Chapter 1

Investments: Background and

Issues

1.1 Real Versus Financial Assets

• Real Assets• Used to produce goods and services: Property,

plant & equipment, human capital, etc.• the net wealth of an economy is the sum of its

real assets.

• Financial Assets• Claims on real assets or claims on asset income

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Table 1.1. Balance Sheet – U.S. Households

Table 1.2 Domestic Net Worth

Most Current

http://www.federalreserve.gov/releases/z1/current/

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Major Classes of Financial Assets or Securities

• Debto Money market instruments

• Bank certificates of deposit, T-bills, commercial paper, etc.

o Bondso Preferred stock

• Common stocko Ownership stake in the entity, residual cash flow

• Derivative securitieso A contract whose value is derived from some

underlying market condition.

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1.3 Financial Markets and the Economy

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Financial Markets

• Informational Role of Financial Marketso Do market prices equal the fair value estimate of a

security’s expected future risky cash flows?o Or any thing? – Intrade.com

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Separation of Ownership and Management; Ethics

o Agency costs: Owners’ interests may not align with managers’ interests

o Mitigating factors:• Performance based compensation• Boards of Directors may fire managers• Threat of takeovers – M&A FINC 350

• Governance and ethics failures have cost our economy trillions of dollars.o Eroding public support and confidence in market

based systems

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Example 1.1• In February 2008, Microsoft offered to buy Yahoo at $31

per share when Yahoo was trading at $19.18.

• Yahoo rejected the offer, holding out for $37 a share.

• Billionaire Carl Icahn led a proxy fight to seize control of Yahoo’s board and force the firm to accept Microsoft’s offer.

• He lost, and Yahoo stock fell from $29 to $21.• Did Yahoo managers act in the best interests of their

shareholders?

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Other examples

• Accounting Scandalso Enron, WorldCom, Rite-Aid, HealthSouth, Global

Crossing, Qwest, • Misleading Research Reports

o Citicorp, Merrill Lynch, others• Auditors: Watchdogs or Consultants?

o Arthur Andersen and Enron

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Corporate Governance and Corporate Ethics

• Sarbanes-Oxley Act (SOX)o Increases the number of independent directors on

company boardso Requires the CFO to personally verify the

financial statementso Created a new oversight board for the

accounting/audit industryo 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 w/in an asset class

Stocks

Bonds

Alternative Assets

Money market securities

60%

30%

6%

4%

o Asset allocation

o The asset allocation decision is the primary The asset allocation decision is the primary determinant of a portfolio’s returndeterminant of a portfolio’s return

o Security selection & analysis

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o How do we measure risk?

o How does diversification affect risk?

o Discussed in Part 2 of the texto Investors can choose a desired risk level

Bonds versus stock of a given company

Bank CD versus company bond

Tradeoff between risk and return?

Risk-Return Trade- Off

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Efficient Markets

o Market efficiency: o Securities should be neither underpriced nor

overpriced on average

o Security prices should reflect all information available to investors

o Whether we believe markets are efficient affects our choice of appropriate investment management style.

o 3 forms – strong, semi-strong, weak

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Active vs. Passive Management

Active Management (inefficient markets)Finding undervalued securitiesTiming the market

Passive Management (efficient markets)No attempt to find undervalued securitiesNo attempt to timeHolding a diversified portfolio:

Security Selection

Asset Allocation

• Indexing• Constructing an

“efficient” portfolio

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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”o Commercial Banks

• Traditional line of business: Make loans funded by deposits

o Investment companieso Insurance companieso Pension fundso Hedge funds

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The Players Cont.

• Investment Bankers aka Wall Streeto Firms that specialize in primary market

transactionso Primary market vs Secondaryo After 2008, no more pure investment bankers,

annulling 1933 Acto As a result, they face much stricter banking

regulations, e.g. deleveraging

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1.7 Recent Trends• Globalization

o Managing foreign exchangeo International diversification reduces risko Instruments and vehicles continue to develop

(ADRs and WEBs)

• Securitization• Financial Engineering• Information and Computer Networks

• Nasdaq as of Feb 2011 has the fastest network: 98ms/trade, Soon Singapore 90ms/trade

• Deleveraging

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