Chapter 1 investments background and issues

1.1 Real versus Financial Assets... Major Classes of Financial Assets or Securities• Debt fixed-income securities - Money market instruments • Short-term, highly marketable, and very low

Chapter 1

Investments:

Background and Issues

Chapter Contents

 1.1 Real Versus Financial Assets

 1.2 A Taxonomy of 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

 1.8 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

Table 1.1 Balance Sheet –

U.S Households, 2008

Table 1.2 Domestic Net Worth, 2008

1.2 A Taxonomy of 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 by 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 throug

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

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.

- Eroding public support and confidence in market based systems

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Corporate Governance and Corporate Ethics

• 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

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Corporate Governance and Corporate Ethics

• 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

Choosing the percentage of funds in asset classes

Choosing specific securities within an asset class

1.5 Markets Are Competitive

(No Free-Lunch Propositions)

 Risk-Return Trade-of:

- Assets with higher expected returns have higher risk

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

Average Annual Return Minimum (1931) Maximum (1933)

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- How do we measure risk?

- How does diversification affect risk?

- Discussed in Part 2 of the text

 Risk-Return Trade- Off (continued)

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- Whether we believe markets are efficient affects our choice of appropriate

investment management style.

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Active vs Passive Management

Active Management (inefficient markets)

Finding undervalued securities

Timing the performance of asset classes

Passive Management (efficient markets)

No attempt to find undervalued securities

No attempt to time

Holding a diversified portfolio:

Security Selection Asset Allocation

• Indexing

• Constructing an “efficient”

portfolio

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1.6 The Players

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The Players

• Business Firms – net borrowers

• Households – net savers

• Governments – can be both borrowers and savers

• Financial Intermediaries “Connectors of borrowers and lenders”

The Players (continued)

- Firms that specialize 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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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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• Loans of a given type such as mortgages are placed into a ‘pool’ and new securities are issue

d 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 amo

ng more institutions

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• 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

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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1.8 Outline

• Part 1: Introduction to Financial Markets, Securities and Trading Methods

• Part 2: Modern Portfolio Theory

• Part 3: Debt Securities

• Part 4: Equity Security Analysis

• Part 5: Derivative Markets

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