Chapter 1 investments background and issues

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
1-2
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•
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-
Reduce current consumption in hopes of greater
future consumption.
•

-

Used to produce goods and services: Property,
plant & equipment, human capital, etc.
•

Claims on real assets or claims on asset income
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•
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)(/
•
Short-term, highly marketable, and very low risk
•
Bank certi$cates of deposit, T-bills, commercial paper, etc.
+0/
•
Long-term and ranged from very safe to relatively risky
•
Treasury bonds, bonds issued by various agencies
•
+/
- Not promised any particular payment.
- Ownership stake in the entity, residual cash )ow
- Tend to by risker than investments in debt securities.
•
$

- A contract whose value is derived from some underlying market condition.
- Provide payo+s that depend on the values of other assets.
•
Options and Futures
- Primarily purposed for hedging risks.
1.3 Financial Markets and
the Economy
1-9
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?

1-10
Consumption Timing
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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.
1-11
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?
1-12
Separation of Ownership and Management
•
Large size of firms requires separation of ownership and management
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In 2008, GE had over $800 billion in assets and over 650,000
stockholders
- Owners (principals) ≠ Managers (agents)
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Agency costs: Owners’ interests may not align with managers’ interests
- Mitigating factors:
•
Performance based compensation
•
Boards of Directors may fire managers
•
Threat of takeovers
1-13
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.
1-14
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
1-15
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.
1-16
1.4 The Investment Process
Choosing the percentage of funds in asset classes.
Choosing specific securities within an asset class
Stocks
Bonds
Alternative Assets
Money market securities
60%
30%
6%
4%


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01

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1-17
1.5 Markets Are Competitive
(No Free-Lunch Propositions)

Risk-Return Trade-of
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Average Annual Return Minimum (1931) Maximum (1933)
Stocks About 12% -46% 55%
1-18
- How do we measure risk?
- How does diversification affect risk?
- Discussed in Part 2 of the text

Risk-Return Trade- Off (continued)
1-19
Efficient Markets

Market Eciency

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1-20
Active vs. Passive Management
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Security Selection
Asset Allocation
•
Indexing
•
Constructing an “efficient”
portfolio
1-21
1.6 The Players
1-22
The Players
•
Business Firms – net borrowers
•
Households – net savers

•
Governments – can be both borrowers and savers
•
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
1-23
The Players (continued)
•
Investment Bankers
-
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.
1-24
1.7 Recent Trends

•
Globalization
•
Securitization
•
Financial Engineering
•
Information and Computer Networks
1-25