CHAPTER 1
Investments Background and Issues
McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Key Points
Real assets VS Financial assets
The role of financial assets
The main steps of investing
Market competitiveness
Participants in financial markets
2008 financial crisis
1-2
1.1 REAL ASSETS VERSUS
FINANCIAL ASSETS
1-3
Financial Versus Real Assets
Essential nature of investment
– Reduced current consumption (減少目前消費)
– Planned later consumption (增加未來的消費)
Real Assets (實質資產)
– Assets used to produce goods and services
– Examples: Land, buildings, machines,
knowledge used to produce goods and services
Financial Assets (金融資產)
– Claims on “real assets” or “real asset income”
1-4
Practices
Question 1: Are the following assets real
or financial?
a. Patents
b. Lease obligations
c. Customer goodwill
d. A college education
e. A $5 bill
1-5
Table 1.1
Balance Sheet, U.S. Households, 2014
Assets
Real assets
Real estate
Consumer durables
Other
$ Billion
% Total
$22,820
5,041
468
23.9%
5.3%
0.5%
Total real assets
$28,330
29.6%
Financial assets
Deposits
Life insurance reserves
Pension reserves
Corporate equity
Equity in noncorp. business
Mutual fund shares
Debt securities
Other
8,038
1,298
13,419
8,792
6,585
5,050
4,129
1,536
11.2%
1.8%
18.7%
12.2%
9.2%
7.0%
5.7%
2.1%
Total financial assets
TOTAL
48,847
71,932
67.9%
Liabilities and Net Worth
Mortgages
Consumer credit
Bank and other loans
Security credit
Other
Total liabilities
$ Billion
% Total
$9,551
3,104
493
13.3%
4.3%
0.7%
352
286
$13,785
0.5%
0.4%
19.2%
家戶單位實質與金融資產比
The ratio of real assets to financial assets
US約30：70
TW約45：55
Net worth
100.0%
58,147
$71,932
80.8%
100.0%
Note: Column sums may differ from total because of rounding error.
SOURCE: Flow of Funds Accounts of the United States, Board of Governors of the Federal Reserve System, June 2014.
1-6
Financial Assets = Financial Liabilities
• Financial Assets and Liabilities must balance.
Financial Assets
(Owner of the claim)
Financial Liability
(Issues of the Claim)
• Thus, when all balance sheets are
aggregated, only real assets remain
• Domestic Net Worth = Sum of real assets
1-7
Table 1.2
Domestic Net Worth, 2014
Assets
$ Billion
Commercial real estate
$20,092
Residential real estate
22,820
Equipment and software
7,404
Inventories
2,514
Consumer durables
5,041
TOTAL
$57,873
Note: Column sums may differ from total because of rounding error.
2006: $45,199
2008: $40,925
2011: $43,417
SOURCE: Flow of Funds Accounts of the United States, Board of Governors of the Federal
Reserve System, June 2014.
1-8
1.2 A TAXONOMY OF FINANCIAL ASSETS
1-9
Classes of Financial Assets
Common Stock
Ownership stake in entity,
residual cash flow
Asset
Classes
Derivative Securities
Contract, value derived
from underlying market
condition
Fixed Income
Securities
Money market instruments,
Bonds, Preferred stock
1-10
Debt (Fixed Income)
Payments fixed or determined by a
formula
Money market instruments(貨幣市場
工具): short term(≦ 1 year), highly
marketable, usually low credit risk
– Bank certificates of deposit
Capital market instruments(資本市場
工具): long term bonds, can be safe
or risky
– Bonds
1-11
Equity and Derivatives
Equity ( 股 權 ) is ownership ( 所 有 權 ) in a
corporation.
– common stock (普通股): Payments to stockholders are
not fixed, but depend on the success of the firm
– Preferred Stock (特別股): Holders have priority to get
fixed dividends, if the company fails to pay, it can be
accumulated to the next period, and there is no
problem of default and bankruptcy (it can also be
regarded as a fixed income securities)
– Derivatives (衍生性商品):Value derives from prices of
other securities, such as stocks and bonds
– Used to transfer risk (避險)
1-12
1.3 FINANCIAL MARKETS AND
THE ECONOMY
1-13
Financial Markets and the Economy
Informational Role of Financials
Markets
Consumption Timing
Allocation of Risk
Separation of Ownership and
Management (所有權與經營權分離)
– Agency Problems (代理問題)
1-14
Financial Markets and the Economy
• Informational Role of Financial Markets
• Do market prices equal the fair value estimate
of a security's expected future risky cash flows?
