1. INVESTMENTS | BODIE, KANE, MARCUS Chapter One The Investment Environment Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

2. INVESTMENTS | BODIE, KANE, MARCUS 1-2 Role of financial assets in the economy: Real vs. financial assets Risk–return trade-off and the efficient pricing Financial crisis 2008 Connections between the financial system and the “real” side of the economy Lessons learned for evaluating systemic risk Chapter Overview

3. INVESTMENTS | BODIE, KANE, MARCUS 1-3 Real Assets vs. Financial Assets Real Assets Determine the productive capacity and net income of the economy Examples: Land, buildings, machines, knowledge used to produce goods and services Financial Assets Claims on real assets, do not contribute directly to the productive capacity of the economy. Examples: Stocks, bonds

4. INVESTMENTS | BODIE, KANE, MARCUS 1-4 Fixed income or debt Promise either a fixed stream of income or a stream of income determined by a specified formula Common stock or equity Represent an ownership share in the corporation Derivative securities Provide payoffs that are determined by the prices of other assets Financial Assets

5. INVESTMENTS | BODIE, KANE, MARCUS 1-5 Investment in currency Investment in real assets through commodity futures Corporations invest in the commodity futures to hedge the risk Other Types of Investment

6. INVESTMENTS | BODIE, KANE, MARCUS 1-6 The Informational Role Capital flows to companies with best prospects Consumption Timing Use securities to store wealth and transfer consumption to the future Allocation of Risk Investors can select securities consistent with their tastes for risk, which benefits the firms that need to raise capital as security can be sold for the best possible price Financial Markets and the Economy

7. INVESTMENTS | BODIE, KANE, MARCUS 1-7 Informational Role of Financial Markets Do market prices equal the fair value estimate of a security's expected future risky cash flows? Price reflect our assessment of the value of assets. Can we rely on markets to allocate capital to the best uses? Financial Markets and the Economy

8. INVESTMENTS | BODIE, KANE, MARCUS 1-8 Consumption Timing Consumption smoothes over time When current basic needs are met, shift consumption through time by investing surplus When there are surpluses we delay consumption, when there are deficits we utilize our stored assets. Financial Markets and the Economy

9. INVESTMENTS | BODIE, KANE, MARCUS 1-9 Risk Allocation Investors can choose desired risk level Bond vs. stock of company Bank CD vs. company bond Risk-and-return trade-off A primary construct of investment theory. As risks increase, investors want to be paid for assuming these additional risks. Financial Markets and the Economy

10. INVESTMENTS | BODIE, KANE, MARCUS 1-10 Separation of Ownership and Management Agency problems arise when managers start pursuing their own interests instead of maximizing firm's value Mechanisms to mitigate agency problems: Tie managers' income to the success of the firm (stock options) Monitoring from the board of directors Monitoring from the large outside investors and security analysts Takeover threat Financial Markets and the Economy

11. INVESTMENTS | BODIE, KANE, MARCUS 1-11 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 Proxy fight to seize control of Yahoo's board and force Yahoo to accept offer Proxy failed; Yahoo stock fell from $29 to $21 Did Yahoo managers act in the best interests of their shareholders? Financial Markets and the Economy

12. INVESTMENTS | BODIE, KANE, MARCUS 1-12 Corporate Governance and Corporate Ethics Accounting Scandals Examples – Enron, Rite Aid, HealthSouth Auditors: Watchdogs of the firms Analyst Scandals Arthur Andersen Sarbanes-Oxley Act Tighten the rules of corporate governance Financial Markets and the Economy

13. INVESTMENTS | BODIE, KANE, MARCUS 1-13 Sarbanes-Oxley Act: Requires more independent directors on company boards Requires CFO to personally verify the financial statements Created new oversight board for the accounting/audit industry Charged board with maintaining a culture of high ethical standards Financial Markets and the Economy

14. INVESTMENTS | BODIE, KANE, MARCUS INVESTMENT PROCESS

15. INVESTMENTS | BODIE, KANE, MARCUS 1-15 Portfolio: Collection of investment assets. Asset allocation Choice among broad asset classes Primary determinant of a portfolio's return Percentage of fund in asset classes Security selection Choice of securities within each asset class The Investment Process

16. INVESTMENTS | BODIE, KANE, MARCUS 1-16 “Top-down” approach Determine the asset allocation that matches the risk tolerances and investment objectives of the investor. Security analysis then takes place within the asset classes. Diversification Risk tolerances Investment objectives The Investment Process

17. INVESTMENTS | BODIE, KANE, MARCUS 1-17 “Bottom-up” approach Investment based solely on the price- attractiveness, which may result in unintended heavy weight of a portfolio in only one or another sector of the economy Usually only the most well-known companies included in the portfolio Not necessarily bad but there could be opportunities in the lesser known companies The Investment Process

18. INVESTMENTS | BODIE, KANE, MARCUS 1-18 Risk-Return Trade-Off Higher-risk assets are priced to offer higher expected returns than lower-risk assets Stock portfolio loses money 1 of 4 years on average Bonds Have lower average rates of return (under 6%) Have not lost more than 13% of their value in any one year Markets Are Competitive

19. INVESTMENTS | BODIE, KANE, MARCUS 1-19 Risk-Return Trade-Off How do we measure risk? Stand-alone risk?? What does this represent? How does diversification affect risk? The combination of dissimilar assets creates an off-setting of asset specific risks Markets Are Competitive

20. INVESTMENTS | BODIE, KANE, MARCUS 1-20 Efficient Markets In fully efficient markets when prices quickly adjust to all relevant information, there should be neither underpriced nor overpriced securities Security prices should reflect all information available to investors Choice of appropriate investment-management style based on belief in market efficiency Markets Are Competitive

