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Outline of the Chapter

Real assets vs Financial Assets Classification of Financial Assets Financial Markets and the Economy The Investment Process The Competitiveness of the Financial Markets The Players in the Financial Markets Recent Trends in the Financial Markets

Real Assets Versus Financial Assets

What is investment?
Reduced current consumption Planned later consumption

Real Assets
Assets used to produce goods and services

Financial Assets
Claims on real assets


A Taxonomy (Classification) of Financial Assets

Fixed income or debt
Money market instruments
Treasury Bills, Bank certificates of deposit, Repos and reverses, Capital market instruments Bonds Treasury bonds, bonds issued by federal agencies, state and local municipalities, corporations

Common stock or equity

Represent an ownership share in a corporation

Derivative securities


Financial Markets and the Economy

Information Role
Stock prices reflect the collective judgement of professionals Stock market encourages the allocation of capital to those firms that have the best prospect

Consumption Timing
Shift the purchasing power from high-earning periods to low-earning periods

Allocation of Risk
Allow investors with the greater taste for risk bear that risk.


Financial Markets and the Economy (Continued)

Separation of Ownership and Management
Agency Problems
Stockholders-Board of Directors-Managers Do these managers really work for the best interest of the firm? The possibility of conflict of interest between the owners and management of a firm. Methods to decrease agency problem

Financial Markets and the Economy (Continued)

Corporate Governance and Corporate Ethics Importance of transparency and wellinformed investors Accounting Scandals WorldCom and Enron Auditors and Analyst Scandals Arthur Andersen


The Investment Process

Saving and Investing
Saving: not spending all of your current income on consumption Investing: choosing which assets to hold

Forming a portfolio
A portfolio is the collection of investment assets Asset allocation Choice among broad asset classes such as stocks, bonds, real estate, commodities... Security selection Choice of which securities to hold within asset class Security Analysis 1-8

Markets are Competitive

Financial markets are competitive
No-free lunch

Risk-Return Trade-Off
Higher expected return means higher investment risk There is a trade-off between risk and return in the securities market


Markets are Competitive

Efficient Markets
EMH: security prices reflects all the information available to the investors related to the valuation of the security Passive Management
Holding a highly diversified portfolio No attempt to find undervalued securities No attempt to time the market

Active Management
Finding mispriced securities Timing the market

The Players
Households-Net Lender (Government) Firms-Net Borrower (Government)

Direct markets

Financial Intermediaries


The Players (Continued)

Financial Intermediaries Formed to bring lenders and borrowers together Banks, Investment Companies, Insurance companies, Credit unions... Advantages
Pool the resources from small lenders to the business sector Lend to many borrowes so they diversify portfolios Build expertise through the volume of business


The Players (Continued)

Investment Bankers Hired by the firms that want to raise capital by selling securities (stocks and bonds) Perform specialized services for businesses and advise on the prices, interest rates ... Markets in the primary market


Recent Trends
1) Globalization
Investors do not have to limit themselves to the domestic assets Foreign securities offered in dollars, Mutual funds that invest internationally, Derivative securities with payoffs that depend on prices in foreign security markets...


Recent Trends (Continued)

2) Securitization
GNMA Mortgage pass-through securities Enables banks to trade the mortgages as other securities Sub-Prime Crises
2007 Decrease in House Prices in 2006-2007 Defaults on Mortgages Loss in Value of Securities Backed with Subprime Mortgages Decline in the capital of many banks

Recent Trends (Continued)

3) Financial Engineering
Use of mathematical models and computer-based trading technology to synthesize new financial products Bundling and unbundling of cash flows

4) Information and Computer Networks

Online Trading
Connects customers directly to the online brokerage firms Decreases the commissions

Information is made cheaply and widely available to the public 1-16