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Overview: Investments

Investment ProcessTaxonomy of Financial Assets

Players and VehiclesMarket Microstructure

Recent Trends

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Investment processInvestment

Trade current benefit for future payoffBank deposit, stock purchase, education

Real vs Financial AssetsReal Assets: assets for generating goodsand services

Factory, farm, gas station, restaurant, etc.Financial Assets: claims on real assets

Bank loans, stocks, bonds, options, etc.

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Taxonomy of Financial AssetsWhy financial assets?

Consumption timing: to shift consumptionneeds across time

Savings to buy a house Allocation of risk: real asset too risky

Amazons stock for the brave and bond for theless adventurous souls

Separation of ownership & management:real asset too bigIts inefficient for GEs half -million stock ownersto participate day-to-day operations

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Taxonomy of Financial AssetsMoney and Capital Markets

Debt Instruments Common Stock & Preferred Stock

Maturity < 1 Maturity 1

MoneyMarket

Capital Market

Derivative Securities

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Investment processFive step approach

1. Setting investment objectives

2. Establishing investment policy

3. Selecting a portfolio strategy

4. Selecting the assets

5.Measuring and evaluating performance

Generating sufficient funds

Guarantee a payment atsome time in the future

Asset allocation decision:stocks, bonds, real estate

Active strategy,passive strategy,structured strategy

Portfolio formation:market timing or assetpicking

Benchmarking:S&P500, risk adjustment

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Players and VehiclesWho are they?

Financial IntermediariesCommercial Bank

Taking deposit and making loans

Investment BankSelling securities to investors

Consumers/investors

Companies

Government$

$

$

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Market MicrostructurePrimary Market

New issue of securities to the public

Secondary MarketTrading places for existing securities

OTC Market(Over-the-Counter)

Exchange (e.g. NYSE)

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Market MicrostructureDirect Search Market

Buyers/sellers search each other directlyBrokered Market

Brokers search buyers/sellers for sellers/buyersModerate trading activity, e.g., real estate, IPODealer Market

Dealers buy/sell for their own accounts

Active trading, e.g., OTC, NASDAQ Auction Market

Players buy/sell in one centralized place Active trading, e.g., NYSE

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Recent TrendsThe milestones of modern finance

Return-Risk TradeoffMarkowitz (1952; Nobel Prize in 1990)Security selection from a view of overall portfolio Risk

preference (or tolerance)Equity Valuation and Asset Allocation

Tobins q (1958; Nobel Prize in 1981) Mutual Funds

Performance EvaluationCAPM, Sharpe-Linter (1964; Nobel Prize in 1990).Mutual fund performance

Derivative Security ValuationBlack and Scholes, Merton (1973, Nobel Prize in 1997).

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Recent TrendsGlobalization

An Integration of worldwide economic environmentand national capital markets

Major ActivitiesInternational diversificationUS market down, Asia markets up, average out

Cross border tradingLocal stocks, ADRs, mutual funds, WEBS (World Equity

Benchmark Shares) now part of iShares, etc.Foreign exchange risk

Exchange rate fluctuation affects foreign stock returns

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Recent TrendsSecuritization

Pooling loans/mortgages/debts to createstandardized securities

Efficiency gain (in theory )Improved information flow based on marketactivity increases liquidityService and financing separation encouragesspecialization and results better risk allocationReduced cost for originatorEnhanced yield for investor

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Recent TrendsFinancial Engineering

The process of creating customizedsecurities tailored to investors need

BundlingCombining cash flows togetherStraight bond+call option=convertible bond

UnbundlingSlicing and dicing cash flow of an asset toseveral classesCMO to mortgage pass-through tranches andtreasury strips.

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Recent DebaclesSubprime mortgage meltdown

Credit and liquidity crunch

What went wrong?

Video (from Britain)

http://www.youtube.com/watch?v=hXBcmqwTV9shttp://www.youtube.com/watch?v=hXBcmqwTV9s

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Wrap-upWhat is investment?What are the differences betweenfinancial and real assets?Whats hot? Whats not?