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Chapter 1
The Investment
Environment
INVESTMENTS
THIRTEENTH EDITION
BODIE, KANE, MARCUS
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Chapter Overview
Real assets versus financial assets.
Risk–return trade-off and efficient pricing of financial assets.
Financial Institutions and Players.
Financial crisis of 2008–2009.
• Illustrated connections between financial system and “real”
side of the economy.
• Lessons about systemic risk.
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Real Assets Versus Financial Assets
Real Assets.
• Used to produce goods
and services.
• Can be tangible or
intangible.
• Have innate productive
capacity.
• Examples:, Buildings,
land, machines, and
intellectual property.
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Financial Assets.
• Claims to the income
generated by real assets
or claims on income from
the government.
• Do not directly contribute
to the productive capacity
of the economy.
• Examples: Stocks and
bonds.
3
Types of Financial Assets
Fixed-income/Debt securities.
• Promises either a fixed stream of income or a stream of
income determined by a specified formula (e.g., corporate
bond).
Equity.
• Represents ownership share in a firm (e.g., common
stock).
Derivative securities.
• Payoff depends on the value of other financial variables
such as stock prices, interest rates, or exchange rates.
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Other Types of Financial Markets
Currency.
• $2 trillion of currency traded each day in London alone.
• Worldwide trading volume exceeds $6 trillion.
Commodities.
• For example, corn, wheat, and natural gas.
• Multiple exchanges including the New York Mercantile
Exchange and the Chicago Board of Trade.
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Table 1.1 Balance Sheet of U.S.
Households
Assets
$Billion
% total
Liabilities and Net Worth
Real assets
Real estate
24.40%
Mortgages
Consumer durables
6362
4.10%
Other
679
$44,599
$11,331
7.40%
Consumer credit
4,163
2.70%
0.40%
Bank and other loans
1,125
0.70%
28.90%
Other
624
0.40%
Total liabilities
$17,244
11.20%
Net worth
136,917
88.80%
$154,161
100.00%
Financial assets
Deposits and money market shares
% total
Liabilities
$37,558
Total real assets
$Billion
$17,374
11.30%
Life insurance reserves
1,854
1.20%
Pension reserves
29,876
19.40%
Corporate equity
28,285
18.30%
Equity in noncorporate business
13,114
8.50%
Mutual fund shares
11,661
7.60%
Debt securities
5,772
3.70%
Other
1,626
1.10%
Total financial assets
$109,562
71.10%
TOTAL
$154,161
100.00%
Table 1.1
Balance sheet of U.S. households
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 2021.
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Table 1.2 Domestic Net Worth
Assets
$ Billion
Commercial real estate
$20,842.9
Residential real estate
45,816.3
Equipment & intellectual property
10,316.2
Inventories
2,944.5
Consumer durables
6,361.9
TOTAL
$ 86,282
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 2021.
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Financial Markets and the Economy
1
The Informational Role.
Consumption Timing.
Allocation of Risk.
Separation of Ownership and Management.
• Agency problems: Conflicts of interest between
managers and owners (shareholders).
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Financial Markets and the Economy
2
Mechanisms to mitigate potential agency problems.
• Compensation plans 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.
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Financial Markets and the Economy
3
Corporate Governance and Corporate Ethics.
Accounting scandals.
• Enron, Rite Aid, HealthSouth.
Auditing scandals.
• Arthur Andersen (Enron’s auditor).
Sarbanes–Oxley Act (aka “SOX”).
• Passed in 2002 in response to ethics scandals.
• Focused on corporate governance.
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The Investment Process
1
Portfolio: Collection of investment assets.
Asset allocation:
• Choice among broad asset classes.
• For example: stocks, bonds, real estate, and so on .
etera
Security selection.
• Choice of securities within each asset class.
• For example: Ford, Alphabet, Microsoft, General Mills, and
so on .
etera
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The Investment Process
2
Security analysis involves the valuation of particular
securities that might be included in the portfolio.
“Top-down” approach.
• Asset allocation followed by determination of particular
securities to be held in each asset class.
“Bottom-up” approach.
• Investment based on attractively priced securities without
as much concern for asset allocation.
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Markets Are Competitive
1
Financial markets are highly competitive.
There will almost always be risk associated with investments.
Risk–return trade-off: Higher-risk assets are priced to offer
higher expected returns than lower-risk assets.
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Markets Are Competitive
2
You should rarely expect to find bargains in the security
markets.
Efficient market hypothesis.
• The prices of securities fully reflect available information.
• If true, there would exist neither underpriced nor
overpriced securities.
• Chapter 11 presents the theory and evidence of the
efficient market hypothesis (EMH).
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Markets Are Competitive
3
Passive management.
• Highly diversified portfolio.
• No attempt to improve investment performance by
identifying mispriced securities.
Active management.
• Focus on improving performance by finding mispriced
securities or by timing the performance of broad asset
classes.
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The Players
1
1. Firms.
• Net demanders of capital.
• Raise capital now to pay for investments in plant and
equipment.
2. Households.
• Typically, net suppliers of capital.
• Purchase securities issued by firms that need to raise
funds.
3. Governments.
• Can function as borrowers or lenders, depending on the
relationship between tax revenue and government
expenditures.
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The Players
2
Financial intermediaries bring the suppliers of capital
(investors) together with the demanders of capital (primarily
corporations and the federal government).
