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 such as land, building and equipment. Financial Assets –Claims on real assets or the income generated by them such as stocks and bonds. Financial Versus Real Assets

1-4 Real assets generate net income to the economy. Financial assets allocate income or 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 (Short-term) Treasury Bills, Commercial papers, Bank certificates of deposit (CDs) – Capital market instruments (Long-term) Treasury Bonds and Corporate 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. –Hedging and Speculation

FINANCIAL MARKETS AND THE ECONOMY

1-10 Financial Markets and Economy Informational Role of Financials Markets: Fin. Markets play a central role in the allocation of funds. If the investors think that the corporation has good prospects for future profitability, they will bid up its share price.

1-11 Financial Markets and Economy Consumption Timing: Some individuals are eqrning more than they spend or vse versa. Fin. Markets help to purchase fin. İnstruments when you are earning more than spend and sell them in order to satisfy your consumption needs when you are spending more than currently earning.

1-12 Financial Markets and Economy Allocation of Risk: Fin markets provide the allocation of risk among the investors who are more or less risk averse. Separation of Ownership and Management: In today’s business owners elect the board of directors which in turn hires and supervises the management: owners and managers are different –Agency Problem: conflict of interest between the managers and owners. –Bonuses, compansation plans and etc.

1-13 Financial Markets and Economy Corporate Governance and Ethics: Fin. Markets play an imp. Role in facilitating excess funds to their most productive uses. In order to provide this effectively, there must be enough transpapency for investors to make well-informed decisions. Firms must not mislead public about their prospects.

THE INVESTMENT PROCESS

1-15 The Investor’s Portfolio Portfolio: collection of investment assets. Asset classes consist of stocks, bonds, real estate, commodities and etc. Investors make two types of decisions in constructing portfios: 1. Asset allocation –Choice among broad asset classes such as stocks, bonds, bills, real estate and commodities. 2. 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

1-17 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.

1-18 Efficient Markets Theory Securities should be neither underpriced nor overpriced: fairly priced Security price should reflect all information available to investors

1-19 Active Versus Passive Management Passive Management: Buying and holding a diversified portfolio without attempting to identfy mispriced securities Passive Management: Buying and holding a diversified portfolio without attempting to identfy mispriced securities No attempt to find undervalued (mispriced) securities No attempt to time Holding an efficient portfolio Active Management: Attempting to identify mispriced securities or to forecast broad market trends Finding undervalued securities Timing the market

THE PLAYERS

1-21 The Players Business Firms – net borrowers Households – net savers Governments – can be both borrowers and savers

1-22 Financial Institutions Financial Intermediaries: Institutions that “connect” borrowers and lenders by accepting funds from lenders and loaning funds to borrowers. –Commercial Banks: accept deposits (borrowing) and give loans such as credits (lending) –Investment companies: Firms managing funds for investors. They manage several mutual funds.

1-23 Investment Bankers (Investment banks and brokerage firms) (such as Goldman Sachs and Merrill Lynch): 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.

1-24 Table 1.3 Balance Sheet of Commercial Banks

1-25 Table 1.4 Balance Sheet of Nonfinancial U.S. Business

RECENT TRENDS

1-27 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.

1-28 Figure 1.1 Global Debt Issue

1-29 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.

1-30 Figure 1.2 Asset-backed Securities Outstanding

1-31 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

1-32 Figure 1.3 Building a Complex Security

1-33 Unbundling – Mortgage Security

1-34 Computer Networks Online trading connects a customer directly to a brokerage firm. Internet has allowed the information to be made cheaply and widely available. Electronic communication networks allow direct trading among investors