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CHAPTER 1Investments - Background and Issues

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1.1 REAL ASSETS VERSUS FINANCIAL ASSETS

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Real AssetsReal Assets– Assets used to produce goods and Assets used to produce goods and

servicesservices such as land, building and such as land, building and equipment.equipment.

Financial AssetsFinancial Assets– Claims on real assetsClaims on real assets or the income or the income

generated by them such as stocks and generated by them such as stocks and bonds.bonds.

Financial Versus Real AssetsFinancial Versus Real Assets

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Real assets generate net income to the Real assets generate net income to the economy.economy.

Financial assets allocate income or Financial assets allocate income or wealth among investors.wealth among investors.

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Table 1.1. Balance Sheet – U.S. Households, 2006

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Table 1.2 Domestic Net Worth, 2006

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1.2 A TAXONOMY OF FINANCIAL ASSETS

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Major Classes of Financial Assets or Securities

Fixed Income (Fixed Income (DebtDebt) Securities: Pay a specified cash ) Securities: Pay a specified cash flow over a specific period. flow over a specific period. – Money market instrumentsMoney market instruments (Short-term) (Short-term)

Treasury Bills, Commercial papers, Treasury Bills, Commercial papers, Bank certificates of depositBank certificates of deposit (CDs)(CDs)

– Capital market instrumentsCapital market instruments (Long-term) (Long-term)Treasury Treasury BondsBonds and Corporate Bonds and Corporate Bonds

Equity: An ownership share in a corporation.Equity: An ownership share in a corporation.– Common stockCommon stock

Derivative securitiesDerivative securities: Provide payoffs that depend on the : Provide payoffs that depend on the values of the other securitiesvalues of the other securities– Futures, Options and etc.Futures, Options and etc.– Hedging and SpeculationHedging and Speculation

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1.3 FINANCIAL MARKETS AND THE ECONOMY

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Financial Markets and Economy

Informational Role of Financials MarketInformational Role of Financials Markets: s: Fin. Markets play a central role in the Fin. Markets play a central role in the allocation of funds. If the investors think allocation of funds. If the investors think that the corporation has good prospects that the corporation has good prospects for future profitability, they will bid up its for future profitability, they will bid up its share price.share price.

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Financial Markets and Economy

Consumption TimingConsumption Timing: Some individuals : Some individuals are eqrning more than they spend or vse are eqrning more than they spend or vse versa. Fin. Markets help to purchase fin. versa. Fin. Markets help to purchase fin. İnstruments when you are earning more İnstruments when you are earning more than spend and sell them in order to than spend and sell them in order to satisfy your consumption needs when you satisfy your consumption needs when you are spending more than currently earning.are spending more than currently earning.

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Financial Markets and Economy

Allocation of RiskAllocation of Risk: Fin markets provide the : Fin markets provide the allocation of risk among the investors who are allocation of risk among the investors who are more or less risk averse.more or less risk averse.Separation of Ownership and ManagementSeparation of Ownership and Management: In : In today’s business owners elect the board of today’s business owners elect the board of directors which in turn hires and supervises the directors which in turn hires and supervises the management: owners and managers are management: owners and managers are differentdifferent– Agency Agency Problem: conflict of interest between the Problem: conflict of interest between the

managers and owners. managers and owners. – Bonuses, compansation plans and etc.Bonuses, compansation plans and etc.

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Financial Markets and EconomyFinancial Markets and Economy

Corporate Governance and Ethics: Fin. Corporate Governance and Ethics: Fin. Markets play an imp. Role in facilitating Markets play an imp. Role in facilitating excess funds to their most productive excess funds to their most productive uses. In order to provide this effectively, uses. In order to provide this effectively, there must be enough transpapency for there must be enough transpapency for investors to make well-informed decisions.investors to make well-informed decisions.

Firms must not mislead public about their Firms must not mislead public about their prospects. prospects.

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1.4 THE INVESTMENT PROCESS

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The Investor’s Portfolio

Portfolio: collection of investment assets. Asset classes Portfolio: collection of investment assets. Asset classes consist of stocks, bonds, real estate, commodities and consist of stocks, bonds, real estate, commodities and etc.etc.Investors make two types of decisions in constructing Investors make two types of decisions in constructing portfios: portfios: 1. 1. Asset allocationAsset allocation– Choice among broad asset classesChoice among broad asset classes such as stocks, bonds, bills, such as stocks, bonds, bills,

real estate and commodities.real estate and commodities.

2. 2. Security selectionSecurity selection– Choice of which securities to hold within asset classChoice of which securities to hold within asset class..– Top-down approach and Bottom-up approachTop-down approach and Bottom-up approach

Security Security analysis: valuation of particular securities that analysis: valuation of particular securities that might be included in the portfolio. might be included in the portfolio.

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1.5 MARKETS ARE COMPETITIVE

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Risk-Return Trade-OffRisk-Return Trade-Off

Assets with higher expected returns have Assets with higher expected returns have greater riskgreater risk..