• Can we rely on markets to allocate capital to the
best uses?
• Other mechanisms to allocate capital?
• Advantages/disadvantages of other systems?
1-15
Financial Markets and the Economy
• Consumption Timing
• Consumption smoothes over time
• When current basic needs are met, shift
Dollars
consumption through time by investing surplus
Consumption
Savings
Dissavings
Dissavings
Income
Age
1-16
Financial Markets and the Economy
• Risk Allocation
• Investors can choose desired risk level
• Bond vs. stock of company
• Bank CD vs. company bond
• Is there always a Risk/Expected Return trade-off?
• Separation of Ownership and Management
• Large size of firms requires separate principals
and agents
1-17
Agency Problems
When separating management rights and ownership,
managers may consider self-interest and do things
that damage shareholders' rights and interests.
– Solution 1: Performance-based
compensation(將經理人的薪資與公司營運成
果或股價表現掛勾)
– Solution 2: Boards of directors may fire
managers(董事會的監督)
– Solution 3: Threat of takeovers (公開市場的監
督機制)
1-18
Financial Markets and the Economy
• Agency Problems: Example 1.1
• 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? (2017/6/15被美國電信巨頭威瑞
森(Verizon)併購時股價 $52.58)
1-19
Financial Markets and the Economy
• Corporate Governance and Corporate Ethics
• Businesses and markets require trust to operate
efficiently
• Without trust additional laws and regulations are
required
• Laws and regulations are costly
• Governance and ethics failures cost the economy
billions, if not trillions
• Eroding public support and confidence
1-20
Corporate Governance and Ethics
• Accounting scandals
• Enron (安隆), WorldCom, Rite-Aid,
HealthSouth, Global Crossing, Qwest
• Misleading research reports
• Citicorp, Merrill Lynch, others
• Auditors: Watchdogs or consultants?
• Arthur Andersen (安達信) in Enron Case
1-21
Corporate Governance and Ethics
• Sarbanes-Oxley Act(沙氏法案):
• Requires more independent directors on
company boards
• Requires CFO to personally verify the financial
statements
• Created new oversight board for the
accounting/audit industry
• Charged board with maintaining a culture of high
ethical standards
1-22
1.4 THE INVESTMENT PROCESS
1-23
The Investor’s Portfolio
Asset allocation (資產配置)
– Choice among broad asset classes
Security selection (證券選擇)
– Choice of which securities to hold within
asset class
– Security analysis to value securities and
determine investment attractiveness
Portfolio (投資組合): Top-Down & Bottom-Up
1-24
The Investment Process:
Asset Allocation
• Asset Allocation
• Primary determinant of a portfolio's return
• Percentage of fund in asset classes, for example:
10%
Equity
30%
60%
25%
25%
Bonds
Bills
50%
• Top-Down Investment Strategies starts with
Asset Allocation
1-25
The Investment Process:
Security Selection
• Security Selection
• Choice of particular securities within each asset
class
• Security Analysis
• Analysis of the value of securities.
• Bottom-Up Investment Strategies starts with
Security Selection
1-26
1.5 MARKETS ARE COMPETITIVE
1-27
Risk-Return Trade-Off
How should one measure risk
Assets with higher expected returns
have greater risk
What role does diversification play
1-28
Risk-Return Trade-Off
• Assets with higher expected returns have higher risk
Stocks
Average Annual Return
Minimum (1931)
Maximum (1933)
About 12%
−46%
55%
Namely, Mean = 12%; STD = (55% - -46%) / 6 = 16.8%
Pr( return < 0 ) = 24% (約每4年就有1年虧錢)
• Stock portfolio loses money 1 of 4 years on average
• Bonds
• Have lower average rates of return (under 6%)
• Have not lost more than 13% of their value in any
one year
1-29
Efficient Markets Theory
Securities should be neither
underpriced nor overpriced securities
Security price should reflect all
information available to investors
Your Belief in
Market
Efficiency
Choice of
InvestmentManagement
Style
1-30
Active Versus Passive Management
Active Management (積極型管理)
Finding undervalued securities
Timing the market
Passive Management (消極型管理)
No attempt to find undervalued
securities
No attempt to time
Holding an efficient portfolio
1-31
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
1-32
1.6 THE PLAYERS
1-33
The Players
Business Firms
Households
Governments
Financial Intermediaries
Investment Bankers
市場流通性
(Liquidity)
1-34
The Players (Ctd.)