Examples.
• Investment companies.
• Banks.
• Insurance companies.
• Credit unions.
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The Players
3
Investment bankers: Specialize in the sale of new securities
to the public.
• Typically, by underwriting the issue.
• Advise the issuing corporation on appropriate price,
interest rates, and so on .
etera
Primary Market: Market where new issues of securities are
offered to the public for the first time.
Secondary Market: Market where investors trade previously
issued securities among themselves.
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Fintech, Financial Innovation, and
Decentralized Finance
Fintech is the application of technology to financial markets.
Led to some financial disintermediation.
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.
• Digital Tokens: Issued in an initial coin offering and can
eventually be used to purchase products or services form the
start-up.
• Digital Currency: Sovereign cryptocurrency.
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The Players
4
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.
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The Players
5
Venture capital (VC): Professionally managed money
invested in new, not yet publicly traded firm.
• VC investors commonly take an active role in the
management of a start-up firm.
Private equity refers to investments in companies whose
shares are not publicly traded in a stock market.
• Examples: venture capital, buyout funds (professionally
managed money that enlists debt to take public firms
private).
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The Financial Crisis of 2008
Antecedents of the Crisis.
Fed response to high-tech bubble of 2000 to 2002 was an
aggressive reduction in interest rates.
• T-bill rates dropped drastically between 2001 and 2004.
• The recession was mild and brief→ the “Great Moderation.”
Historic boom in housing market resulted from seemingly
stable economy and dramatically reduced interest rates.
• Greater tolerance for risk, such as securitized mortgages.
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Changes in Housing Finance
1
Old Way
New Way
• Mortgage loans came from
a local lender—a
neighborhood savings
bank or credit union.
• Securitization: The pooling
of loans into standardized
securities backed by those
loans; can be traded like
any other security.
• Typical thrift institution
would have as its major
asset a portfolio of these
long-term home loans.
• Thrift’s main liability were
depositors’ accounts.
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• Fannie Mae and Freddie
Mac became the
behemoths of the
mortgage market.
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Figure 1.1 Short-Term LIBOR and
Treasury-Bill Rates and the TED Spread
Access the text alternative for slide images.
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Figure 1.3 The Case–Shiller Index of U.S.
Housing Prices
Source: Case Shiller Composite Housing Price Index, www.us.spindices.com.
Access the text alternative for slide images.
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Changes in Housing Finance
2
Conforming mortgages were pooled almost entirely through
Freddie Mac and Fannie Mae.
• Low-risk requiring demonstration of ability to repay loan.
New product resulting from securitization model.
• Securitization by private firms of nonconforming “subprime”
loans with higher default risk.
• Trend towards low- and no-documentation loans.
• Little verification of borrower’s ability to repay.
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Figure 1.4 Cash Flows in a Mortgage
Pass–Through Security
Access the text alternative for slide images.
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Mortgage Derivatives
Collateralized debt obligations (CDOs).
Concentrates the credit risk of a bundle of loans on one class
of investors; the other pooled investors are relatively
protected from that risk.
Prioritization of claims on loan repayments by dividing the
pool into tranches.
• Senior tranches—first claim on repayments from the entire
pool.
• Junior tranches—paid only after the senior tranches.
Credit ratings significantly underestimated credit risk.
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Why Was Credit Risk Underestimated?
• Default probabilities were estimated using historical data
from an unrepresentative time period with a very different
borrower pool.
• Cross-regional diversification did not reduce risk as much
as anticipated.
• Agency problems with rating agencies.
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Credit Default Swap (CDS)
A CDS is an insurance contract against the default of one of
more borrowers.
Purchaser of the swap pays an annual premium for
protection from credit risk.
Investors bought CDSs to insure safety against subprime
loans.
Some swap issuers did not have enough capital to back their
CDSs.
• For example, AIG alone sold more than $400 billion of CD
S contracts on subprime mortgages.
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Rise of Systemic Risk
Sources of fragility in 2007.
• Many highly leveraged, large banks were relying primarily
on short-term loans for funding.
• Widespread investor reliance on “credit enhancement” via
CDOs.
Systemic risk is the risk of breakdown in the financial
system, particularly due to spillover effects from one market
into others.
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The Shoe Drops
Fall 2007.
• Housing price declines were widespread.
• Mortgage delinquencies increased.
• Stock market entered its own free fall.
• Many investment banks, which had large investments in
mortgages, began to suffer.
Crisis peaked in September 2008.
• Fannie Mae and Freddie Mac put into conservatorship.
• Lehman bankruptcy, AIG bailout, and Merrill Lynch sold to BOA.
Crisis not limited to the United States.
• Greece was hardest hit.
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Figure 1.2 Cumulative Returns of S&P 500
Index
Note the sharp decline in 2008–2009.
Access the text alternative for slide images.
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The Dodd–Frank Reform Act
Dodd–Frank Wall Street Reform and Consumer Protection
Act passed in 2010.
• Partial rollback in 2018.
Mechanisms to mitigate systemic risk.
Stricter rules for bank capital, liquidity, and risk management
practices.
• For example, stress tests for large banks.
Limit risky activities in which banks can engage.
• Creation of the Office of Credit Ratings within the SEC to
oversee the credit rating agencies.
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®
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© McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.