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Chapter 1 Investments: Background and Issues Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin
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1.1 Real Versus Financial Assets 1-2
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Investment
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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 1-4
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Table 1.1. Balance Sheet – U.S. Households, 2008 1-5
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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. 1-6
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Table 1.2 Domestic Net Worth, 2008 1-7
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1.2 A Taxonomy of Financial Assets 1-8
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Major Classes of Financial Assets or Securities Debt o Money market instruments Bank certificates of deposit, T-bills, commercial paper, etc. o Capital market instrument Treasury Bonds Common stock o Ownership stake in thecorporation, residual cash flow Derivative securities o Securities providing payoffs that depend on the values of other assets 1-9
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1.3 Financial Markets and the Economy 1-10
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Financial Markets Informational Role of Financial Markets If a firm performing well, investors will bid up,on the other hand, a company’s prospects seem poor, investors will bid down However, Some companies can be “hot” for a short period of time, attract a large flow of investor capital, and then fail after only a few years Hence, professionals analyse the prospects of firms whose shares trade on the stock market. 1-11
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Consumption Timing In high-earnings periods, you can invest your savings in financial assets such as stocks and bonds. In low-earnings periods, you can sell these assets to provide funds for your consumption needs. –Thus, financial markets allow individuals to separate decisions concerning current consumption from constraints that otherwise would be imposed by current earnings. 1-12
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Allocation of Risk Investors can choose a desired risk level Bonds versus stock of a given company The risk-tolerant investors can buy stock why? the more conservative ones buy bonds why? 1-13
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Separation of Ownership and Management Large size of firms requires separation of ownership and management o In 2008 GE had over $800 billion in assets and over 650,000 stockholders o Agency problem : Conflicts of interest between managers and stockholders o Several Mitigating factors: Performance based compensation Boards of Directors may fire managers Threat of takeovers 1-14
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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? 1-15
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Corporate Governance and Corporate Ethics If firms can mislead the public about their prospects, then much can go wrong. Business and market require trust to operate efficiently o Without trust additional laws and regulations are required o All laws and regulations are costly Governance and ethics failures have cost our economy billions if not trillions of dollars. 1-16
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Corporate Governance and Corporate Ethics Accounting Scandals and Misleading Research Reports o Enron, WorldCom, Rite-Aid, HealthSouth, Global Crossing, Qwest. Auditors: Watchdogs or Consultants? o Arthur Andersen and Enron 1-17
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Corporate Governance and Corporate Ethics Sarbanes-Oxley Act o Increases the number of independent directors on company boards o Requires the CFO to personally verify the financial statements o Created a new oversight board for the accounting/audit industry o Charged the board with maintaining a culture of high ethical standards 1-18
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1.4 The Investment Process Choosing the percentage of funds in asset classes Stocks Bonds Alternative Assets Money market securities 60% 30% 6% 4% o Asset allocation Choosing specific securities within an asset class The asset allocation decision is the primary determinant of a portfolio’s return o Security selection & analysis 1-19
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1.5 Markets Are Competitive o Risk-return trade-off: oWe conclude that there should be a risk-return trade-off in the securities markets, with higher- risk assets priced to offer higher expected returns than lower-risk assets. oNote: Bonds have a much lower average rate of return (under 6%) Average Annual Return Minimum (1931)Maximum (1933) StocksAbout 12%-46%55% 1-20
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o How do we measure risk? o How does diversification affect risk? o Discussed in Part 2 of the text o Modern Portfolio theory Risk-Return Trade- Off 1-21
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Efficient Markets o Security prices should reflect all information available to investors o Securities should be neither underpriced nor overpriced on average o Whether we believe markets are efficient affects our choice of appropriate investment management style. 1-22
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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
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1-24 1.6 The Players
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The Players Business Firms – net borrowers Households – net savers Governments – can be both borrowers and savers Financial Intermediaries “Connectors of borrowers and lenders” o Banks o Investment companies o Insurance companies o Pension funds o Mutual funds 1-25
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The Players Cont. Investment Bankers o Firms that specialize in primary market transactions o Primary market: A market where newly issued securities are offered to the public. The investment banker typically ‘underwrites’ the issue. o Secondary market A market where pre-existing securities are traded among investors. 1-26
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Investment Bankers o Commercial and investment banks’ functions and organizations were separated by law from 1933 to 1999. o 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. o 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. 1-27
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Investment Bankers o Some investment banks chose to become commercial banks to obtain deposit funding and government assistance o All of the major investment banks are now under more strict commercial bank regulations. 1-28
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Table 1.3 Balance Sheet of Commercial Banks, 2008 1-29
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Table 1.4 Balance Sheet of Nonfinancial U.S. Business, 2008 1-30
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1.7 Recent Trends Globalization Securitization Financial Engineering Information and Computer Networks 1-31
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Globalization Domestic firms compete in global markets Performance in one country or region depends on other regions Opportunities for better returns & implications for risk o Managing foreign exchange o International diversification reduces risk o Information and analysis improves 1-32
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Securitization Loans of a given type such as mortgages are placed into a ‘pool’ and then can be traded like any other security Securitization has grown rapidly due to changes in financial institutions and regulation improved marketability. 1-33
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Financial Engineering Repackaging cash flows of a security to enhance marketability applying mathematics, computer sciences and economic theory Bundling and unbundling of cash flows o Bundling: o combining more than one security into a composite security Unbundling breaking up and allocating the cash flows from one security to create several new securities 1-34
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Computer Networks Online low cost trading Information made cheaply and widely available Direct trading among investors via electronic communication networks 1-35
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