatives: their payoff is dependent on the value

of some other (usually financial) assets

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Example 1: IBM Corporation

 Real assets:
 Plants used to build computers
 Patents and trademarks for software, operating
systems, etc.
 Financial assets: claims to the income generated by
IBM‘s real assets
 Equity: IBM stocks
 Debt: IBM bonds
 Derivatives: claims on IBM stocks
 Ex. Call option: a security giving the right (but not the
obligation) to purchase IBM stocks at a given
(exercise) price
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Real Assets in the Economy

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The financial system

 It is the collection of institutions by which financial

assets are created and traded
 It serves the purpose of creating wealth by:
 Improving allocation of capital: transferring resources
from savers (investors) to users (corporations)
 Improving allocation of risk: risk sharing, hedging, etc.
 Consumption timing: allowing investors to smooth
consumption intertemporally
 Separating owners and managers: using best skills
 Disciplining firms’ investment decisions: good versus
bad choices
 Disseminating information: prices
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The financial system: institutions

 The government
 Sets the regulatory environment
 Controls the money supply, interest rates, and the
real value of money via the Central Bank
 Financial markets
 Regulated (stocks) and unregulated (foreign
exchange) markets where financial assets trade.
 Financial intermediaries
 Entities which operate within or outside financial
markets to facilitate the trading of financial assets

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Informational Role of Financial Markets

 Sports Betting, Intrade did a good job predicting the

probability of an event using a market. As more people
bet an event will take place, the odds change to reflect
the probability of the event occurring. Financial Markets
work the same way.

 Market prices equal the fair value estimate of a security’s

expected future risky cash flows.

 Markets Allocate Capital Efficiently. Good companies are

able to raise money easily, bad companies have a harder
time raising money and growing.

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 Consumption Smoothing
 Markets allow individuals to consumption smooth.
 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.

 Think of how over the course of your life how you must save money in
high income times to help you in low income times. Financial markets
help make this process much more efficient

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Risk Sharing

 Financial Markets allows individuals to share risk.

 Risk seeking people can buy risky securities, risk-
averse people can buy conservative securities.
 If you have exposure to a specific risk, the financial
markets allow you to reduce exposure to this risk. If
you are a small business owner in Detroit, the profits
of your business are highly linked to the GM factory
down the street. Via the financial market you could
short GM to limit your exposure to GM risk.

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Separation of Ownership and Management

 Separation of Ownership and Management via Financial Markets

Allow:
 Corporations to have more easily change management.

 Companies to increase size by bringing in new owners.

In 2008 GE had over $800 billion in assets and over 650,000

stockholders
Cons => Agency costs: Owners’ interests may not align with
managers’ interests
o Mitigating factors:

 Performance based compensation

 Boards of Directors represent owners and can fire

manager.
 Threat of takeovers

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Market Efficiency

 Example
 Apple (AAPL) is trading at $549.07 (Closing price

on Jan 21,2014)
 Suppose you know the “true” price is $700.

What should you do?

Buy AAPL!
 What will happen?

 AAPL share price will increase to $700

• In an efficient market, prices reflect all available

information

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Portfolio Evaluation
 We will see that financial markets are not 100% efficient
• Some investors could earn higher returns because of

their information/skills
• But high returns could be due to luck as well

• The important issue here is to separate luck and skill

• Luck or skill? An octopus correctly guessed the results of the

World Cup matches

• How can we evaluate fund

managers?

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Fidelity Magellan Fund (FMAGX)

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The financial markets

 Primary versus secondary markets

 Primary: where new issues of securities are sold to
the public (ex. IPOs, Initial Public Offerings of stocks)
 Secondary: where seasoned securities are traded
 Exchange versus over-the-counter markets
 Exchange: buyers and sellers meet in one central
location (physical or electronic) to trade
 OTC: intermediaries at different locations stand ready
to trade with investors
 Money versus capital markets
 Money: short-term debt (less than 1 year maturity)
 Capital: long-term debt and equity
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Hierarchy of types of financial markets

 Direct search: Buyers and sellers find each other

directly (used cars)
 Brokered markets: Buyers and sellers use
intermediaries (not acting as principals) to find each
other (residential real estate)
 Dealer markets: As above, but intermediaries often
act as principals, taking long / short positions and
providing liquidity (NASDAQ, U.S. Treasuries)
 Auction markets: Centralized, where buyers and
sellers interact directly with each other (NYSE)
 From top to bottom: higher fixed costs, lower trading
costs, greater structure
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Financial Intermediaries

 Commercial Banks - Traditional line of business:

Make loans funded by deposits
 Investment Banks – Help firms raise money
 Investment companies – Help householders invest
money
 Insurance companies
 Pension funds
 Hedge funds
 Venture Capital and Private Equity

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2008 Financial Crisis

 Link between the real and financial side of the

economy broken.

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Housing bubble

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