Chapter 1
The investment environment
Investments and Portfolio Management
Readings
BKM, chapter 1
2
Investment
a current commitment of resources in the
expectation of obtaining future benefits
3
Real assets versus financial assets
Real assets
Financial assets
Assets used to produce
goods and services
(e.g., land, buildings,
machines, knowledge)
Claims on real assets or
the income they
generate (e.g., bonds
and stocks)
4
Real assets versus financial assets
Investment
decision
Purchase of real assets
Financing
decision
Sale of financial assets
5
Investment decision
Capital budgeting decision
• Decision to invest in tangible or intangible
assets
• Criteria for evaluating investment decisions
• Risk
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Financing decision
A corporation can raise money from lenders or shareholders
• If it borrows, the corporation promises to pay back the
debt plus interest to the lenders
• If the shareholders put up the cash, they get no fixed
return, but they hold shares of stock and therefore get
a fraction of future profits
• The shareholders are equity investors
• The choice between debt and equity financing is called
the capital structure decision
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Flow of cash between financial markets and the firm’s operations
(2)
Firm’s
operations
(a set of real
assets)
(3)
(1)
Financial
manager
(4)
(5)
Financial
markets
(investors holding
financial assets)
(1) Cash raised by selling financial assets to investors
(2) Cash invested in the firm’s operations and used to purchase real assets
(3) Cash generated by the firm’s operations
(4) Cash reinvested
(5) Cash returned to investors
8
In what do we invest in?
Major classes of
financial assets
Debt (fixed income
securities)
Stocks (equity)
Derivatives
9
Fixed income securities
Debt securities - Payments are fixed or determined by a
formula that depends on interest rates
•
A corporate bond typically promises that the bondholder
will receive a fixed amount of interest each year
•
Floating rate bonds promise payments that depend on
current interest rates (e.g., a bond may pay an interest
rate that is fixed at 2% points above the rate paid on US
Treasury Bills)
•
Unless the borrower goes bankrupt, the payments on
these securities are certain (either fixed or determined by
a formula)
10
Fixed income securities
Fixed income securities come in a variety of maturities
Money market debt
Capital market debt
Refers to securities that
are short term, highly
marketable, and usually
of low credit risk (e.g.,
Treasury Bills)
Includes long term bonds
(such as Treasury bonds or
corporate bonds)
Range from safe in terms of
default risk (e.g., Treasury
bonds) to relatively risky
(e.g., junk bonds)
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Common stock or equity
Represents ownership in a corporation
•
Equityholders are not promised any particular
payment
•
Payments to stockholders – dividends – are not fixed,
but depend on the success of the firm
•
If the firm is successful, the value of equity will
increase; otherwise, it will decrease
•
Since the performance of equity investments is tied to
the success of the firm, equity securities tend to be
riskier than debt securities
12
Derivative securities
Value derives from prices of other assets (e.g.,
stocks)
Used to hedge risk
E.g., options and futures
13
Derivative securities
Futures
An agreement made today regarding the delivery of an
asset (or its cash value) at a specified delivery or maturity
date for an agreed-upon price, called the futures price, to
be paid at contract maturity
• Long position: held by the trader who commits to
purchasing the asset on the delivery date
• Short position: held by the trader who commits to
delivering the asset at contract maturity
14
Derivative securities
Options
A call option gives its holder the
right to purchase an asset at a
specified exercise price on or
before some expiration date.
A put option gives its holder
the right to sell an asset at a
specified exercise price on or
before some expiration date.
Long position on calls: higher
profits when spot prices rise
Long position on puts: higher
profits when spot prices fall
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Derivative securities
Options
Right, but not obligation, to
buy or sell; option is exercised
only when it is profitable
The premium is the price of
the option itself.