Price of Capital
Business Firms– net borrowers(借>存)
Households – net savers(存>借)
Governments – can be both borrowers
and savers
Who Supplies Capital? Households
What Demands Capital? Firms
Quantity of Capital
1-35
The Players (Ctd.)
Financial Intermediaries: Connectors of
borrowers and lenders, who pool and
invest funds (集資&投資)
– Investment Companies
– Banks
– Insurance companies
– Credit unions(信用合作社)
– Pension funds
– Hedge funds
1-36
The Players (Ctd.)
Investment banking (投資銀行業)
– When a security is issued, an investment bank
evaluates the underwriting price, interest rate
level, etc., and then sells the security to the
public. ("underwrites" issue)
– Primary market: The market for the initial public
offering (IPO) of a security (初級市場)
– Secondary market: The market for buying and
selling securities that have been publicly issued
(次級市場).
1-37
Table 1.3
Balance Sheet of Commercial Banks, 2014
Assets
$ Billion
% Total
Real assets
Equipment and premises
Other real estate
Total real assets
Liabilities and Net Worth
$ Billion
% Total
Liabilities
$120.7
27.9
$148.6
0.8%
0.2%
1.0%
Deposits
Debt and other borrowed funds
Federal funds and repurchase agreements
Other
Total liabilities
$11,490.3
888.2
366.7
703.2
75.8%
5.9%
2.4%
4.6%
$13,448.4
88.7%
1,716.2
11.3%
$15,164.6
100.0%
Financial assets
Cash
Investment securities
Loans and leases
Other financial assets
Total financial assets
$1,843.1
3,113.1
8,111.2
870.3
12.2%
20.5%
53.5%
5.7%
$13,937.7
91.9%
$365.6
712.7
$1,078.3
2.4%
4.7%
7.1%
$15,164.6
100.0%
Other assets
Intangible assets
Other
Total other assets
TOTAL
Net worth
Note: Column sums may differ from total because of rounding error.
SOURCE: Federal Deposit Insurance Corporation, www.fdic.gov, Sept. 2014.
1-38
Table 1.4
Balance Sheet of Nonfinancial U.S. Business, 2014
Assets
Real assets
Equipment and software
Real estate
Inventories
Total real assets
Financial assets
Deposits and cash
Marketable securities
Trade and consumer credit
Other
Total financial assets
TOTAL
$ Billion
% Total
$6,200
17.7%
10,166
29.0%
2,203
6.3%
$18,569
53.1%
Liabilities and Net Worth
Liabilities
Bonds and mortgages
Bank loans
Other loans
Trade debt
Other
Total liabilities
$1,040
3.0%
838
2.4%
2,581
7.4%
11,969
34.2%
$16,428
46.9%
$34,997
100.0%
Net worth
$ Billion % Total
$7,905
22.6%
654
1.9%
1,072
3.1%
1,996
5.7%
4,275
12.2%
$15,902
45.4%
19,094
54.6%
$34,997
100.0%
Note: Column sums may differ from total because of rounding error.
SOURCE: Flow of Funds Accounts of the United States, Board of Governors of the Federal Reserve System, June 2014.
1-39
1.7 Financial Crisis of 2008
1-40
Financial Crisis of 2008
Antecedents of the Crisis:
– “The Great Moderation” (大平穩): After the
mid-1980s, the U.S. economic fluctuations
have a long-term stable trend. Important
economic variables such as real GDP growth
rate, inflation rate, unemployment rate and
other important economic variables can all
find that cyclical fluctuations have a stable
trend
– Historic boom in housing market (房市熱絡)
1-41
Jul-10
Jan-10
Jul-09
Jan-09
Jul-08
5
Jan-08
降息
cutting
interest
rates
Jul-07
Jan-07
Jul-06
Jan-06
Jul-05
Jan-05
6
Jul-04
7
Jan-04
8
Jul-03
Jan-03
Jul-02
Jan-02
Jul-01
Jan-01
Jul-00
Jan-00
Jul-99
Jan-99
Jul-98
Jan-98
Jul-97
Jan-97
Jul-96
Jan-96
Interest rates (%)
Figure 1.1 Short-Term LIBOR and Treasury-Bill
Rates and the TED Spread
3-month LIBOR
3-month T-bill
TED Spread
4
3
2
1
0
1-42
Figure 1.2 Cumulative Returns
50
40
30
20
10
0
1980
1984
1988
1992
1996
2000
2004
2008
2012
2016
Cumulative returns on a $1 investment in the S&P 500 index
1-43
2016
2014
2012
2010
2008
2006
2004
2002
2000
1998
1996
1994
1992
1990
Index (January 2000 = 100)
Figure 1.3
Case-Shiller Index of U.S. Housing Prices
250
200
150
100
50
0
1-44
Changes in Housing Finance
Old Way
Local thrift institution (地
性儲蓄機構) made
mortgage loans to
homeowners
Thrift’s major asset: a
portfolio of long-term
mortgage loans
Thrift’s main liability:
deposits
“Originate to hold”
New Way
Securitization: Fannie
Mae(房利美) and Freddie
Mac(房地美) bought
mortgage loans and
bundled them into large
pools
Mortgage-backed
securities(MBS, 抵押擔保
債保債券) are tradable
claims against the
underlying mortgage pool
“Originate to distribute”
1-45
Figure 1.4 Cash Flows in a Mortgage
Pass-Through Security
1-46
Changes in Housing Finance
(Ctd.)
