Ch 1

Investment: current commitment of money or other resources in the expectation of

reaping future benefits.
Role of financial assets in economy, relationship between assets and why financial
assets are important to the functioning of developed economy.
Material wealth of a society is ultimately determined by the productive capacity of
its economy, the goods and services its members can create.
Real assets: land, building machines, knowledge that can be used to produce goods
and services.
Financial assets: stocks and bonds. No more than sheets of paper or computer
entries. Do not directly contribute to productive capacity of economy. These assets
hold claims on income generated by real assets.
Financial asset define the allocation of income or wealth among investors.
FINANCIAL ASSETS:
Distinguishes among 3 broad types
Fixed income, Equity, Derivatives.
Fixed-income or debt securities: promise either a fixed stream of income or a stream
of income specified by a formula. Eg. Corporate bond would promise bondholder will
receive fixed amount of interst each year.
Floating-rate bonds promise payment depending on current interest rates. Eg bond
pays interst rate of 2+t-bill rate.
Money market refers to debt securities that are short-term and highly marketable
and low risk. US T-Bills or Bank CDs
Fixed income capital market includes long term T bonds and notes, bonds issued by
federal agency, state and local munis, corporate bonds. Range from safe to high
default risk.
Common stock / Equity: represents ownership share in the corporation. Not
promised any payment, but receive dividends the firm may pay and have prorated
ownership in real assets of firm. Performance of equity tied directly with
performance of company. Riskier than investment sin debt securities.
Derivative Securities: options and futures contracts provide payoffs that are
determined by price of other assets such as bond or stock price.
One use of derivatives is to hedge risk or transfer them to other parties. Used to
take highly speculative positions.
Commodity and derivative markets allow firms to adjust their exposure to various
business risks. Whenever there is uncertainty, investors may be interested in
traditing, either to speculate or to lay off their risks, and a market arises to meet the
demand.
FINANCIAL MARKETS IN ECONOMY:

Informational role of Financial Market:

Stock prices reflect investors collective assessment of firms current performance
and future prospect. The higher price makes it easier for firm to raise capital and
thereore encourage investment. Stock prices play major role in allocation of capital
in market economies.
Unreasonable to expet that markets will never make mistakes. Stock market
encourages allocation to those firms that appear at the time to have the best
prospects.
Consumption Timing:
Some earn more than they spend, and some spend more than they earn. Retirees
spend more than they earn. In high-earnings periods, you can invest your savings in
financial assets such as stocks and bonds. In low earnings period, you can sell these
assets to provide funds for your consumption needs.
Allocation of Risk:
Virtually all real assets involve some risk. If ford builds a new plant, optimist and risk
tolerant investors will buy stock , while conservative investors buy bonds. Bonds
provide fixed payments , but stock holder reap higher rewards.
Separation of Ownership and Management:
Many are owned and managed by same individual. Simple organization is well
suited to small businesses and was the most common form of business organization
before Industrial Revolution. As industry grows bigger, management cannot be done
by owner. Instead they elect board of directors that inturn hires and supervises
management of firm. Owners and managers are different parties.
Financial assets and the ability to buy and sell those assets in the financial markets
allow for easy separation of ownership of management.
Agency problems. Managers may pursue their own interest rather than that of the
owners.
1- Compensation plan
2- Board of directors force out management teams that are underperforming.
3- Outsiders such as security analysts and large institutional investors such
as mutual funds or pension funds monitor firm closely and make the life of
poor performers uncomfortable.
4- Bad performers are subject to takeovers, by proxy contest.
Corporate Governance and Corporate Ethics:
Market signals will help allocate capital efficiently only if investors are acting on
accurate information.
Market needs to be transparent for investors to make informed decisions.
Scandals = page 8
THE INVESTMENT PROCESS:
Investors portfolio is simply his collection of investment assets. Once established, it
is updated or rebalances by selling existing securities and buying new securities.

2 types of decisions in constructing their portfolios:

1- Asset allocation: choice among broad asset classes such as stocks, bonds,
real estate, etc.
2- Security selection: choice of which particular securities to hold within each
asset class.
Asset allocation includes decision of how much ones portfolio to place in safe
assets such as bank accounts or money market securities vs risky assets.
Saving is not safe investing. Saving means you do not spend all of your current
income, and therefore can add to your portfolio. Can choose to invest savings in
safe assets, risky assets or combo of both.
Top-down portfolio starts with asset allocation, choosing what proportion of the
overall portfolio ought to be moved into stock, bonds, and so on. While average
annual return on common stock of large firms since 1926 has been better than 11%
per year, average return on US T-Bill has been less than 4%.
Stocks are far riskier. T-bills are risk free. Top-down investor first makes this and
other crucial asset allocation decisions before turning the decision of particular
securities to be held in each asset class.
Security analysis involves the valuation of particular securities that might be
included in portfolio.
Bottom up strategy is where portfolio is constructed from securities that seem
attractively priced without as much concern for the resultant asset allocation. Can
result in unintended bets on one or another sector of economy. Could be heavy
representation of firms in one industry or part of the country with exposure to one
source of uncertainty. This strategy does focus on portfolio on the assets that seem
to offer the most attractive investments.
MARKETS ARE COMPETITIVE:
Many analysis constantly scour securities markets for best buys. There is no free
lunch in the industry because securities are always in demand.
2 Implications of NO FREE LUNCH:
The Risk Return Tradeoff:
Always risk in investment returns rarely can be predicted precisely. Actualized
returns will always deviate from expected returns at the start of investment period.
If all held equal, investors prefer investments with highest expected returns. But in
no free lunch, not all can be held equal. Higher expected return can be achieved
with higher risk involved. If there is no risk, then the price of the security will be
driven up due to demand.
Therefore risk return tradeoff in securities marker with higher risk assets priced to
offer higher expected returns than lower-risk assets.
2- Efficient Markets:

