McGraw-Hill/Irwin Copyright © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. CHAPTER 1 Investments - Background and Issues

REAL ASSETS VERSUS FINANCIAL ASSETS

1-3 Real Assets –Assets used to produce goods and services Financial Assets –Claims on real assets or the income generated by them Financial Versus Real Assets

1-4 Real assets generate net income to the economy. Financial assets define the allocation of income and wealth among investors.

1-5 Table 1.1. Balance Sheet – U.S. Households, 2006

1-6 Table 1.2 Domestic Net Worth, 2006

A TAXONOMY OF FINANCIAL ASSETS

1-8 Major Classes of Financial Assets or Securities Fixed Income (Debt) Securities: Pay a specified cash flow over a specific period. – Money market instruments Bank certificates of deposit – Capital market instruments Bonds Equity: An ownership share in a corporation. –Common stock Derivative securities: Provide payoffs that depend on the values of the other securities –Futures, Options and etc.

FINANCIAL MARKETS AND THE ECONOMY

1-10 Financial Markets Informational Role of Financials Markets Consumption Timing Allocation of Risk Separation of Ownership and Management –Agency Issues

THE INVESTMENT PROCESS

1-12 The Investor’s Portfolio Asset allocation –Choice among broad asset classes such as stocks, bonds, bills, real estate and commodities. Security selection –Choice of which securities to hold within asset class. –Top-down approach and Bottom-up approach Security analysis: valuation of particular securities that might be included in the portfolio.

MARKETS ARE COMPETITIVE

1-14 Risk-Return Trade-Off Assets with higher expected returns have greater risk. Diversification means that many assets are held in the portfolio so that the exposure to any particular asset is limited.

1-15 Efficient Markets Theory Should be neither underpriced nor overpriced securities Security price should reflect all information available to investors

1-16 Active Versus Passive Management Active Management Finding undervalued securities Timing the market Passive Management Passive Management No attempt to find undervalued securities No attempt to time Holding an efficient portfolio

THE PLAYERS

1-18 The Players Business Firms – net borrowers Households – net savers Governments – can be both borrowers and savers

1-19 Financial Institutions Financial Intermediaries: Institutions that “connect” borrowers and lenders by accepting funds from lenders and loaning funds to borrowers. –Banks –Investment companies: Firms manageing funds for investors such as mutual funds. –Insurance companies

1-20 Investment Bankers: Firms specializing in the sale of new securities to the public. –Primary market: A market in which new issue of securities are offered to the public.(IPOs: Initial Public Offerings) –Secondary market: Previously issued securities are traded among investors.

1-21 Table 1.3 Balance Sheet of Commercial Banks

1-22 Table 1.4 Balance Sheet of Nonfinancial U.S. Business

RECENT TRENDS

1-24 Globalization Tendency toward a worldwide investment environment, and the integration of the international capital markets. US investors; –Purchase foreign securities using ADRs (American Depository Receipts). –Purchase foreign securities that are offered in dollars. –Buy mutual funds that invest internationally.

1-25 Figure 1.1 Global Debt Issue

1-26 Securitization Pooling loans into standartized securities backed by those loans, which can then be traded like any other security. Pooling loans into standartized securities backed by those loans, which can then be traded like any other security. Asset- backed securities, Mortgage-backed securities are called as Pass-through securities: Pools of loans (such as home mortgage loans) sold in one package. Owners of them receive all the principal and interest payments made by the borrowers.

1-27 Figure 1.2 Asset-backed Securities Outstanding

1-28 Financial Engineering Creation of new securities by unbundling- breaking up and allocating the cash flows from one security to create several new securities or by bundling- combining more than one security into a composite security. Examples: strips, principal/interest splits

1-29 Figure 1.3 Building a Complex Security

1-30 Unbundling – Mortgage Security

1-31 Computer Networks Online trading Information made cheaply and widely available Direct trading among investors