At first, Fannie Mae and Freddie Mac
securitized conforming mortgages,
which were lower risk and properly
documented.
Later, private firms began securitizing
nonconforming “subprime” loans with
higher default risk.
– Little due diligence
– Placed higher default risk on investors
– Greater use of ARMs and “piggyback” loans
1-47
Mortgage Derivatives
Collateralized debt obligations (CDOs)
– Mortgage pool divided into slices or tranches
to concentrate default risk
– Senior tranches: Lower risk, highest rating
– Junior tranches: High risk, low or junk rating
1-48
Mortgage Derivatives
Problem: Ratings were wrong! Risk
was much higher than anticipated, even
for the senior tranches
1-49
Why was Credit Risk
Underestimated?
No one expected the entire housing
market to collapse all at once
Geographic diversification did not
reduce risk as much as anticipated
Agency problems with rating
agencies
Credit Default Swaps (CDS) did not
reduce risk as anticipated
1-50
Credit Default Swap (CDS)
A CDS is an insurance contract
against the default of the borrower
Investors bought sub-prime loans
and used CDS to insure their
safety
1-51
Credit Default Swap (CDS)
Some big swap issuers did not
have enough capital to back their
CDS when the market collapsed.
– AIG sold $400 billion in CDS contracts
Consequence: CDO insurance
failed
1-52
Rise of Systemic Risk
Systemic Risk: a potential breakdown of
the financial system in which problems in
one market spill over and disrupt others.
– One default may set off a chain of further
defaults
– Waves of selling may occur in a downward
spiral as asset prices drop
– Potential contagion from institution to
institution, and from market to market
1-53
Rise of Systemic Risk (Ctd.)
Banks had a mismatch between the
maturity and liquidity of their assets
and liabilities.
– Liabilities were short and liquid
– Assets were long and illiquid
– Constant need to refinance the asset portfolio
Banks were very highly levered, giving
them almost no margin of safety.
1-54
Rise of Systemic Risk (Ctd.)
Investors relied too much on “credit
enhancement” through structured
products like CDS
CDS traded mostly “over the
counter”, so less transparent, no
posted margin requirements
Opaque linkages between financial
instruments and institutions
1-55
The Shoe Drops
2000-2006: Sharp increase in housing
prices caused many investors to
believe that continually rising home
prices would bail out poorly performing
loans
2004: Interest rates began rising
2006: Home prices peaked
1-56
The Shoe Drops
2007: Housing defaults and losses on
mortgage-backed securities surged
2007: Bear Stearns announces trouble
at its subprime mortgage–related
hedge funds
1-57
The Shoe Drops
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
1-58
Systemic Risk and the Real Economy
Add liquidity to reduce insolvency risk and
break a vicious circle of valuation
risk/counterparty risk/liquidity risk
Increase transparency of structured
products like CDS contracts
Change incentives to discourage
excessive risk-taking and to reduce
agency problems at rating agencies
1-59
Dodd-Frank Reform Act
Called for stricter rules for bank capital,
liquidity, risk management
Mandated increased transparency
Clarified regulatory system
Volcker Rule: Limited banks’ ability to
trade for own account
1-60
1.8 Text Outline
Part 1: Introduction to Financial Markets,
Securities and Trading Methods
Part 2: Modern Portfolio Theory
Part 3: Debt Securities
Part 4: Equity Security Analysis
Part 5: Derivative Markets
Part 6: Active Investment Management
Strategies: Performance Evaluation,
Global investing, Taxes, and the
Investment Process
1-61