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 What do we mean by an “investment”?

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 Assets” versus “Financial Assets”?

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. 1-4

Financial Markets and the Economy 1-5

- 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 “allocation of capital”?

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? What do we mean by “shifting your consumption”?

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 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 1-14

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

o How do we measure risk? o How does diversification affect risk? o Discussed in Part 2 of the text Risk-Return Trade- Off 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. 1-17

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 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 Investment companies o Insurance companies o Pension funds o 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. 1-21