Diversification means that many assets Diversification means that many assets are held in the portfolio so that the are held in the portfolio so that the exposure to any particular asset is limited. exposure to any particular asset is limited.

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Efficient Markets TheoryEfficient Markets Theory

SSecurities ecurities sshould be neither underpriced hould be neither underpriced nor overpricednor overpriced: fairly priced: fairly priced

Security price should reflect all information Security price should reflect all information available to investorsavailable to investors

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Active Versus Passive ManagementActive Versus Passive Management

Passive ManagementPassive Management:: Buying and holding a diversified Buying and holding a diversified portfolio without attempting to identfy mispriced portfolio without attempting to identfy mispriced securitiessecuritiesNo attempt to find undervaluedNo attempt to find undervalued (mispriced) (mispriced) securities securitiesNo attempt to timeNo attempt to timeHolding an efficient portfolioHolding an efficient portfolioActive ManagementActive Management: Attempting to identify mispriced : Attempting to identify mispriced securities or to forecast broad market trendssecurities or to forecast broad market trendsFinding undervalued securitiesFinding undervalued securitiesTiming the marketTiming the market

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1.6 THE PLAYERS

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The Players

Business Firms – net borrowersBusiness Firms – net borrowers

Households – net saversHouseholds – net savers

Governments – can be both borrowers Governments – can be both borrowers and saversand savers

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Financial InstitutionsFinancial Institutions

Financial IntermediariesFinancial Intermediaries: Institutions that : Institutions that “connect” borrowers and lenders by “connect” borrowers and lenders by accepting funds from lenders and loaning accepting funds from lenders and loaning funds to borrowers.funds to borrowers.– Commercial Commercial BanksBanks: accept deposits : accept deposits

(borrowing) and give loans such as credits (borrowing) and give loans such as credits (lending)(lending)

– Investment companiesInvestment companies: Firms managing funds : Firms managing funds for investors. They manage several mutual for investors. They manage several mutual funds.funds.

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Investment BankersInvestment Bankers (Investment banks (Investment banks and brokerage firms) (such as Goldman and brokerage firms) (such as Goldman Sachs and Merrill Lynch): Firms Sachs and Merrill Lynch): Firms specializing in the sale of new securities to specializing in the sale of new securities to the public. the public. – Primary market: A market in which new issue Primary market: A market in which new issue

of securities are offered to the public.(IPOs: of securities are offered to the public.(IPOs: Initial Public Offerings)Initial Public Offerings)

– Secondary market: Previously issued Secondary market: Previously issued securities are traded among investors. securities are traded among investors.

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Table 1.3 Balance Sheet of Table 1.3 Balance Sheet of Commercial BanksCommercial Banks

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Table 1.4 Balance Sheet of Table 1.4 Balance Sheet of Nonfinancial U.S. BusinessNonfinancial U.S. Business

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1.7 RECENT TRENDS

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Globalization

Tendency toward a worldwide investment Tendency toward a worldwide investment environment, and the integration of the environment, and the integration of the international capital markets.international capital markets.US investors;US investors;

– Purchase foreign securities using ADRs (American Purchase foreign securities using ADRs (American Depository Receipts).Depository Receipts).

– Purchase foreign securities that are offered in dollars.Purchase foreign securities that are offered in dollars.– Buy mutual funds that invest internationally.Buy mutual funds that invest internationally.

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Figure 1.1 Global Debt Issue

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Securitization

Pooling loans into standartized securities backed by Pooling loans into standartized securities backed by those loans, which can then be traded like any other those loans, which can then be traded like any other security.security.Asset- backed securities, Mortgage-backed securities Asset- backed securities, Mortgage-backed securities are called as Pass-through securities: Pools of loans are called as Pass-through securities: Pools of loans (such as home mortgage loans) sold in one package. (such as home mortgage loans) sold in one package. Owners of them receive all the principal and interest Owners of them receive all the principal and interest payments made by the borrowers.payments made by the borrowers.

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Figure 1.2 Asset-backed Securities Outstanding

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Financial EngineeringCreation of new securities by unbundling- Creation of new securities by unbundling- breaking up and allocating the cash flows breaking up and allocating the cash flows from one security to create several new from one security to create several new securities or by bsecurities or by bundlingundling- combining more - combining more than one security into a composite security.than one security into a composite security.

Examples: strips, principal/interest splitsExamples: strips, principal/interest splits

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Figure 1.3 Building a Complex Security

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Unbundling – Mortgage Security

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Computer Networks

Online tradingOnline trading connects a customer connects a customer directly to a brokerage firm.directly to a brokerage firm.

Internet has allowed the Internet has allowed the information information to be to be made cheaply and widely availablemade cheaply and widely available..

Electronic communication networks allow Electronic communication networks allow ddirect trading among investorsirect trading among investors