Investments: Background and Issues Chapter 1 Investments: Background and Issues Describes the financial instruments traded in primary and secondary markets. Discusses Market indexes. Discusses options and futures. McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.

1.1 Real Versus Financial Assets 1-2

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 1-3

Table 1.1. Balance Sheet – U.S. Households, 2008 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. 1-5

Table 1.2 Domestic Net Worth, 2008 Net wealth in 2006 was $45,199, notice the reduction (about -9.46%) due to the financial crisis. 1-6 1-1

1.2 A Taxonomy of Financial Assets 1-7

Major Classes of Financial Assets or Securities Debt Money market instruments Bank certificates of deposit, T-bills, commercial paper, etc. Bonds Preferred stock Common stock Ownership stake in the entity, residual cash flow Derivative securities A contract whose value is derived from some underlying market condition. 1-8

1.3 Financial Markets and the Economy 1-9

Financial Markets Informational Role of Financial Markets Do market prices equal the fair value estimate of a security’s expected future risky cash flows? 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? 1-10

Consumption Timing People tend to smooth consumption over time. 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. 1-11

Allocation of Risk 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

Separation of Ownership and Management Large size of firms requires separation of ownership and management In 2008 GE had over $800 billion in assets and over 650,000 stockholders Owners (principals) ≠ Managers (agents) Agency costs: Owners’ interests may not align with managers’ interests Mitigating factors: Performance based compensation Boards of Directors may fire managers Threat of takeovers 1-13

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? About ¾ of proxy fights are lost. Similarly, most shareholder initiatives are defeated unless management supports them. Perhaps we get the kind of corporate governance we deserve since most shareholders pay little attention to these matters (there is a huge free rider problem for activist shareholders). 1-14 1-1

Corporate Governance and Corporate Ethics Business and market require trust to operate efficiently Without trust additional laws and regulations are required All laws and regulations are costly Governance and ethics failures have cost our economy billions if not trillions of dollars. Eroding public support and confidence in market based systems 1-15

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 1-16

Corporate Governance and Corporate Ethics Sarbanes-Oxley Act Increases the number of independent directors on company boards Requires the CFO to personally verify the financial statements Created a new oversight board for the accounting/audit industry Charged the board with maintaining a culture of high ethical standards 1-17

1.4 The Investment Process Asset allocation Choosing the percentage of funds in asset classes Stocks Bonds Alternative Assets Money market securities 60% 30% 6% 4% Security selection & analysis Choosing specific securities w/in an asset class The asset allocation decision is the primary determinant of a portfolio’s return 1-18

1.5 Markets Are Competitive Risk-return trade-off: Assets with higher expected returns have higher risk. A stock portfolio can be expected to lose money about 1 out of every 4 years. 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. Average Annual Return Minimum (1931) Maximum (1933) Stocks About 12% -46% 55% 2008 stock returns were close to the 1931 record, depending on the index used stocks lost over 40% of their value in 2008. Note the large market return in 1933, although the depression did not end until World War II. Results are since 1926 and do not include results before that date. 1-19 1-1

Risk-Return Trade- Off How do we measure risk? How does diversification affect risk? Discussed in Part 2 of the text 2008 stock returns were close to the 1931 record, depending on the index used stocks lost over 40% of their value in 2008. Note the large market return in 1933, although the depression did not end until World War II. Results are since 1926 and do not include results before that date. 1-20 1-1

Efficient Markets Market efficiency: Securities should be neither underpriced nor overpriced on average Security prices should reflect all information available to investors Whether we believe markets are efficient affects our choice of appropriate investment management style. 2008 stock returns were close to the 1931 record, depending on the index used stocks lost over 40% of their value in 2008. Note the large market return in 1933, although the depression did not end until World War II. Results are since 1926 and do not include results before that date. 1-21 1-1

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 Here an “efficient” portfolio refers to the best diversified portfolio at the chosen risk level, and in practice should include administrative costs, and choice of investments to include (based on cash flow desired, taxes, willingness to invest in international & alternative investments, etc.) Indexing Constructing an “efficient” portfolio 1-22 1-1

1.6 The Players 1-23

The Players Business Firms – net borrowers Households – net savers Governments – can be both borrowers and savers Financial Intermediaries “Connectors of borrowers and lenders” Commercial Banks Traditional line of business: Make loans funded by deposits Investment companies Insurance companies Pension funds Hedge funds 1-24

