Chapter 1
Investments:
Background and
Issues
1.1 Real Versus Financial Assets
• Real Assets
• Used to produce goods and services: Property,
plant & equipment, human capital, etc.
• the net wealth of an economy is the sum of its real
assets.
• Financial Assets
• Claims on real assets or claims on asset income
1-2
Table 1.1. Balance Sheet –
U.S. Households
Table 1.2 Domestic Net Worth
Most Current
http://www.federalreserve.gov/releases/z1/current/
1-3
Major Classes of Financial Assets or
Securities
• Debt
o Money market instruments
• Bank certificates of deposit, T-bills,
commercial paper, etc.
o Bonds
o Preferred stock
• Common stock
o Ownership stake in the entity, residual cash flow
• Derivative securities
o A contract whose value is derived from some
underlying market condition.
1-4
1.3 Financial Markets and
the Economy
1-5
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 Or any thing? – Intrade.com
1-6
Separation of Ownership and
Management; Ethics
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 – M&A FINC 350
• Governance and ethics failures have cost our
economy trillions of dollars.
o Eroding public support and confidence in market
based systems
1-7
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.
• Billionaire Carl Icahn led a proxy fight to seize
control of Yahoo’s board and force the firm to accept
Microsoft’s offer.
• He lost, and Yahoo stock fell from $29 to $21.
• Did Yahoo managers act in the best interests of their
shareholders?
1-8
Other examples
• Accounting Scandals
o Enron, WorldCom, Rite-Aid, HealthSouth, Global
Crossing, Qwest,
• Misleading Research Reports
o Citicorp, Merrill Lynch, others
• Auditors: Watchdogs or Consultants?
o Arthur Andersen and Enron
1-9
Corporate Governance and
Corporate Ethics
• Sarbanes-Oxley Act (SOX)
o Increases the number of independent directors on
company boards
o Requires the CFO to personally verify the
financial statements
o Created a new oversight board for the
accounting/audit industry
o Charged the board with maintaining a culture of
high ethical standards
1-10
1.4 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
1-11
Risk-Return Trade- Off
o How do we measure risk?
o How does diversification affect risk?
o Discussed in Part 2 of the text
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?
1-12
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.
o 3 forms – strong, semi-strong, weak
1-13
Active vs. Passive Management
Active Management (inefficient markets)
Finding undervalued securities Security Selection
Timing the market
Asset Allocation
Passive Management (efficient markets)
No attempt to find undervalued securities
No attempt to time
• Indexing
Holding a diversified portfolio: • Constructing an
“efficient” portfolio
1-14
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
1-15
The Players Cont.
• Investment Bankers aka Wall Street
o Firms that specialize in primary market
transactions
o Primary market vs Secondary
o After 2008, no more pure investment bankers,
annulling 1933 Act
o As a result, they face much stricter banking
regulations, e.g. deleveraging
1-16
1.7 Recent Trends
• Globalization
o Managing foreign exchange
o International diversification reduces risk
o Instruments and vehicles continue to develop
(ADRs and WEBs)
• Securitization
• Financial Engineering
• Information and Computer Networks
• Nasdaq as of Feb 2011 has the fastest network: 98ms/trade,
Soon Singapore 90ms/trade
• Deleveraging
1-17