1. The Need for Capital Firms need capital to finance projects or purchase physical assets Investors have more than needed for immediate consumption Transfer of capital secured through securities

2. What is a Security? A claim on pre-specified streams of payments (bonds, for example) A claim on the residual value of a firm (stocks, for example) A claim on the price of another security (options) Securities are created to satisfy investors and borrowers’ needs

3. Examples A bond with face value of $1,000 and 5% coupon payment. The bondholder is entitled to the coupon payment and the $1,000 at the maturity date. What does the value of the bond depend on? An option to buy a stock at $20

4. Real and Financial Investment A real investment is an investment in productive assets A financial investment is a flow of funds into assets that do not produce anything Real investments involve real assets Financial investments involve financial assets

5. Real and Financial Assets A real asset determines productivity A financial asset determines ownership One’s financial asset is another’s financial liability In the aggregate, financial assets and financial liabilities cancel out, so real assets only determine productivity

6. Examples A cow is real, a dollar is financial A building is real, a bond is financial A computer is real, a company’s share is financial A patent is? A university education is?

7. Sectors of the Economic System Households: Providers of capital Businesses: Users of capital Governments: Also users of capital, and responsible for regulations

8. Households Investment decisions influenced by tax and risk considerations Tax: Interest payments have different tax treatments than dividends or capital gains Risk: Individuals are willing to take risk as long as the expected return compensates Risk tolerance may be linked to age. Young individuals have time to recover losses

9. Risk Tolerance

10. Financial Objectives of Individuals Maximize (discounted) lifetime consumption? Smooth consumption? Types of investments: Human capital, house, car, financial assets Investments can have consumption or insurance motives, not only financial motives

11. Firms Businesses want to raise capital at the lowest possible cost Low interest rate on bonds High stock prices

12. Governments Also need to raise capital Governments have a special advantage: The right to tax, which increases their ability to repay debts Governments are also responsible for regulations

13. Intermediaries and Innovation Intermediaries arise to bring together providers and the users of capital Intermediaries gain from economies of scale and specialization Chartered banks can borrow at low rates and lend at higher rates Mutual funds can diversify more effectively than individuals

14. Investment Dealers A software developer does not necessarily know the market value of his firm Investment dealers have the tools to evaluate businesses and sell them to the public Economies scale in trading and advising

15. Financial Engineering Creation of new types of securities Tax concerns (investors): capital gains and dividends are taxed differently ==> Split Shares: Separate income and growth Regulation concerns: Eurodollars Insurance concerns: Asset-backed securities

16. Asset-Backed Securities Take, for example, a car loan ($10,000) Problem for the issuer: Borrower may default, in which case the lender loses his money Take 1,000 car loans: Probability that all borrowers default is small. Pool 1,000 car loans together, sell shares from this pool to individuals Buyers of this pass-through security are repaid over time (as lenders, capital + interest) What are the risks involved?

17. Agency Problem Principal (shareholders) hire an agent (board members) but cannot watch him all the time. How to align the agent’s interests with the principal’s? Was the high-tech bubble an agency problem? Analysts and investment banking

18. The Right Approach Is there one?