Investments (Hsin, C.)
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General classifications:
Chapter 1
• Real Investment - investment in “real asset”
• Real assets:
assets used to produce goods and services
e.g., machine, land, real estate. Property, plant &
equipment, human capital, etc
Investments –
Background and Issues
• Financial Investment - investment in “financial
asset”
– Financial assets:
• claims on real assets or claims on the income
generated by real assets
– e.g., bonds, stocks.
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Real Assets vs. Financial Assets
1.1 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.
• Investment, Real assets, and
Financial assets
• consuming today vs. investing
for the future
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Investment usually involves:
Investment:
initial cash outflow
<def.>
subsequent (uncertain) cash flows (CFs)
– A sacrifice of 'certain' 'present' cash
flows for certain/uncertain 'future'
cash flows.
Two attributes of cash flows generated from an
investment:
– Commitment of current resources in the
hope of deriving greater resources in the
future.
– (i) time - time of occurring for future CF's
– (ii) risk - uncertainty of future CF's
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Investments (Hsin, C.)
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e.g. Purchase a machine:
1.2 A TAXONOMY OF FINANCIAL
ASSETS
• Security:
– A legal representation of the right to
receive prospective future benefits under
stated conditions.
• Suppose the price of the machine is
$100,000. Are you going to buy it?
• You have to ask yourself some
questions.
- usually at least 2 parties involved:
capital
demander
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sec.


$
capital
supplier
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Q1: What are the projected future
(uncertain) cash flows?
e.g.
• GM (General Motors) bond
– capital demander
=
– capital supplier
=
– prospective benefit =
$12,000 over the next 3 years.
Also, we need to know:
 timing of expected cash flows
• GM common stock
– capital demander
=
– capital supplier
=
– prospective benefit =
0
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+-----------+-----------+-----------+
-100,000
3,000
4,000
5,000
Some types of financial assets can be transferred
from one owner to another, e.g., common stocks
and bonds.
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Three broad types of financial assets:
Q2: We need to evaluate the ‘quality’ of
these expected CF‘s
(1) Fixed Income Securities
(2) Equity Securities
(3) Derivatives
 the uncertainty or the risk of CFs
 determination of the “discount rate”.
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(1) Fixed Income Securities:
1.3 Financial Markets and
the Economy
- promises to pay a series of specified cash
flows over a specific period
- Fixed income securities promise either
- a fixed stream of income, or
- a stream of income that is determined
according to a specified formula.
- eg. Fixed rate bond, Preferred stocks, or
floating rate bond
- Unless the borrower is declared bankrupt,
the payment must be paid.
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– a.) Securities issued by government
e.g. Issued by US Department of Treasury
• Treasury Bills (T-Bills):
issued w terms to maturity < 1 yr (4, 13, 26, 52 wks) (no
coupons)
• Treasury Notes (T-Notes):
issued w terms to mat btw 2-10 yrs (coup)
• Treasury Bonds (T-bonds):
issued w terms to maturity 20-30 yrs
• Treasury Inflation Protected Securities (TIPS):
inflation-indexed bonds (1997).
principal is adjusted to CPI: CPI up -> Principal up
constant coupon rate -> variable interest payment
=> protecting against inflation rate
- Terms to maturities: 5, 10, 30 yrs
Financial Markets
• Informational Role of Financial Markets
o Market price = Fair Value ?
Do market prices equal the fair value estimate
of a security’s expected future risky cash
flows?
o Can we rely on markets to allocate capital to
the best uses?
• What other mechanism could we use to
allocate capital?
• What would be the advantages and
disadvantages of another system?
- Other examples: municipal bonds
b.) Corporate bonds
– issued by corporations
– pay par and, usually, int payments
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(2)
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equity:
Consumption Timing
• An ownership share in a corporation. Ownership stake
in the entity, residual cash flow
o People tend to smooth consumption over time.
– common stocks
– issued by corporations
– pay dividends, stockholders have voting rights.
(3)
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.
derivative securities:
• Securities providing payoffs that depend on the values
of other assets.
• A contract whose value is derived from some
underlying market condition.
– e.g. options and futures
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Investments (Hsin, C.)
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1.4 THE INVESTMENT PROCESS
Allocation of Risk
Suppose you have $1 million, what are
you going to do with the money?
o Investors can choose a desired risk level
• Bond vs. stock (of a given company)
• Portfolio:
a collection of investment assets
• Bank CD vs. company bond
• Tradeoff between risk and expected return?
→ update, rebalance periodically.
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Investors make two types of decisions in
constructing their portfolios:
Separation of Ownership and Management
(1) Asset allocation資產配置
• Large size of firms requires separation of
ownership and management
o Owners (principals) ≠ Managers (agents)
– Allocation of investment portfolio across broad
asset classes (stocks, bonds, money market)
 Money market assets
 Fixed-income securities
 Stocks
 International securities
 Real estate
 Precious metals and other commodities
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
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Corporate Governance and Corporate Ethics
(2) Security selection 選擇投資證券
– Choice of specific securities within each asset
classes.
• Business and market require trust to operate
efficiently
o No trust  additional laws and regulations are
required
o All laws and regulations are costly
– Security Analysis:
Analysis of the value of securities
 Fundamental analysis vs.
Technical analysis
• Governance and ethics failures cost the economy
o Eroding public support and confidence in
market based systems
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Risk-Return Trade- Off
• “top-down” approach:
– How do we measure risk?
