Chapter
1
Investments:
Background and Issues
Bodie, Kane, and Marcus
Essentials of Investments
12th Edition
Introduction
• What is an investment?
Commitment of current resources in the expectation of deriving greater
resources in the future
• You are making an investment taking this class: the current time you spend
and the cost you commit for the expectation of a higher salary job in the future
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1.1 Real versus Financial Assets
• Real assets
• Assets used to produce goods and services.
• Financial assets
• Claims on real assets or the income
generated by them.
• Financial assets simply define the allocation of
wealth among investors
Financial
Assets:
Claims on Real
Assets or Real
Asset Income
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Real
Assets
Productive
Capacity
Property,
plants and
equipment,
human
capital, etc.
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Table 1.1 Balance Sheet, U.S. Households, 2019
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1.1 Financial Assets = Financial Liabilities
• Financial Assets and Liabilities must balance
Financial Assets
(Owner of the
claim)
Financial Liability
(Issues of the Claim)
• Aggregated balance sheets  only real assets
remain
• Domestic Net Worth = Sum of real assets
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Table 1.2 Domestic Net Worth, 2019
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1.2 Broad Types of Financial Assets
• Fixed-income (debt) securities
• Pay a specified cash flow over a specific period
• Equity
• An ownership share in a corporation
• Derivative securities
• Securities providing payoffs that depend on the
values of other assets
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1.2 Broad Types of Financial Assets
Common Stock
Ownership stake in entity,
residual cash flow
Asset
Classes
Derivative Securities
Contract, value derived
from underlying market
condition
Since equity is tied more closely to
a firm’s real assets, it is considered
more risky than bonds
Fixed Income
Securities
Money market instruments,
Bonds, Preferred stock
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8
1.3 Financial Markets and the Economy
• Informational Role of Financial Markets
• Capital flow to companies with best prospects
• Market Price = Fair Value? (Not Always)
• Do markets allocate capital to best uses?
• Other mechanisms to allocate capital?
• Advantages/disadvantages of other systems?
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9
1.3 Financial Markets and the Economy
• Consumption Timing
• Use securities to store wealth
• Transfer consumption to the future
Dollars
• Consumption smoothed over time
Consumption
Surplus
Deficit
Deficit
Income
Age
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10
1.3 Financial Markets and the Economy
• Risk Allocation
• Investors select desired risk level
• Bond vs. company stock vs. cash
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11
1.3 Financial Markets and the Economy
• Separation of Ownership and Management
• Large firms require separation between principals & agents
• Separation  Agency Problems
• Ways to reduce Agency Problems:
• Performance-based compensation
• Boards of directors may fire managers
• Threat of takeovers
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12
1.3 Financial Markets and the Economy
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13
1.3 Financial Markets and the Economy
• An agency problem example:
• 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
• Proxy fight to seize control of Yahoo's board and force Yahoo to
accept offer
• Proxy failed; Yahoo stock fell from $29 to $21
• Did Yahoo managers act in the best interests of their shareholders?
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1.3 Financial Markets and the Economy
• Corporate Governance and Corporate Ethics
• Businesses and markets require trust to operate efficiently
• No trust  additional costly laws and regulations
• Governance and ethics failures cost the economy
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1.3 Financial Markets and the Economy
• Corporate Governance and Corporate Ethics
• Accounting scandals
• Enron, WorldCom, Rite-Aid, HealthSouth, Global
Crossing, Qwest
• Misleading research reports
• Citicorp, Merrill Lynch, others
• Auditors: Watchdogs or consultants?
• Arthur Andersen and Enron
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1.3 Financial Markets and the Economy
• Corporate Governance and Corporate Ethics
• The U.S. Securities and Exchange Commission (SEC)
passed the Sarbanes-Oxley Act (SOX):
• Requires more independent directors
• Requires CFO personally verifies the financial statements
• Created new oversight board for the accounting/audit industry
• Charged board to maintaining a culture of high ethical standards
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1.4 The Investment Process: Asset Allocation
• Asset Allocation
• Allocation of an investment portfolio across
broad asset classes.
• Primary determinant of a portfolio's return
• Percentage of fund in asset classes, for example:
10%
30%
60%
Equity
25% 25%
Bonds
Bills
50%
• Top Down Investment Strategies start with Asset
Allocation
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1.4 The Investment Process: Security Selection
• Security Selection
• Choice of particular securities within asset class
• Security Analysis
• Analysis of the value of securities
• Bottom up Investment strategies starts with
Security Selection
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1.5 Markets Are Competitive
• Risk-Return Trade-Off
• Higher expected returns  Higher risk
• Stock portfolios lose money an average of 25%
• Bonds
• Lower average rates of return (under 6%)
• Not lost more than 13% of value in any one year
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1.5 Markets Are Competitive
• Risk-Return Trade-Off
• How do we measure risk?
• How does diversification affect risk?
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1.5 Markets Are Competitive
• Efficient Markets:
Prices reflect all information available to investors
• Passive management
• Buying and holding a diversified portfolio
• No attempt to identify mispriced securities
• Active management
• Identify mispriced securities of forecast broad market trends
Your Belief in Market
Efficiency
Choice of InvestmentManagement Style
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1.5 Markets Are Competitive
Markets are…
Security Selection:
Asset Allocation
Active
Management
Passive
Management
Inefficient
Efficient
Actively Seeking
Undervalued
Stocks
No Attempt to Find
Undervalued
Securities
Market Timing
No Attempt to
Time Market
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1.6 The Players
• Business Firms (net borrowers): Raise capital now to pay for
investments
• Households (net savers): Purchase securities issued by firms
• Governments (can be both borrowers and savers)
• Financial Intermediaries (connecting borrowers & lenders)
•
•
•
•
•
Commercial banks
Investment companies
Insurance companies
Pension funds
Hedge funds
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1.6 The Players
• Investment Bankers
• Entities that specialize in primary market transactions
• Primary market
• Newly issued securities (with the help of investment banks)
offered to public
• Investment banker “underwrites” issue
• Secondary market
• Preexisting securities traded among investors (Example: Stock
Exchanges)
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Table 1.3 Balance Sheet of Commercial Banks, 2019
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Table 1.4 Balance Sheet of Nonfinancial U.S. Business, 2019
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1.6 The Players
• Venture Capital and Private Equity
• Venture capital
• Equity Investment to finance new firm
• Private equity
• Investments in privately-held companies
• Fintech and Financial Innovation
• Application of technology to financial markets
• Ex: cryptocurrencies and blockchain technology
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1.7 The Financial Crisis of 2008-2009
Changes in Housing Finance
Old Way
New Way
• Local bank institution made
mortgage loans to
homeowners
• A bank possessed a
portfolio of long-term
mortgage loans
• Bank’s main liability:
Deposits
• “Originate to hold”
• Securitization: Fannie Mae
and Freddie Mac bought
mortgage loans, bundled
them into large pools
• Mortgage-backed securities
are tradable claims against
the underlying mortgage
pool
• “Originate to distribute”
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1.7 Changes in Housing Finance
• Securitization
• Pooling loans into standardized securities back
by loans
• Can be traded like any other security
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1.7 The Financial Crisis of 2008-2009
• Mortgage Derivatives
• Collateralized Debt Obligation (CDO): Consolidated
default risk of loans onto one class of investor,
divided payment into tranches
• Ratings agencies paid by issuers; pressured to give
high ratings
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1.8 The Outline
• Part One: Introduction to Financial Markets,
Securities, and Trading Methods
• Part Two: Modern Portfolio Theory
• Part Three: Debt Securities
• Part Four: Equity Security Analysis
• Part Five: Derivative Markets
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