Futures
Obliged to make or take
delivery. Long position must
buy at the futures price, short
position must sell at futures
price
Futures contracts are entered
into without cost
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Financial markets and the economy
Roles of financial markets
informational role
consumption timing
risk allocation
separation of ownership and management
agency problems
17
Agency problems
Forms of business organization
Sole proprietorship
Partnership
Corporation
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Agency problems
Corporation
Separation of ownership and management
Advantages?
Disadvantages?
19
What is the goal of financial management?
Maximize firm value
20
Agency problems
Shareholders desire wealth maximization of the firm
Do managers maximize shareholder wealth?
Agency problems represent the conflict of interest
between management and owners
Managers, acting as agents for stockholders, may act
in their own interests rather than maximizing value
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Mechanisms to mitigate potential
agency problems
Compensation plans that tie the income of
managers to the success of the firm
Monitoring from the board of directors
Monitoring by large investors and security analysts
Threat of takeover for poor performers
22
Do market prices equal the fair-value estimate of a
security’s expected future risky cash flows, all of the
time, some of the time or none of the time?
Informationally efficient
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Can we rely on markets to allocate capital
to the best uses?
Allocation efficiency
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Corporate governance and
corporate ethics
Markets can only be informationally efficient
and allocate capital efficiently
if they receive accurate information
25
Corporate governance and
Financial Markets and the Economy
corporate ethics
Accounting Scandals
WorldCom, Enron, Parmalat
Role of auditors / Analyst scandals
Arthur Andersen
International Financial Crisis (2007/2008)
Regulation
Sarbanes-Oxley Act (2002)
Dodd Frank Act (2010)
26
Corporate governance and
corporate ethics
Governance and ethics failures
Erode investors’ trust
Without trust additional laws and regulations are required
27
Portfolio management concepts
Portfolio
Collection of investment assets
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Portfolio management concepts
Asset allocation
Choice among broad asset classes
(e.g., money market, stocks, bonds,
real estate, etc.)
Security selection
Choice of securities
within each asset class
29
Portfolio management concepts
Asset allocation
Security Selection
30
Markets are competitive
risk vs return
risk/return tradeoff
31
Markets are competitive
risk vs return
How do we measure risk?
What is the relationship
between expected return and
risk?
32
Markets are competitive
risk vs return
Can we reduce risk?
…yes, by diversifying
33
Markets are competitive
efficient markets
active vs passive
34
Financial market players
Lenders
Borrowers
Financial
Intermediaries
Financial Instruments
35
Financial market players
Companies (net demanders of capital)
Households (net suppliers of capital)
Governments
Financial intermediaries
36
Financial market players
Financial Intermediaries
Stand between security issuers and investors
Bring lenders and borrowers together
E.g., banks, investment companies, insurance
companies
37
Financial market players
Investment banking
Specialize in the sale of new
securities to the public, typically
by underwriting the issue
Commercial banking
Take deposits and make loans
Sell newly issued securities to
public in the primary market
Investors trade previously issued
securities among themselves in
the secondary market
38
Financial market players
Venture capital (VC)
Money invested to finance a new, not yet publicly traded
firm.
VC Investors commonly take an active role in the
management of a start-up firm
Private equity
Investments in companies whose shares are not publicly
traded in a stock market
39
Financial market players
Mutual Funds
Pooled, regulated, and professionally managed money
open to the public.
Hedge funds
Pooled, private, and professionally managed money
open only to institutional investors or wealthy
individuals.
40
Financial market players
Fintech and financial innovation
“Fintech is the application of technology to provide
new and improved financial services.”
Thakor (2020,p.1)
Technology that allows individuals to interact
directly has been the source of some financial
disintermediation.
41
Thakor (2020,p.1)
Source: Thakor (2020)
42
Financial market players
Fintech and financial innovation
• Peer-to-peer lending: Links lenders and borrowers
directly
• Robo advice
• Blockchains: Provide record of transactions securely
added to a public distributed ledger.
• Cryptocurrency: Payment systems that use blockchain
technology.
43
The fintech industry
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