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Chapter 1
The Investment Environment
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Chapter Overview
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Real Assets versus Financial Assets
Risk-return trade-off and efficient pricing
Financial crisis 2008
– Financial system  “Real” economy
– Systemic risk
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Investments
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AN INVESTMENT is the current commitment of
money or other resources in the expectation
of reaping future benefits
Save now, hope to consume more later
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Real Assets Versus Financial Assets
Real Assets
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Financial Assets
Have Productive Capacity
Examples: Land, buildings,
machines, intellectual property
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Claims on real assets
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Do not contribute directly to productive
capacity
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Examples: Stocks, bonds
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Financial Assets
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Financial Assets: Claims on Real Assets
– Fixed-Income Securities: Promises a fixed
stream of income or a stream of income
determined by a specified formula; debt
– Equity: Represents ownership share in a
corporation; common Stock
– Derivatives: Provide payoffs that are
determined by the prices of other assets
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Other Types of Investment
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Investment in currency
Commodity futures
– Corporations invest in the commodity futures to
hedge the risk
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Financial Markets and the Economy
(1 of 4)
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Capital / resource allocation through markets
The Informational Role
Consumption Timing
Allocation of Risk
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Financial Markets and the Economy
(2 of 4)
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Separation of Ownership and Management
– Agency Problems:
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Managers’ interests vs. owners’ interests
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Financial Markets and the Economy
(3 of 4)
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Mechanisms to mitigate Agency Problems:
– Tie managers' income to the success of the firm
– Monitoring from the board of directors
– Monitoring by large investors and security
analysts
– Activist investor
– Takeover threat
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Financial Markets and the Economy
(4 of 4)
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Corporate Governance and Corporate Ethics
– Accounting Scandals
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Enron, WorldCom
– Auditors: Watchdogs
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Arthur Andersen (consulting and auditing for
Enron)
– Analyst Scandals
– Sarbanes-Oxley Act
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Corporate governance rules (2002)
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The Investment Process (1 of 2)
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Portfolio: Collection of investment assets
– Create, update/rebalance
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Asset allocation
– Choice among broad asset classes
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Security selection
– Choice of securities within each asset class
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The Investment Process (2 of 2)
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“Top-down” approach
– Asset allocation followed by security analysis
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“Bottom-up” approach
– Investment based solely on the priceattractiveness
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Markets Are Competitive (1 of 3)
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Risk-Return Trade-Off
Higher-risk assets are priced to offer higher
expected returns than lower-risk assets
Risk and expected return are positively
correlated
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Markets Are Competitive (2 of 3)
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Efficient Markets
Efficient markets: prices quickly adjust to all
relevant information
There should be neither underpriced nor
overpriced securities
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Markets Are Competitive (3 of 3)
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Passive Management
– Holding a highly diversified portfolio
– No attempt to find undervalued securities
– No attempt to time the market
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Active Management
– Finding mispriced securities
– Timing the market
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The Players (1 of 2)
Role of Government?
Can be either borrowers or lenders
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The Players (2 of 2)
Financial Intermediaries: Pool and invest
funds, connecting the suppliers of capital with
the demanders of capital
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Investment Companies
Banks
Insurance companies
Credit unions
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Universal Bank Activities
Investment Banking
Commercial Banking
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Underwrite new securities issues
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Sell newly issued securities to
public in the primary market
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Take deposits and make loans
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Financial Crisis of 2008 (1 of 3)
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Antecedents of the Crisis:
– “The Great Moderation”
– Historic boom in housing market
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“The Big Short”, Michael Lewis
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Financial Crisis of 2008 (2 of 3)
“The Great Moderation”
Figure 1.2 Cumulative returns on the S&P 500 index
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Financial Crisis of 2008 (3 of 3)
Historic boom in housing market
Figure 1.3 The Case-Shriller Index of U.S. housing prices
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Figure 1.1 Short-Term LIBOR and
Treasury-Bill Rates and the TED
Spread
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Changes in Housing Finance (1 of 2)
Old Way
New Way
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Local thrift institution made
mortgage loans to
homeowners
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Securitization: Fannie Mae and Freddie
Mac bought mortgage loans and bundled
them into large pools
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Thrift’s possessed a portfolio
of long-term mortgage loans
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Mortgage-backed securities are tradable
claims against the underlying mortgage
pool
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Thrift’s main liability:
Deposits
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“Originate to hold”
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“Originate to distribute”
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Changes in Housing Finance (2 of 2)
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Securitization:
Inclusion of nonconforming “subprime” loans
Low/No-documentation loans
Rising loan-to-value ratio
Adjustable-Rate Mortgages
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Figure 1.4 Cash Flows in a Mortgage
Pass-Through Security
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Mortgage Derivatives
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Collateralized debt obligations (CDOs)
– Mortgage pool divided into tranches to
concentrate default risk:
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Senior tranches:
Junior tranches:
– Ratings significantly underestimated risk
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Why Was Credit Risk
Underestimated?
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Default probabilities were misestimated
Geographic diversification did not reduce risk
sufficiently
Agency problems with rating agencies
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Credit Default Swap (CDS)
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A CDS is an insurance contract against
borrower default
– Investors bought sub-prime loans and CDSs
– Some big swap issuers did not have enough
capital to back their CDSs
– This lack of capital resulted in the failure of
CDO insurance
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Rise of Systemic Risk (1 of 3)
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Systemic Risk:
– One default triggers
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Further Defaults
Further Defaults
Further Defaults
– Waves of selling  downward spiral as asset
prices drop
– Potential contagion
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Rise of Systemic Risk (2 of 3)
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Banks mismatched maturity/liquidity of their
assets and liabilities:
– Liabilities were short and liquid
– Assets were long and illiquid
– Constant need to refinance
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Banks: highly leveraged  no margin of safety
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Rise of Systemic Risk (3 of 3)
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Investors relied too much on credit
enhancement through structured products
CDS traded mostly over-the-counter
– No posted margin requirements
– Little transparency
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Opaque linkages between instruments and
institutions
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The Shoe Drops (1 of 2)
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2004: Interest rates began rising
2006: Home prices peaked
2007: Housing defaults and losses on
mortgage-backed securities surged
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The Shoe Drops (2 of 2)
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2008: Troubled firms include Bear Stearns,
Fannie Mae, Freddie Mac, Merrill Lynch,
Lehman Brothers, and AIG
– Money market breaks down
– Credit markets freeze up
– Federal bailout to stabilize financial system
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The Dodd-Frank Reform Act
Mechanisms to Mitigate Systemic
Risk
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Mechanisms to mitigate systemic risk
– Stricter rules for bank capital, liquidity, and risk
management practices
– Increased transparency, especially in
derivatives markets
– Office of Credit Ratings within the SEC to
oversee the credit rating agencies
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End of Presentation
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