Overview: Investments Investment Process Taxonomy of Financial Assets Players and Vehicles Market Microstructure Recent Trends

Investments 12 Investment process  Investment  Trade current benefit for future payoff  Bank deposit, stock purchase, education  Real vs Financial Assets  Real Assets: assets for generating goods and services  Factory, farm, gas station, restaurant, etc.  Financial Assets: claims on real assets  Bank loans, stocks, bonds, options, etc.

Investments 13 Taxonomy of Financial Assets  Why financial assets?  Consumption timing: to shift consumption needs across time  Savings to buy a house  Allocation of risk: real asset too risky  Amazon’s stock for the brave and bond for the less adventurous souls  Separation of ownership & management: real asset too big  It’s inefficient for GE’s half-million stock owners to participate day-to-day operations

Investments 14 Taxonomy of Financial Assets  Money and Capital Markets Debt InstrumentsCommon Stock & Preferred Stock Maturity < 1 Maturity  1 Money Market Capital Market Derivative Securities

Investments 15 Investment process  Five step approach 1. Setting investment objectives 2. Establishing investment policy 3. Selecting a portfolio strategy 4. Selecting the assets 5.Measuring and evaluating performance Generating sufficient funds Guarantee a payment at some time in the future Asset allocation decision: stocks, bonds, real estate Active strategy, passive strategy, structured strategy Portfolio formation: market timing or asset picking Benchmarking: S&P500, risk adjustment

Investments 16 Players and Vehicles  Who are they? Financial Intermediaries Commercial Bank Taking deposit and making loans Investment Bank Selling securities to investors Consumers/investors Companies Government $ $ $

Investments 17 Market Microstructure  Primary Market  New issue of securities to the public  Secondary Market  Trading places for existing securities OTC Market (Over-the-Counter) Exchange (e.g. NYSE)

Investments 18 Market Microstructure  Direct Search Market  Buyers/sellers search each other directly  Brokered Market  Brokers search buyers/sellers for sellers/buyers  Moderate trading activity, e.g., real estate, IPO  Dealer Market  Dealers buy/sell for their own accounts  Active trading, e.g., OTC, NASDAQ  Auction Market  Players buy/sell in one centralized place  Active trading, e.g., NYSE

Investments 19 Recent Trends  The milestones of modern finance  Return-Risk Tradeoff  Markowitz (1952; Nobel Prize in 1990)  Security selection from a view of overall portfolio Risk preference (or tolerance)  Equity Valuation and Asset Allocation  Tobin’s q (1958; Nobel Prize in 1981)  Mutual Funds  Performance Evaluation  CAPM, Sharpe-Linter (1964; Nobel Prize in 1990).  Mutual fund performance  Derivative Security Valuation  Black and Scholes, Merton (1973, Nobel Prize in 1997).

Investments 110 Recent Trends  Globalization  An Integration of worldwide economic environment and national capital markets  Major Activities  International diversification  US market down, Asia markets up, average out  Cross border trading  Local stocks, ADRs, mutual funds, WEBS (World Equity Benchmark Shares) – now part of iShares, etc.  Foreign exchange risk  Exchange rate fluctuation affects foreign stock returns

Investments 111 Recent Trends  Securitization  Pooling loans/mortgages/debts to create standardized securities  Efficiency gain (in theory…  )  Improved information flow based on market activity increases liquidity  Service and financing separation encourages specialization and results better risk allocation  Reduced cost for originator  Enhanced yield for investor

Investments 112 Recent Trends  Financial Engineering  The process of creating customized securities tailored to investor’s need  Bundling  Combining cash flows together  Straight bond+call option=convertible bond  Unbundling  Slicing and dicing cash flow of an asset to several classes  CMO to mortgage pass-through tranches and treasury strips.

Investments 113 Recent Debacles  Subprime mortgage meltdown  Credit and liquidity crunch  What went wrong?  Video (from Britain) Video (from Britain)

Investments 114 Wrap-up  What is investment?  What are the differences between financial and real assets?  What’s hot?  What’s not?