1. Chapter 1: Investments - Background and Issues

2. 1.1 REAL ASSETS VERSUS FINANCIAL ASSETS
Essential nature of investment
Reduced current consumption
Planned later consumption
Real Assets
Material wealth of a society is ultimately determined by the productive capacity of its economy, that is, the goods and services its members can create. This capacity is a function of the real assets of the economy. Real assets mean the land, buildings, machines, inventories and knowledge that can be used to produce goods and services
Financial Assets
Claims on real assets like stocks and bonds that are no more than sheets of paper or, computer entries and do not contribute directly or indirectly to the productive capacity of the economy.

3. Table 1.1. Balance Sheet – U.S. Households, 2006

4. Table 1.3 Balance Sheet of Commercial Banks

5. 1.2 A TAXONOMY OF FINANCIAL ASSETS Major Classes of Financial Assets or Securities
Debt
Money market instruments
Bank certificates of deposit, treasury bills
Capital market instruments
Bonds (Treasury bonds, municipal bond, high yield junk bonds)
Common stock: ownership
Preferred stock: Hybrid
Derivative securities: Option & Future: to hedge risk

6. 1.3 FINANCIAL MARKETS & THE ECONOMY Functions of Financial Markets
Bridging the gap between net borrowers and net savers (Slide 7)
Providing the equilibrium interest rate (Slide 8)
Consumption Timing: Separation Principle (Slide 9)
Allocation of Risk (Slide 10)
How does a risky project get financed?
Allocation of liquidity: Opposite liquidity preferences of borrowers and savers.
Law of large number
Separation of Ownership and Management
Agency Issues (Slide 11 & 12)

7. Bridging the gap . Net savers: Surplus sector
Net Borrowers: Deficit sector
Financial
Market

8. Equilibrium interest rate: (Loanable Fund Theory)
S (Savings) k
D (Investment)
Quantity of Loanable Fund

9. Intertemporal consumption: Separation Principle
210
Lending
i=10%
100
Borrowing Co
100
190.9

10. Risk-Return trade-off
Return=f(Risk)
Return Rf
Risk

11. Agency Cost
Managers are naturally inclined to act in their own best interests. Expensive perquisites like high salaries and allowances of the agency (rationalized on motivational point) increases cost.
High short term profit adds to the credentials of board of directors.
High scale investment makes the firm dependent on the present agency.
Risky investment. If successful, credit goes to the agency, if failure loss goes to the shareholders.
Less payout of dividends to facilitate more investment

12. Solution to agency problem
Performance shares
Hostile takeover (Example: Compaq take-over of Hewlett-Packard, Microsoft take-over of Yahoo)
Formal contract
Market effects

13. 1.4 THE INVESTMENT PROCESS (Concept of portfolio)
Asset allocation
Choice among broad asset classes
Security selection
Choice of which securities to hold within asset class

14. 1.5 MARKETS ARE COMPETITIVE a. Risk-Return Trade-Off
How should one measure risk
Assets with higher expected returns have greater risk
What role does diversification play:
intelligent versus random diversification

15. Effect of random diversification on risk: Systematic and Unsystematic
We can break down the total risk of holding a stock into two components: systematic risk and unsystematic risk: 2
Total risk 
Risk
Nonsystematic Risk:
Systematic Risk: m n
Number of securities in the portfolio

16. 1.5 MARKETS ARE COMPETITIVE b. Efficient Markets Theory
There should be neither underpriced nor overpriced securities (Why? see the next slide)
Security price should reflect all information available to investors

17. Why Technical Analysis Fails
Investor behavior tends to eliminate any profit opportunity associated with stock price patterns.
Stock Price
If it were possible to make big money simply by finding “the pattern” in the stock price movements, everyone would do it, and the profits would be competed away.
Sell
Sell
Buy
Buy
Time

18. Active Versus Passive Management
Active Management
Attempting to identify mispriced securities or to forecast broad market trends
Finding undervalued securities
Timing the market
Passive Management
Buying and holding a diversified portfolio without attempting to identify mispriced securities.
No attempt to find undervalued securities
No attempt to time
Holding an efficient portfolio

19. 1.6 THE PLAYERS Business Firms – net borrowers Households – net savers
Governments – can be both borrowers and savers. In case of deficit financing government issues treasury bills, notes, and bonds to borrow from public.
Financial Intermediaries:
Banks: Deals with other people’s money with interest margin. The balance sheet is characterized by very small amount of tangible assets.
Mutual funds : pool and manage the scattered savings of many investors, and invest in well-diversified portfolios
Investment companies design portfolio for large investors with particular risk preferences
Insurance companies handle risk
Credit unions: cooperative financial institutions owned and controlled by its members for the purpose of different financial services including investment
Investment Bankers: such as Goldman, Sachs, Merrill Lynch advise the issuing corporation on the prices it can charge for the securities issued, appropriate interest rates, and so forth.

20. 1.7 MARKETS AND MARKET STRUCTURE
Direct search markets: Direct placement
Brokered markets: Investment bank markets a firm’s securities to the public in the primary markets.
Dealer markets: OTC market like NASDAQ (National Association of Securities Dealers Automatic Quotation)
Auction markets: All traders converge at one place to buy and sell an asset. example, NYSE, DSE, etc.

21. 1.8 RECENT TRENDS a. Globalization
Managing foreign exchange
American Depository Receipts (ADRs): Domestically traded securities that represent claims to shares of foreign stocks
foreign securities offered in dollars
mutual funds that invest internationally
derivative securities with payoffs that depends on prices in foreign security markets
Motivation: Diversification to improve performance
Instruments and vehicles continue to develop (WEBS, World Equity Benchmark Shares): Like ADR, WEBS facilitates diversification in international markets. Each WEBS security tracks the performance of an index of share returns for a particular country
Information and analysis improves

22. 1.8 RECENT TRENDS b. Securitization
Pools of loans (such as home mortgage loans) sold in one package. This also includes car loans, student loans, credit card loans, and debts of firms. Owners of pass-through receive all of the principal and interest payments made by the borrowers.
Offers opportunities for investors and originators
Changes in financial institutions and regulation
Improvement in information capabilities
Credit enhancement and its role

23. 1.8 RECENT TRENDS c. Financial Engineering
Repackaging Services of Financial Intermediaries
Bundling (combining more than one security into a composite security) and unbundling of cash flows
Slicing and dicing of cash flows
Examples: strips, CMOs (Collateral Mortgage Obligations) , dual purpose funds, principal/interest splits

24. 1.8 RECENT TRENDS d. Computer Networks
Online trading
Information made cheaply and widely available
Direct trading among investors