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Investments:
Background and
Issues
McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.
1.1 Real Versus Financial
Assets
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Real Versus Financial Assets
• Essential nature of investment
• Reduce current consumption in hopes of greater
future consumption
• Real Assets
• Used to produce goods and services: Property,
plant & equipment, human capital, etc.
• Financial Assets
• Claims on real assets or claims on asset income
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Table 1.1. Balance Sheet –
U.S. Households, 2008
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Real versus Financial Assets
• All financial assets (owner of the claim) are offset by
a financial liability (issuer of the claim).
• When we aggregate over all balance sheets, only real
assets remain.
• Hence the net wealth of an economy is the sum of its
real assets.
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Table 1.2 Domestic Net Worth, 2008
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1.2 A Taxonomy of
Financial Assets
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Major Classes of Financial Assets or
Securities
• Debt
o Money market instruments
• Bank certificates of deposit, T-bills,
commercial paper, etc.
o Bonds
o Preferred stock
• Common stock
o Ownership stake in the entity, residual cash flow
• Derivative securities
o A contract whose value is derived from some
underlying market condition.
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1.3 Financial Markets and
the Economy
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Financial Markets
• Informational Role of Financial Markets
o Do market prices equal the fair value estimate of a
security’s expected future risky cash flows?
o Can we rely on markets to allocate capital to the
best uses?
• What other mechanism could we use to
allocate capital?
• What would be the advantages and
disadvantages of another system?
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Consumption Timing
o People tend to smooth consumption over time.
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Allocation of Risk
o Investors can choose a desired risk level
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Separation of Ownership and
Management
• Large size of firms requires separation of ownership
and management
o In 2008 GE had over $800 billion in assets and
over 650,000 stockholders
o Owners (principals) ≠ Managers (agents)
o Agency costs: Owners’ interests may not align
with managers’ interests
o Mitigating factors:
• Performance based compensation
• Boards of Directors may fire managers
• Threat of takeovers
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Example 1.1
• In February 2008, Microsoft offered to buy Yahoo at
$31 per share when Yahoo was trading at $19.18.
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Corporate Governance and
Corporate Ethics
• Business and market require trust to operate
efficiently
o Without trust additional laws and regulations are
required
o All laws and regulations are costly
• Governance and ethics failures have cost our
economy billions if not trillions of dollars.
o Eroding public support and confidence in market
based systems
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Corporate Governance and
Corporate Ethics
• Accounting Scandals
o Enron, WorldCom, Rite-Aid, HealthSouth, Global
Crossing, Qwest,
• Misleading Research Reports
o Citicorp, Merrill Lynch, others
• Auditors: Watchdogs or Consultants?
o Arthur Andersen and Enron
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Corporate Governance and
Corporate Ethics
• Sarbanes-Oxley Act
o Increases the number of independent directors on
company boards
o Requires the CFO to personally verify the
financial statements
o Created a new oversight board for the
accounting/audit industry
o Charged the board with maintaining a culture of
high ethical standards
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1.4 The Investment Process
o Asset allocation
Choosing the percentage of funds in asset classes
Stocks 60%
Bonds 30%
Alternative Assets 6%
Money market securities 4%
o Risk-return trade-off:
o Assets with higher expected returns have higher risk.
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Risk-Return Trade- Off
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Efficient Markets
o Market efficiency:
o Securities should be neither underpriced nor
overpriced on average
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Active vs. Passive Management
Active Management (inefficient markets)
Finding undervalued securities Security Selection
Timing the market Predict future market price
movements
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The Players
• Business Firms – net borrowers
• Households – net savers
• Governments – can be both borrowers and
savers
• Financial Intermediaries “Connectors of
borrowers and lenders”
o Commercial Banks
• Traditional line of business: Make loans funded by
deposits
o Investment companies
o Insurance companies
o Pension funds
o Hedge funds
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The Players Cont.
• Investment Bankers
o Firms that specialize in primary market
transactions
o Primary market:
• A market where newly issued securities are offered to
the public.
• The investment banker typically ‘underwrites’ the issue.
o Secondary market
• A market where pre-existing securities are traded among
investors.
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Investment Bankers
• Investment Bankers
o Commercial and investment banks’ functions and
organizations were separated by law from 1933 to
1999.
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Table 1.3 Balance Sheet of
Commercial Banks, 2008
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Table 1.4 Balance Sheet of
Nonfinancial U.S. Business, 2008
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1.7 Recent Trends
• Globalization
• Securitization
• Financial Engineering
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Globalization
• Domestic firms compete in global markets
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Securitization
• Loans of a given type such as mortgages are
placed into a ‘pool’ and new securities are issued
that use the loan payments as collateral.
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Securitization
• Securitization has grown rapidly due to
• Changes in financial institutions and regulation
permitting its growth, particularly lower capital
requirements on securitized loans,
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Figure 1.1 Asset-backed
Securities Outstanding
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Financial Engineering
• Repackaging cash flows of a security to enhance
marketability
• Bundling and unbundling of cash flows
o Bundling:
Combining more than one asset into a composite
security, for example securities sold backed by a
pool of mortgages.
o Unbundling
Selling separate claims to the cash flows of one
security, for example a CMO
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Figure 1.2 Building a Complex
Security
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Figure 1.3 Mortgage Security
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Computer Networks
• Online low cost trading
• Information made cheaply and widely available
• Direct trading among investors via electronic
communication networks
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The Future
• Globalization will continue and investors will
have far more investment opportunities than
in the past
• Securitization will continue to grow after the
crisis
• Continued development of derivatives and
exotics, more regulation for “over the
counter” derivatives
• Strong fundamental foundation of
understanding is critical
• Understanding corporate finance requires
understanding investments
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1.8 Text Outline
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