– Asset allocation  Security selection
– How does diversification affect risk?
• “bottom-up” approach:
– Discussed in Part 2 of the text
– Security selection  Asset allocation
- The definition of “Risk” concerns with the
concept of “Diversification”:
- Mean-Variance portfolio theory
- relevant risk and expected return
• The asset allocation decision is the
primary determinant of a portfolio’s
return
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Efficient Markets
1.5 MARKETS ARE COMEPETITIVE
o Market efficiency:
o Securities should be neither underpriced nor
- Competition  few “free lunch”
(few highly under-priced securities)
overpriced on average
o Security prices should reflect all information
- Implications:
 Risk-return trade-off
 Assets with greater risk should have
higher expected returns.
available to investors
o Whether we believe markets are efficient
affects our choice of appropriate investment
management style.
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Risk-Return Trade- Off
Active vs. Passive management
Active management:
• Attempt to identify mis-priced securities and/or to forecast broad
market trends.
– Believe: market is inefficient
– Security selection: Actively seeking undervalued securities
– Asset Allocation: Timing the market (asset allocation)
 Frequent buy and sell assets

o Assets with higher expected returns have higher
risk.
Average Annual
Return
Stocks
About 12%
Minimum
(1931)
Maximum
(1933)
-46%
55%
 Passive management:
• Buy and hold a diversified portfolio without attempting to identify
mis-priced securities.
買入持有風險分散之投資組合，並不特意選擇價格被市場誤估之證券
– Believe: market is efficient
– Security selection: No attempt to find undervalued securities
– Asset Allocation: No attempt to time the market
 Holding an efficient portfolio:
• Indexing, Constructing an “efficient” portfolio
o Stocks: a stock portfolio can be expected to lose
money about 1 out of every 4 years.
o Bonds:
‐ much lower average rate of return (under 6%)
‐ have not lost more than 13% of their value in
any one year.
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Investments (Hsin, C.)
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1.6 THE PLAYERS
Advantages of financial intermediaries:
Major players:
 by pooling the resources of many small
 Firms: net borrowers (capital demanders)
(receive $capital from investors)
investors, they are able to lend considerable
sums to large borrowers.
 Households: net savers (capital suppliers)
(provide $ in the market)
 by lending to many borrowers, f.i. achieve
 Governments: can be borrowers or lenders,
depending on the relationship between tax
revenue and government expenditures. (if
deficits, then borrowers)
significant diversification (e.g. mutual fund)
 f.i. build expertise through the volume of
business they do and can use economies of
scale to assess and monitor risk.
 Financial Intermediaries: Connectors of
borrowers and lenders
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• Corporations and governments do not sell all or
even most of their securities directly to
“individual investors”.
Investment Companies:
Firms managing funds for investors. An
investment company may manage
several mutual funds.
• Many of the stocks and bonds are held by
“institutional investors”
e.g. mutual funds, pension funds, banks and
insurance companies
• These financial institutions stand between the
security issuer (the firm) and the ultimate
owner of the security (the individual investor):
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Financial Intermediaries
Investment Bankers:
 Firms specializing in the sales of new securities to the
public, typically by underwriting (承銷) the issue.
 Institutions that connect borrowers and
lenders by accepting funds from lenders and
loaning funds to borrowers
o Commercial Banks
• Traditional line of business: Make loans funded
by deposits
o Insurance companies
o Pension funds
o Hedge funds
o bank, mutual fund companies
• Primary market 初級市場 (發行市場):
– A market where newly issued securities are offered to
the public.
• The investment banker typically ‘underwrites’ the issue.
• Secondary market 次級市場:
– A market where pre-existing securities are traded
among investors.
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Investments (Hsin, C.)
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1.7 RECENT TRENDS
MARKETS AND MARKET STRUCTURE
 Globalization
Four types of markets (evolving upwards)
 Tendency towards a worldwide investment
environment, and the integration of national
capital market.
 examples:
1. Direct Search Market: least organized market.
– Buyers and sellers must seek each other out
directly. (e.g. sell a used textbook)
2. Brokered Markets
Depository Receipts (存託憑證)
 ADRs (American Depository Receipts) shares
of foreign stocks traded in US
 TDR, GDR
仲介市場
purchase foreign securities
buy mutual funds that invest internationally
buy derivatives with payoffs that depend on
prices in foreign security market.
– In markets where trading is active, brokers find
it profitable to offer services to buyers and
sellers. (e.g. real estate market)
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3. Dealer Markets:
 Securitization
經紀人市場
 Pooling loans into standardized securities backed by those
loans, which can then be traded like any other securities.
– A market where traders specializing in
particular assets, buy and sell for their own
accounts. (e.g. OTC markets)
4. Auction Markets
 Financial Engineering
•
•
拍賣市場
– A market where all traders in a good meet
at one place to buy or sell an asset. (e.g.
NYSE or TSE)
• Advantage: need not search across
dealers to find the best price
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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
- A trend allowing creation of securities either by combining
primitive and derivative securities into one composite hybrid
or by separating returns on an asset into classes.
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• Computer Networks
1.7 RECENT TRENDS
• Globalization
• Online low cost trading
• Information made cheaply and widely available
• Direct trading among investors via electronic
communication networks
• Securitization
• Financial Engineering
• Information and Computer Networks
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