P.V. VISWANATH FOR A FIRST COURSE IN INVESTMENTS

2 Distinguish between the real economy and the financial economy The Financial System What is the Role of the financial markets?

3 Real Assets  Determine the productive capacity and net income of the economy  Examples: Land, buildings, machines, knowledge used to produce goods and services Financial Assets  Claims on real assets The two systems are parallel, but not entirely  You can have trading in financial assets, with no change in the amount of real assets, or you can have creation of new financial assets which then also causes a change in real assets.  Sometimes financial assets that have not been traded up to that point then become tradeable – i.e. securitization, but this does not increase the amount of real assets.

P.V. Viswanath 4

5 Information Role: Capital flows to companies with best prospects Consumption Timing: Use securities to store wealth and transfer consumption to the future Allocation of Risk: Investors can select securities consistent with their tastes for risk Separation of Ownership and Management: This allows the firm to operate on a day-to-day basis even as shareholders acquire increased liquidity and change possibly from minute-to-minute. However, with stability comes agency problems. Are managers interested in maximizing shareholder wealth?

6 Households Firms Government Financial Intermediaries/Financial Service Companies

P.V. Viswanath 7 Commercial Banks Insurance Companies Pension and Retirement Funds Mutual Funds Investment Banks Venture Capital Firms Asset Management Firms Information Service Providers

8 Top down  Asset Allocation – how much to invest in broad security classes  Security Selection – what securities to hold within a security class Bottom up  Security Analysis Start with bottom up and pay attention to portfolio characteristics