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Chapter 1

Investments: Background and Issues


Copyright 2010 by The McGraw-Hill Companies, Inc. All rights reserved.

Real versus Financial Assets

The Meaning of Investment Reduce current consumption in hopes of greater future consumption Real Assets Used to produce goods and services: Property, plant & equipment, human capital, etc. Financial Assets Claims on real assets or claims on asset income
Real Assets generate net income to the economy while Financial Assets define the allocation of income or wealth among investors.

Table 1.1. Balance Sheet U.S. Households, 2008


contd Real versus Financial Assets

All financial assets (owner of the claim) are offset by a financial liability (issuer of the claim). When we aggregate over all balance sheets, only real assets remain. Hence the net wealth of an economy is the sum of its real assets.


Table 1.2 Domestic Net Worth, 2008


Major Classes of Financial Assets or Securities

Fixed-income or Debt o Money market instruments Bank certificates of deposit, T-bills, commercial paper, etc. o Bonds o Preferred stock Common Stock o Ownership stake in the entity o residual cash flow distributed as dividends Derivative Securities o A contract whose value is derived from the underlying asset.

Financial Markets
Informational Role of Financial Markets
o Information conveyed by financial markets play an important role in determining the future of corporations.
o The stock price of a corporation reflects the collective judgment of market analysts.


Consumption Timing
o People tend to smooth consumption over time.

o If one has more than enough cash to meet their basic needs in the current time period one might shift consumption through time by investing the surplus.


Allocation of Risk
o Allocation of Risk
Bonds versus stock of a given company
Which is riskier?

Tradeoff between risk and return


Separation of Ownership and Management

Large size of firms requires separation of ownership and management o In 2008 GE had over $800 billion in assets and over 650,000 stockholders o Owners (principals) Managers (agents) 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

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 Yahoos board and force the firm to accept Microsofts offer. He lost, and Yahoo stock fell from $29 to $21. Did Yahoo managers act in the best interests of their shareholders?

Corporate Governance and Corporate Ethics

Business and market require trust to operate efficiently o Without trust additional laws and regulations are required o All laws and regulations are costly Governance and ethics failures have cost our economy billions if not trillions of dollars. o Has eroded public support and confidence in market based systems


Corporate Governance and Corporate Ethics

Accounting Scandals o 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


Corporate Governance and Corporate Ethics

Sarbanes-Oxley Act o Increases the number of independent directors on company boards. o Requires the CFO to personally verify the financial statements o Created a new oversight board for the accounting/audit industry o Charged the board with maintaining a culture of high ethical standards

The Investment Process: 3 Steps o Asset Allocation

Choosing the percentage of funds in asset classes: Broad choice - Stocks, Bonds, Real Estate, Commodities, etc.

o Security Selection
Choosing specific securities within an asset class

o Security Analysis
oValuation of specific securities that may be considered for a portfolio


The asset allocation decision is the primary determinant of a portfolios return.

Discuss Top-down vs Bottom-up approach?


Markets Are Competitive

o Risk-return trade-off:
o Assets with higher expected returns have higher risk.
Average Annual Return Stocks About 12% Minimum (1931) -46% Maximum (1933) 55%

A stock portfolio can be expected to lose money about 1 out of every 4 years.

o 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.


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.


Active vs. Passive Management

Active Management (inefficient markets) Finding undervalued securities Security Selection Asset Allocation Timing the market
Passive Management (efficient markets) No attempt to find undervalued securities Indexing No attempt to time Constructing an Holding a diversified portfolio: efficient portfolio

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 o o o

Investment companies Insurance companies Pension funds Hedge funds


contd The Players

Investment Bankers
o Firms that specialize in primary market transactions
o Primary market:
A market where newly issued securities are offered to the public. The investment banker typically underwrites the issue.

o Secondary market
A market where pre-existing securities are traded among investors.


Investment Bankers
Investment Bankers o Commercial and investment banks functions and organizations were separated by law from 1933 to 1999.

o Post 1999 large investment banks, collectively known as Wall Street, operated independently from commercial banks, although many of the large commercial banks increased their investment banking activities, pressuring profit margins of investment banks.
o In September 2008 major investment banks either went bankrupt, reorganized as commercial banks or were purchased by commercial banks as a result of the collapse of the mortgage markets. 1-22

Investment Bankers
o Some investment banks chose to become commercial banks to obtain deposit funding and government assistance o All of the major investment banks are now under the much stricter commercial bank regulations.
What are the implications for innovation and capital issuance resulting from these changes?


Table 1.3 Balance Sheet of Commercial Banks, 2008


Table 1.4 Balance Sheet of Nonfinancial U.S. Business, 2008


Recent Trends
Globalization Securitization Financial Engineering Information and Computer Networks


Domestic firms compete in global markets Performance in one country or region depends on other regions Opportunities for better returns & implications for risk o Managing foreign exchange o International diversification reduces risk o Instruments and vehicles continue to develop (ADRs and WEBs) o Information and analysis improves

Loans of a given type such as mortgages are placed into a pool and new securities are issued that use the loan payments as collateral. The securities are marketable and are purchased by many institutions. Shadow banking system End result is more investment opportunities for purchasers, and spreading loan credit risk among more institutions


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, Credit enhancement provided by pool issuers has improved marketability.


Figure 1.1 Asset-backed Securities Outstanding


Financial Engineering
Repackaging cash flows of a security to enhance marketability Bundling and unbundling of cash flows o Bundling: Combining more than one asset into a composite security, for example securities sold backed by a pool of mortgages. o Unbundling Selling separate claims to the cash flows of one security, for example a CMO


Figure 1.2 Building a Complex Security


Figure 1.3 Mortgage Security


Computer Networks
Online low cost trading Information made cheaply and widely available Direct trading among investors via electronic communication networks What have been the effects on Wall Street firms profit margins? o How has Wall Street responded?


The Future
Globalization will continue and investors will have far more investment opportunities than in the past Securitization will continue to grow after the crisis Continued development of derivatives and exotics, more regulation for over the counter derivatives Strong fundamental foundation of understanding is critical Understanding corporate finance requires understanding investments