CHAPTER 1
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Investments: Background and issues
CHAPTER 1
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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
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Balance Sheet – U.S. Households
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Financial Assets
Financial assets
Fixed-income (Bonds) Equity (Stocks) Derivatives
Money Market(Short-term)
Common StocksPreferred Stocks
OptionsFutures
Bond Market(Long-term)
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Role of Financial asset and financial markets in the Economy
Consumption Timing Allocation of Risk Separation of Ownership and
Management
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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?
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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
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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
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The Investment Process
Asset allocation Security selection Risk-return trade-off Market efficiency Active vs. passive management
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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
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30s 70% 30%40s 60 4050s 50 5060s 40 60
CommonAge Stocks Bonds
Example of Asset Allocation
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Example of Security Selection
Your Stock Portfolio
Auto Retail Financial
Wal-MartNordstroms
Sears
Bank of AmericaBerkshire Hathaway
Citibank
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There is no free lunch!
Return
Risk
less risk
lessreturn
more risk
morereturn
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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
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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
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Players in the Financial Markets
Business Firms – net borrowers Households – net savers Governments – can be both borrowers
and savers Investment Bankers
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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
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Recent Trends
Globalization Securitization Financial Engineering Computer Networks
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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
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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
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Figure 1.2 Asset-backed Securities Outstanding
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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
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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.
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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.
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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.
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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)
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Building a Complex Security
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Unbundling – Mortgage Security
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Recent Trends—Computer Networks
Online information dissemination Information is made cheaply and widely
available to the public Automated trade crossing
Direct trading among investors
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2008: Making History
30
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2008: The End of Wall Street
31
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Decision Making
1. Perceive the situation
2. Possible actions
3. Evaluate the outcomes
4. Choose the action with the best outcome
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Summary
Financial assets Risk return tradeoff Next class: Financial Securities