Chapter 1 Investments: Background and Issues Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

Real Versus Financial Assets 1-2

1-3 Real Versus Financial Assets Essential nature of investment Reduce current consumption in hopes of greater future consumption Real Assets Used to produce goods and services: Property, plant & equipment, human capital, etc. Financial Assets Claims on real assets or claims on asset income

1-4 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.

A Taxonomy of Financial Assets

1-6 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.

Financial Markets and the Economy

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?

1-9 Consumption Timing o People tend to smooth consumption over time. o If one has more than enough cash to meet their basic needs in the current time period one might shift consumption through time by investing the surplus.

1-10 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?

1-11 Separation of Ownership and Management Large size of firms requires separation of ownership and management o Owners (principals) ≠ Managers (agents) 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

1-12 Corporate Governance and Corporate Ethics Business and market require trust to operate efficiently o Without trust additional laws and regulations are required o All laws and regulations are costly Governance and ethics failures have cost our economy billions if not trillions of dollars. o Eroding public support and confidence in market based systems

The Investment Process Choosing the percentage of funds in asset classes Choosing specific securities w/in an asset class Stocks Bonds Alternative Assets Money market securities 60% 30% 6% 4% o Asset allocation o The asset allocation decision is the primary determinant of a portfolio’s return o Security selection & analysis

Markets Are Competitive o Risk-return trade-off: oAssets with higher expected returns have higher risk. A stock portfolio can be expected to lose money about 1 out of every 4 years. oBonds have a much lower average rate of return (under 6%) and have not lost more than 13% of their value in any one year. Average Annual Return Minimum (1931) Maximum (1933) StocksAbout 12%-46%55%

1-15 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.

1-16 Active vs. Passive Management Active Management (inefficient markets) Finding undervalued securities Timing the market Passive Management (efficient markets) No attempt to find undervalued securities No attempt to time Holding a diversified portfolio: Security Selection Asset Allocation Indexing Constructing an “efficient” portfolio

The Players

1-18 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 Investment companies o Insurance companies o Pension funds o Hedge funds

1-19 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.

Recent Trends Globalization Securitization Financial Engineering Information and Computer Networks

1-21 Globalization Domestic firms compete in global markets Performance in one country or region depends on other regions Opportunities for better returns & implications for risk o Managing foreign exchange o International diversification reduces risk o Instruments and vehicles continue to develop (ADRs and WEBs) o Information and analysis improves

1-22 Securitization Loans of a given type such as mortgages are placed into a ‘pool’ and new securities are issued that use the loan payments as collateral. The securities are marketable and are purchased by many institutions. “ Shadow banking system ” End result is more investment opportunities for purchasers, and spreading loan credit risk among more institutions

1-23 Securitization Securitization has grown rapidly due to Changes in financial institutions and regulation permitting its growth, particularly lower capital requirements on securitized loans, Improvement in information capabilities, Credit enhancement provided by pool issuers has improved marketability.

1-24 Financial Engineering Repackaging cash flows of a security to enhance marketability Bundling and unbundling of cash flows o Bundling: Combining more than one asset into a composite security, for example securities sold backed by a pool of mortgages. o Unbundling Selling separate claims to the cash flows of one security, for example a CMO

1-25 Computer Networks Online low cost trading Information made cheaply and widely available Direct trading among investors via electronic communication networks What have been the effects on Wall Street firms’ profit margins? o How has Wall Street responded?

1-26 The Future Globalization will continue and investors will have far more investment opportunities than in the past Securitization will continue to grow after the crisis Continued development of derivatives and exotics, more regulation for “over the counter” derivatives Strong fundamental foundation of understanding is critical Understanding corporate finance requires understanding investments

Text Outline Part One: Introduction to Financial Markets, Securities and Trading Methods Part Two: Modern Portfolio Theory Part Three: Debt Securities Part Four: Equity Security Analysis Part Five: Derivative Markets Part Six: Active Investment Management Strategies: Performance Evaluation, Global investing, Taxes, and the Investment Process