Investments: Background and issues

CHAPTER 1

Investments & Financial Assets

Essential nature of investmentReduced current consumptionPlanned later consumption

How to investReal Assets: Assets used to produce goods

and services produce income to economy

Financial Assets Claims on real assets or income generated by them Allocation of income, real assets among investors,

individuals in the economy

Balance Sheet – U.S. Households

Financial Assets

Financial assets

Fixed-income (Bonds) Equity (Stocks) Derivatives

Money Market(Short-term)

Common StocksPreferred Stocks

OptionsFutures

Bond Market(Long-term)

Role of Financial asset and financial markets in the Economy

Consumption Timing Allocation of Risk Separation of Ownership and

Management

Consumption Timing

Savers

(earn more than spend)

Borrowers

(spend more than earn)

Financial assets: stocks, bonds, deposits, etc.

How do you transfer money from when you do not need to when you need?

Allocation of riskExample: GM wants to build a new auto plant, it raised money by issuing stocks and bonds

GM

Stock investors

(high risk)

Bond investors

(low risk)

Auto plant

High risk and low risk

Stock

Bond

Separation of ownership and management

Example: GE, total asset is $640 bil Cannot be single owner, must have many

owners Selling stocks to market Currently, GE has 500,000 owners These owners choose managers Can easily transfer ownership without any

impact on management

The Investment Process

Asset allocation Security selection Risk-return trade-off Market efficiency Active vs. passive management

Investment process

Broad assets

Stocks

Bonds

Real estate

Commodity

Small stock

Big stock

corporate bond

T-bond, T-bill

House

Land

coffee, tea

gold, oil, etc(1) Asset allocation(2) Security analysis

30s 70% 30%40s 60 4050s 50 5060s 40 60

CommonAge Stocks Bonds

Example of Asset Allocation

Example of Security Selection

Your Stock Portfolio

Auto Retail Financial

Wal-MartNordstroms

Sears

Bank of AmericaBerkshire Hathaway

Citibank

There is no free lunch!

Return

Risk

less risk

lessreturn

more risk

morereturn

Market Efficiency

Security prices accurately reflect all relevant information.

The price in the market is the true price Earn return just enough to compensate for risk, no

abnormal return

Active vs. Passive Management

Active Management Finding undervalued securities Timing the market

Passive Management No attempt to find undervalued securities No attempt to time Holding an efficient portfolio

Players in the Financial Markets

Business Firms – net borrowers Households – net savers Governments – can be both borrowers

and savers Investment Bankers

Players in the Financial Markets

borrowers Savers securities

fund

borrowersfinancial

intermediariessavers

securities

lending rate

securities

borrowing rate

borrowers investment bank savers securities

fund

securities

fund

get commission fees

Recent Trends

Globalization Securitization Financial Engineering Computer Networks

Globalization

In 1970, US equity market accounted for about 70 percent of equity in the world

Currently, only 20-30 percent How to invest globally

Purchase ADRs Invest directly into international market Buy mutual fund shares that invest in international market derivative securities with payoff depends on prices of foreign

market

Securitization

Banks

pool all loans

Mortgage loansauto loanscredit card

student loansother loans

securities

loans are securitized

Investors

Benefits of securitization

(1) more funds available to borrowers

(2) Transfer risk of loans to corresponding investors in the market

High risk loan High risk securities High risk investors

Low risk loan low risk securities low risk investors

Figure 1.2 Asset-backed Securities Outstanding

Financial engineering

refer to creation of new securities Bundling: combine more than one security into a

composite security Unbundling: breaking up and allocating the cash flows

from one security to create several new securities

Collateralized Debt Obligation (CDO)

A CDO is an asset backed security (ABS) whose underlying collateral is typically a portfolio of bonds (corporate or sovereign) or bank loan

A CDO cash flow structure allocates interest income and principal repayments from a collateral pool of different debt instruments to a prioritized collection (tranches) of CDO securities.

Mortgage 1Mortgage 2Mortgage 3

Mortgage n

Average Yield12.5%

($100 mil)

Tranche 1 (AAA)Yield = 5%

($25mil)

Tranche 2 (A)Yield = 10%

($25mil)

Tranche 3 (BBB)Yield = 15%

($25mil)

Tranche 4 (junk bond)Yield = 20%

($25mil)

Cash CDO Structure Illustration

An investment

bank creates a set of

securities (tranches)

backed by a mortgage

pool

(CDO)

Investor:banks, pension funds, college saving funds, universities, cities, etc.

Collateralized Debt Obligation (CDO)

In normal time, mortgage borrowers are able to make the mortgage payments, so the investors will get the interest payments, the values of slices of CDOs increase

When housing bubble busts, mortgage borrowers, especially subprime mortgage borrowers are not able to make payments, investors don’t get their money, values of CDOs decrease substantially. The value decrease is write-down and counted as loss in the income statement.

For example, investment bank A, equity: $10 mil, borrow $90 mil. Invest all $100 mil in CDOs. When mortgage crisis happens, the market value of these mortgage backed securities drops substantially say to $80 mil, that means the income will go down by $80 mil, and at this point, technically the bank is insolvent.

Subprime Mortgage Crisis: Winners and Losers

Big losers: http://ml-implode.com/ Bear Stearns: two hedge funds (>$1 billion) Australia: Basis Capital ($1 billion?); Absolute Capital ($200

million?); IKB Deutsche Industriebank … May take two more years to completely resolve!

Big losers: Citigroup ($18B+) Merrill Lynch ($11.5B+) UBS ($17.8B+) Morgan Stanley ($9.4B+) … Bank of China (initial estimate $223 million, now could be $4-5B)

Building a Complex Security

Unbundling – Mortgage Security

Recent Trends—Computer Networks

Online information dissemination Information is made cheaply and widely

available to the public Automated trade crossing

Direct trading among investors

2008: Making History

30

2008: The End of Wall Street

31

Decision Making

1. Perceive the situation

2. Possible actions

3. Evaluate the outcomes

4. Choose the action with the best outcome

32

Summary

Financial assets Risk return tradeoff Next class: Financial Securities