The Players Cont. Investment Bankers Firms that specialize in primary market transactions Primary market: A market where newly issued securities are offered to the public. The investment banker typically ‘underwrites’ the issue. Secondary market A market where pre-existing securities are traded among investors. In 1933 the Glass-Steagall act strictly limited the activities of commercial banks. An institution could not accept deposits and underwrite securities. In 1999 the Financial Services Modernization Act formally did away with Glass-Steagall restrictions. In reality, commercial and investment bank functions were blended long before 1999 and cross functionality actually began after the 1980 Depository Institution Deregulation and Monetary Control Act (DIDMCA). 1-25 1-1

Investment Bankers Investment Bankers Commercial and investment banks’ functions and organizations were separated by law from 1933 to 1999. Post 1999 large investment banks, collectively known as “Wall Street,” operated independently from commercial banks, although many of the large commercial banks increased their investment banking activities, pressuring profit margins of investment banks. In September 2008 major investment banks either went bankrupt, reorganized as commercial banks or were purchased by commercial banks as a result of the collapse of the mortgage markets. In 1933 the Glass-Steagall act strictly limited the activities of commercial banks. An institution could not accept deposits and underwrite securities. In 1999 the Financial Services Modernization Act formally did away with Glass-Steagall restrictions. In reality, commercial and investment bank functions were blended long before 1999 and cross functionality actually began after the 1980 Depository Institution Deregulation and Monetary Control Act (DIDMCA). 1-26 1-1

Investment Bankers Some investment banks chose to become commercial banks to obtain deposit funding and government assistance All of the major investment banks are now under the much stricter commercial bank regulations. What are the implications for innovation and capital issuance resulting from these changes? In 1933 the Glass-Steagall act strictly limited the activities of commercial banks. An institution could not accept deposits and underwrite securities. In 1999 the Financial Services Modernization Act formally did away with Glass-Steagall restrictions. In reality, commercial and investment bank functions were blended long before 1999 and cross functionality actually began after the 1980 Depository Institution Deregulation and Monetary Control Act (DIDMCA). 1-27 1-1

Table 1.3 Balance Sheet of Commercial Banks, 2008 1-28

Table 1.4 Balance Sheet of Nonfinancial U.S. Business, 2008 1-29

1.7 Recent Trends Globalization Securitization Financial Engineering Information and Computer Networks 1-30

Globalization Domestic firms compete in global markets Performance in one country or region depends on other regions Opportunities for better returns & implications for risk Managing foreign exchange International diversification reduces risk Instruments and vehicles continue to develop (ADRs and WEBs) Information and analysis improves ADR: American Depository Receipt: May be listed on an exchange or trade OTC in the U.S. A broker purchases a block of foreign shares, deposits them in a trust and issues ADRs in the U.S. they trade in dollars, receive dividends in dollars and have the same commissions as any other stock. You can buy ADRs on Sony for example. WEBS are World Equity Benchmark Shares, these are the same as ADRs but are for portfolios of stocks. Typically WEBS track the performance of an index of foreign stocks. The investment world is moving forward rapidly and embracing new technology. News is available virtually instantaneously. On-line trading has made trading fast and cheap. 1-31 1-1

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 The Shadow banking system refers to the end result of securitization. Namely that many institutions now provide the ultimate financing for loans that banks traditionally financed. 1-32 1-1

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. Pool organizers typically have a contingent liability for the securities. When the mortgage markets collapsed, this led to the financial crisis of 2007 and 2008. 1-33 1-1

Figure 1.1 Asset-backed Securities Outstanding 1-34

Financial Engineering Repackaging cash flows of a security to enhance marketability Bundling and unbundling of cash flows Bundling: Combining more than one asset into a composite security, for example securities sold backed by a pool of mortgages. Unbundling Selling separate claims to the cash flows of one security, for example a CMO A CMO is a collateralized mortgage obligation. It is a type of mortgage backed security that takes payments from a mortgage pool and separates them into separate classes of payments that investors can buy. A CDO is also an unbundling example. A simpler version of unbundling would be a Treasury Strip. 1-35 1-1

Figure 1.2 Building a Complex Security This is a complex security with of preferred stock with an option component. It is not the simplest example of bundling. 1-36 1-1

Figure 1.3 Mortgage Security This could be considered an unbundling example, but actually it represents both bundling and unbundling. Bundling by creating a security backed by a mortgage pool, (securitization) and unbundling by created the multi-class securities. 1-37 1-1

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? How has Wall Street responded? Computerization has pressured profit margins of Wall Street firms. Similarly technological advances that promoted widespread securitization changed the business model of commercial banks. Both responded by engaging in riskier trading activities and increasing leverage to bolster rates of return. It could be argued this helped set up the financial crisis of 2007-2008. 1-38 1-1

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 1-39

1.8 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 1-40