Chapter One
The Investment
Environment
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Chapter Overview
• 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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Real Assets vs. Financial Assets
Real Assets
Financial Assets
• Have Productive Capacity
• Claims on real assets
• Do not contribute directly
to productive capacity
• Examples: Land, buildings,
machines, intellectual
property
• Examples: Stocks, bonds
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Financial Assets
Financial Assets: Claims on Real Assets
Fixed-Income Securities:
Equity:
Promises a fixed stream of income
or a stream of income determined
by a specified formula; debt
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
• 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)
• The Informational Role
• Capital flows to companies with the best
prospects
• Consumption Timing
• Use securities to store wealth and transfer
consumption to the future
• Allocation of Risk
• Investors can select securities consistent with
their tastes for risk
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Financial Markets and the Economy
(2 of 4)
• Separation of Ownership and Management
• Agency Problems: arise when managers start
pursuing their own interests instead of maximizing
the firm's value
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Financial Markets and the Economy
(3 of 4)
• 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
• Takeover threat
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Financial Markets and the Economy
(4 of 4)
• Corporate Governance and Corporate Ethics
• Accounting Scandals
• Enron, Rite Aid, HealthSouth
• Auditors: Watchdogs
• Analyst Scandals
• Arthur Andersen
• Sarbanes-Oxley Act
• Corporate governance rules
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The Investment Process
(1 of 2)
• Portfolio: Collection of investment assets
• Asset allocation
• Choice among broad asset classes
• Security selection
• Choice of securities within each asset class
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The Investment Process
(2 of 2)
• “Top-down” approach
• Asset allocation followed by security analysis to
evaluate which particular securities to be included
in the portfolio
• “Bottom-up” approach
• Investment based solely on the priceattractiveness, which may result in unintended
heavy weight of a portfolio in only one or another
sector of the economy
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Markets Are Competitive
(1 of 3)
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
Think: Expected Returns are compensation for
accepting the discomfort of higher risk.
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Markets Are Competitive
(2 of 3)
Efficient Markets
• Efficient markets: prices quickly adjust to all
relevant information
• There should be neither underpriced nor
overpriced securities
Think: Which markets will tend to be more
efficient? Less Efficient? Are there consistent
markers for efficiency?
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Markets Are Competitive
(3 of 3)
• 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
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The Players
Price of Capital
(1 of 2)
Who Supplies Capital? Households
What Demands Capital? Firms
Quantity of Capital
Role of Government?
Can be either borrowers or lenders
Think: Is the relationship between price and quantity of capital any different than
any other supply/demand curve?
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The Players
(2 of 2)
• Financial Intermediaries: Pool and invest funds
•
•
•
•
Investment Companies
Banks
Insurance companies
Credit unions
Think: Why are they called intermediaries?
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Universal Bank Activities
Investment Banking
• Underwrite new
securities issues
Commercial Banking
• Take deposits and make
loans
• Sell newly issued
securities to public in the
primary market
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Financial Crisis of 2008
(1 of 3)
• Antecedents of the Crisis:
• “The Great Moderation” : A time in which the U.S.
had a stable economy with low interest rates and
a tame business cycle with only mild recessions
• Historic boom in housing market
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Financial Crisis of 2008
(2 of 3)
“The Great Moderation”
A time in which the U.S. had a stable economy with low interest rates and a tame business cycle
with only mild recessions
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Short-Term LIBOR and
Treasury-Bill Rates and the TED Spread
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Financial Crisis of 2008
(3 of 3)
Historic boom in housing market
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Changes in Housing Finance
(1 of 2)
Old Way
New Way
• Local thrift institution made
mortgage loans to
homeowners
• Thrift’s possessed a portfolio
of long-term mortgage loans
• Thrift’s main liability: Deposits
• Securitization: Fannie Mae and
Freddie Mac bought mortgage
loans and bundled them into
large pools
• Mortgage-backed securities
are tradable claims against the
underlying mortgage pool
• “Originate to hold”
• “Originate to distribute”
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Changes in Housing Finance
(2 of 2)
• Securitization: Buying mortgage loans from originators
and bundling them into mortgage-backed securities
• Inclusion of nonconforming “subprime” loans
• Low/No-documentation loans
• Rising loan-to-value ratio
• Adjustable-Rate Mortgages
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Cash Flows in a Mortgage PassThrough Security
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Mortgage Derivatives
• Collateralized debt obligations (CDOs)
• Mortgage pool divided into tranches to
concentrate default risk:
• Senior tranches:
• Junior tranches:
• Ratings significantly underestimated risk
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Why Was Credit Risk
Underestimated?
• Default probabilities were misestimated
• Geographic diversification did not reduce risk
sufficiently
• Agency problems with rating agencies
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Credit Default Swap (CDS)
• 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)
• Systemic Risk: A potential breakdown of the
financial system in which problems in one market
spill over and disrupt others.
Further Defaults
Further Defaults
• One default triggers
Further Defaults
• Waves of selling  downward spiral as asset prices
drop
• Potential contagion
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Rise of Systemic Risk
(2 of 3)
• Banks mismatched maturity/liquidity of their
assets and liabilities:
• Liabilities were short and liquid
• Assets were long and illiquid
• Constant need to refinance
• Banks: highly leveraged  no margin of safety
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Rise of Systemic Risk
(3 of 3)
• Investors relied too much on credit
enhancement through structured products
• CDS traded mostly over-the-counter
• No posted margin requirements
• Little transparency
• Opaque linkages between instruments and
institutions
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The Shoe Drops
(1 of 2)
• 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)
• 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
• 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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