What do we mean by an “investment”?
• Give up something today -- but expect something better tomorrow
– “Current commitment of money or other resources in the expectation of reaping
future benefits.”
• Earliest investments
– Gathering nuts for winter
– Farming
– Gold
• Common investments
–
–
–
–
–
–
Savings account
Mutual funds
Life insurance
Home
Gold, Jewelry, and Art
Oil and Gasoline
“Real Assets” versus “Financial Assets”?
• Real Assets
– Assets used to produce goods and services
• Examples of Real Assets
–
–
–
–
Inventions and patents
“Goodwill” in financial statements
Oil refineries and auto plants, equipment, computers
Inventories
• Financial Assets
– Claims on real assets or income they generate
– Examples →
“Real Assets” versus “Financial Assets”?
Examples of Financial Assets
• Debt (or “Fixed Income”)
– “Money market” instruments (< 1 year to maturity)
• Bank certificates of deposit
– “Capital market” instruments (1+ year to maturity)
• Bonds
• Common stock
– “Listed” (IBM, GE, GM)
– “Over-the-counter” (“penny” stocks)
• Preferred stock
• Derivative securities
– Futures, options, swaps
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.
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Financial Markets and the
Economy
1-5
What do we mean by “allocation of capital”?
- Financial markets allow for the “allocation of capital”.
- Investor “capital” is the money they invest.
- The money “allocated” to companies (or governments) determines their future.
• Initial public offerings
– Microsoft example
– AT&T bonds example
– Mortgage-backed securities example
• Subsequent stock offerings
– Corporations sometimes issue more of their own stock
• Stock buybacks
– Corporations sometimes by back some of their own stock
• Financial markets: Prices are determined by buyers and sellers
What do we mean by “shifting your consumption”?
• Financial markets allow for “consumption shifting”.
• “Consumption” means using something up
– Example: spend $$ on food and gas.
• “Shifting your consumption” means you don’t have to spend
everything you earn today on things you will consume today.
– Example: most people borrow money to get started (education, home) and then
work and save, and then hope to retire and spend
• What is the impact of inflation?
– What if you save your money under your bed or in “risk-free” Treasury bills?
– What happens if people can’t trust savings accounts or “safe” investments?
Allocation of Risk
o Investors can choose a desired risk level
• Bonds versus stock of a given company
• Bank CD versus company bond
• Tradeoff between risk and return?
1-8
Financial Markets
• Informational Role of Financial Markets
o 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?
1-9
• Separation of Ownership and Management
• Large size of firms requires separate
principals and agents
• Mitigating Factors
• Performance-based compensation
• Boards of directors may fire managers
• Threat of takeovers
• 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
• Corporate Governance and Corporate Ethics
• Accounting scandals
• Enron, WorldCom, Rite-Aid, HealthSouth, Global
Crossing, Qwest
• Misleading research reports
• Citicorp, Merrill Lynch, others
• Auditors: Watchdogs or consultants?
• Arthur Andersen and Enron
• Corporate Governance and Corporate Ethics
• Sarbanes-Oxley Act:
• 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
The Investment Process
o Asset allocation
Choosing the percentage of funds in asset classes
60%
Stocks
30%
Bonds
6%
Alternative Assets
4%
Money market securities
o Security selection & analysis
Choosing specific securities w/in an asset class
o The asset allocation decision is the primary
determinant of a portfolio’s return
1-14
Markets Are Competitive
o Risk-return trade-off:
o Assets with higher expected returns have higher risk.
Average Annual
Return
Stocks
About 12%
Minimum
(1931)
Maximum
(1933)
-46%
55%
A stock portfolio can be expected to lose money about 1
out of every 4 years.
o Bonds have a much lower average rate of return (under
6%) and have not lost more than 13% of their value in
any one year.
1-15
Risk-Return Trade- Off
o How do we measure risk?
o How does diversification affect risk?
o Discussed in Part 2 of the text
1-16
Efficient Markets
o Market efficiency:
o Securities should be neither underpriced
nor overpriced on average
o Security prices should reflect all information
available to investors
o Whether we believe markets are efficient
affects our choice of appropriate investment
management style.
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Active vs. Passive Management
Active Management (inefficient markets)
Finding undervalued securities Security Selection
Asset Allocation
Timing the market
Passive Management (efficient markets)
No attempt to find undervalued
securities
• Indexing
No attempt to time
• Constructing an
Holding a diversified portfolio: “efficient” portfolio
1-18
The Players
1-19
The Players
• Business Firms – net borrowers
• Households – net savers
• Governments – can be both borrowers and
savers
• Financial Intermediaries “Connectors of
borrowers and lenders”
o Commercial Banks
• Traditional line of business: Make loans funded by
deposits
o
o
o
o
Investment companies
Insurance companies
Pension funds
Hedge funds
1-20
The Players Cont.
• Investment Bankers
o Firms that specialize in primary market
transactions
o Primary market:
• A market where newly issued securities are offered to
the public.
• The investment banker typically ‘underwrites’ the issue.
o Secondary market
• A market where pre-existing securities are traded among
investors.
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