21. INVESTMENTS | BODIE, KANE, MARCUS 1-21 Passive Management Holding a highly diversified portfolio No attempt to find undervalued securities No attempt to time the market Active Management Finding mispriced securities Timing the market Markets Are Competitive

22. INVESTMENTS | BODIE, KANE, MARCUS 1-22 Demanders of capital – Firms Suppliers of capital – Households Governments – Can be both borrowers or lenders The Players

23. INVESTMENTS | BODIE, KANE, MARCUS 1-23 Financial Intermediaries: Pool and invest funds Investment Companies Banks Insurance companies Credit unions The Players

24. INVESTMENTS | BODIE, KANE, MARCUS 1-24 Venture Capital and Private Equity Venture capital Investment to finance new firm Pension funds and angel investors Private equity Investments in companies not traded on stock exchange The Players

25. INVESTMENTS | BODIE, KANE, MARCUS 1-25 Universal Bank Activities Investment Banking Underwrite new securities issues Sell newly issued securities to public in the primary market Investors trade previously issued securities among themselves in the secondary markets Commercial Banking Take deposits and make loans

26. INVESTMENTS | BODIE, KANE, MARCUS 1-26 Antecedents of the Crisis: “ The Great Moderation ” : A time in which the U.S. had a stable economy with low interest rates and a tame business cycle with only mild recessions Historic boom in housing market Financial Crisis of 2008

27. INVESTMENTS | BODIE, KANE, MARCUS 1-27 Figure 1.3 The Case-Shiller Index of U.S. Housing Prices

28. INVESTMENTS | BODIE, KANE, MARCUS 1-28 Changes in Housing Finance Old Way Local thrift institution made mortgage loans to homeowners Thrift ’ s major asset: A portfolio of long-term mortgage loans Thrift ’ s main liability: Deposits “ Originate to hold ” New Way Securitization: Fannie Mae and Freddie Mac bought mortgage loans and bundled them into large pools Mortgage-backed securities are tradable claims against the underlying mortgage pool “ Originate to distribute ”

29. INVESTMENTS | BODIE, KANE, MARCUS 1-29 Securitization: Buying mortgage loans from originators and bundling them into mortgage-backed securities Replacement of low-risk conforming mortgages with nonconforming “subprime” loans Trend toward low-documentation and then no- documentation loans and rising allowed leverage on home loans (loan-to-value ratio) Low adjustable-rate mortgages (ARMs) that “maxed out” borrowers' paying capacity at low rates Changes in Housing Finance

30. INVESTMENTS | BODIE, KANE, MARCUS 1-30 Figure 1.4 Cash Flows in a Mortgage Pass- Through Security

31. INVESTMENTS | BODIE, KANE, MARCUS 1-31 Collateralized debt obligations (CDOs) Mortgage pool divided into slices or tranches to concentrate default risk Senior tranches: Lower risk, highest rating (AAA) Junior tranches: High risk, low or junk rating Estimated ratings significantly underestimated the inherent risk Mortgage Derivatives

32. INVESTMENTS | BODIE, KANE, MARCUS 1-32 Default probabilities were estimated on the historical data covering the rising housing market Geographic diversification did not reduce risk as much as anticipated Agency problems with rating agencies Why Was Credit Risk Underestimated?

33. INVESTMENTS | BODIE, KANE, MARCUS 1-33 A CDS is an insurance contract against the default of the borrower Investors bought sub-prime loans and used CDSs to insure their safety Some big swap issuers did not have enough capital to back their CDSs when the market collapsed resulting in the failure of CDO insurance Credit Default Swap (CDS)

34. INVESTMENTS | BODIE, KANE, MARCUS 1-34 Systemic Risk: A potential breakdown of the financial system in which problems in one market spill over and disrupt others. One default may set off a chain of further defaults Waves of selling may occur in a downward spiral as asset prices drop Potential contagion from institution to institution, and from market to market Rise of Systemic Risk

35. INVESTMENTS | BODIE, KANE, MARCUS 1-35 Banks had a mismatch between the maturity and liquidity of their assets and liabilities Liabilities were short and liquid Assets were long and illiquid Constant need to refinance the asset portfolio Banks were very highly levered, giving them almost no margin of safety Rise of Systemic Risk

36. INVESTMENTS | BODIE, KANE, MARCUS 1-36 Investors relied too much on credit enhancement through structured products like CDS CDS traded mostly over-the-counter, with no posted margin requirements and little transparency Opaque linkages between financial instruments and institutions Rise of Systemic Risk

37. INVESTMENTS | BODIE, KANE, MARCUS 1-37 2000-2006: Sharp increase in housing prices caused many investors to believe that continually rising home prices would bail out poorly performing loans 2004: Interest rates began rising 2006: Home prices peaked 2007: Housing defaults and losses on mortgage-backed securities surged The Shoe Drops

38. INVESTMENTS | BODIE, KANE, MARCUS 1-38 2008: Troubled firms include Bear Stearns, Fannie Mae, Freddie Mac, Merrill Lynch, Lehman Brothers, and AIG Money market breaks down Credit markets freeze up Federal bailout to stabilize financial system The Shoe Drops

39. INVESTMENTS | BODIE, KANE, MARCUS 1-39 Mechanisms to mitigate systemic risk Stricter rules for bank capital, liquidity, and risk management practices Increased transparency, especially in derivatives markets (eg.: standardize CDS contracts so they can trade in centralized exchanges) Office of Credit Ratings within the SEC to oversee the credit rating agencies The Dodd-Frank Reform Act