We should rarely expect to find bargains in the security markets. As new

information about a security becomes available, its price quickly adjusts so that at
any time, the security price equals the market consensus estimate of the value of
the security.
Passive management: holding highly diversified portfolios without spending effort or
other resources attempting to improve the investment performance through
security analysis.
Active management: attempt to improve performance by either identifying
mispriced securities or by timing the performance of broad asset classes.
THE PLAYERS:
3 major players in financial markets:
1- Firms are net demanders of capital.
2- Household are typically net suppliers of capital
3- Government can be borrowers or lenders, depending on the relationship
between tax revenue and government expenditure.
Corporations and goverments do not sell all or even most of their securities directly
to individuals.
Held by mutual funds, pension funds, insurance companies, banks etc.
financial intermediaries.
FINANCIAL INTERMEDIARIES:
Evolved to bring suppliers of capital (household) together with demanders of capital
(corp). issue their own securities to raise funds to purchase the securities of other
corps.
Bank raises fun by borrowing (taking deposits) and lending money to other
borrowers. The spread between interest rates paid to depositors and rates charged
to borrowers is source of banks profit.
Financial intermediaries are distinguished from other business in that both their
assets and liabilities are overwhelmingly financial.
Primary function of financial intermediaries is to channel household savings to
business sector.
Investment companies, insurance companies and credit unions.
Investment companies pool and manage the money of many investors. Most
households are not large enough to be spread across a wide variety of securities.
Brokerage fees, research cost may be expensive.
Mutual funds have advantage of large-scale trading and portfolio management.
participating investors are assigned a prorated share of total funds according to size
of their investment.
Investment companies design portfolios specifically for large investors with
particular goals.
Mutual funds are sold in retail market and attract large number of clients.
Hedge funds pool and invemtn money of many clients, but they are only open to
institutional investors such as pension funds, wealthy individuals etc. pursue higherrisk strategies.

INVESTMENT BANKERS:
Specialize in activities such as seling stock and bonds to public. At a cost below that
of maintaining an in-house security issuance division. They are underwriters.
Investment bankers advice issuing corporation on the prices it can charge for the
securities issues, appropriate interest rates etc.
They handle marketing of security to the primary market. Later investors can trade
previously issued securities among themselves in the secondary market.
Venture Capitalist:
Start-up companies rely instead on bank loans and investors who are willing to
invest in them in return for ownership stake in the firm. The equity investment is
called venture capital.
Angel investors wealthy individuals who invest in the startups.
VC investors take active role in management of start-up firm. These firms do not
trade in public stock exchange and are known as private equity investments.
T-bill rates dropped drastically between 2001-2004 and LIBOR rate, which is the
interest rate at which major money-center banks lend to each other, fell in tandem.
This was because of high tech bubble in 2000-2002. The dropping of t-bill rates
eased the recession.
TED Spread = T-bill rate LIBOR rate, common measure of credit risk in the banking
sector.
Feds policy of reducing interest rates resulted in low yields on wide variety of
investments. Investors were hungry for higher-yielding alternatives.
Low volatility and growing complacency about risk encouraged greater tolerance for
risk in search of higher yielding investments.
CHANGES IN HOUSING FINANCE:
FNMA and FHLMC began buying mortgage loans from originators and building
them into large pools that could be traded like any other financial asset. Claims on
underlying mortgages
Because mortgage was passed along from homeowner to lender to fannie and
Freddie to the investor, the mortgage backed securities were also called
passthroughts.

Home owners had to go through underwriting criteria to establish their ability to

repay loan.

Originate to distribute business model, where private firms pooled money, bought
loans, and then sold off to investors
Allowed for securitization by private firms of nonconforming subprime loans with
higher default risk.
Orginiating mortgage brokers had little incentive to perform due diligence on loan
as long as loans could be sold to an investor. They had no direct contact with
borrowers and could not perform detailed underwriting concerning loan quality.
They relied on credit scores.
Underwriting standards deteriorated quickly. Adjustable rate mortgages grew in
popularity. Offered low teaser initial rates, but grew quickly.
Mortgage derivatives:
New risk-shifting tools enabled investment banks to carve out AAA-rated securities
from original-issue junk loans. Collateralized debt obligations (CDOs) were among
the most important and eventually damanging of these innovations.
Prioritize claims on loan repayments by dividing the pool into senior vs junior slices
called tranches. Senior trache had first claim on repayment from entire pool. Junior
tranches would be paid only after senior ones had received their cut.
Rating agencies thus gave senior tranches AAA rating (which were wrong
eventually). They were paid to provide ratings by the issuers of security. So they
provided generous ratings.
Credit Default Swaps: an insurance contract against the default of one or more
borrowers. Purchaser pays annual premium for protection from credit risk.
The RISE OF SYSTEMIC RISK: Page 21