Chapter 1 investments background and issues

Chapter 1 Investments: Background and Issues Chapter Contents  1.1 Real Versus Financial Assets  1.2 A Taxonomy of Financial Assets  1.3 Financial Markets and the Economy  1.4 The Investment Process  1.5 Markets Are Competitive  1.6 The Players  1.7 Recent Trends  1.8 Outline 1-2   •  - Reduce current consumption in hopes of greater future consumption. •  - Used to produce goods and services: Property, plant & equipment, human capital, etc. •  Claims on real assets or claims on asset income   !""# !$%& !""# !'(  )*+ • $,-'. )(/ • Short-term, highly marketable, and very low risk • Bank certi$cates of deposit, T-bills, commercial paper, etc. +0/ • Long-term and ranged from very safe to relatively risky • Treasury bonds, bonds issued by various agencies • +/ - Not promised any particular payment. - Ownership stake in the entity, residual cash )ow - Tend to by risker than investments in debt securities. • $ - A contract whose value is derived from some underlying market condition. - Provide payo+s that depend on the values of other assets. • Options and Futures - Primarily purposed for hedging risks. 1.3 Financial Markets and the Economy 1-9 The Informational Role • Do market prices equal the fair value estimate of a security’s expected future risky cash flows? - Decide which companies will live and which will die. • Can we rely on markets to allocate capital to the best uses? 1-10 [...]... of takeovers 1- 13 Corporate Governance and Corporate Ethics • Business and market require trust and transparency to operate efficiently - Without trust additional laws and regulations are required • All laws and regulations are costly Governance and ethics failures have cost our economy billions - Eroding public support and confidence in market based systems 1- 14 Corporate Governance and Corporate... Minimum (19 31) Maximum (19 33) -46% 55% About 12 % A stock portfolio can be expected to lose money about 1 out of every 4 years - Bonds have a much lower average rate of return (under 6%) and have not lost more than 13 % of their value in any one year 1- 18  Risk-Return Trade- Off (continued) - How do we measure risk? - How does diversification affect risk? - Discussed in Part 2 of the text 1- 19 Efficient... low-earnings periods, sell these assets 1- 11 Allocation of Risk • Investors can choose a desired risk level - Bonds versus stock of a given company - Bank CD versus company bond - Tradeoff between risk and return? 1- 12 Separation of Ownership and Management • Large size of firms requires separation of ownership and management - In 2008, GE had over $800 billion in assets and over 650,000 stockholders - Owners... culture of high ethical standards 1- 16 1. 4 The Investment Process  Asset allocation Choosing the percentage of funds in asset classes Stocks 60% Bonds 30% Alternative Assets Money market securities  6% 4% Security selection & analysis Choosing specific securities within an asset class  The asset allocation decision is the primary determinant of a portfolio’s return 1- 17 1. 5 Markets Are Competitive... in market based systems 1- 14 Corporate Governance and Corporate Ethics • Accounting Scandals - Enron, WorldCom, Rite-Aid, HealthSouth, Global Crossing, Qwest • Misleading Research Reports - Citicorp, Merrill Lynch, others • Auditors: Watchdogs or Consultants? - Arthur Andersen and Enron 1- 15 Corporate Governance and Corporate Ethics • Sarbanes-Oxley Act (SOX) - Increases the number of independent directors... develop - Information and analysis improves 1- 26 Securitization • Loans of a given type such as mortgages are placed into a ‘pool’ and new securities are issue d that use the loan payments as collateral • The securities are marketable and are purchased by many institutions • End result is more investment opportunities for purchasers, and spreading loan credit risk amo ng more institutions 1- 27 Securitization... Selling separate claims to the cash flows of one security 1- 29 Computer Networks • Online trading connects a customer directly to a brokerage firm - Online brokerage firms can charge lower commissions • Cheaply and widely accessed to vast amounts of information via Internet 1- 30 1. 8 Outline • Part 1: Introduction to Financial Markets, Securities and Trading Methods • Part 2: Modern Portfolio Theory •... management style 1- 20 Active vs Passive Management Active Management (inefficient markets) Finding undervalued securities Security Selection Timing the performance of asset classes Asset Allocation Passive Management (efficient markets) No attempt to find undervalued securities No attempt to time Holding a diversified portfolio: • • Indexing Constructing an “efficient” portfolio 1- 21 1.6 The Players 1- 22 The... investors 1- 24 1. 7 Recent Trends • Globalization • Securitization • Financial Engineering • Information and Computer Networks 1- 25 Globalization • Domestic firms compete in global markets • Performance in one country or region depends on other regions • Opportunities for better returns & implications for risk - Managing foreign exchange - International diversification reduces risk - Instruments and vehicles... Households – net savers Governments – can be both borrowers and savers Financial Intermediaries “Connectors of borrowers and lenders” - Commercial Banks : Traditional line of business: Make loans funded by deposits Investment companies : Pool and manage the money of many investors; e.g mutual fund - Insurance companies - Pension funds - Hedge funds 1- 23 The Players (continued) • Investment Bankers - Firms . Chapter 1 Investments: Background and Issues Chapter Contents  1. 1 Real Versus Financial Assets  1. 2 A Taxonomy of Financial Assets  1. 3 Financial Markets and the Economy  1. 4 The. assets. 1- 11 Allocation of Risk • Investors can choose a desired risk level. - Bonds versus stock of a given company - Bank CD versus company bond - Tradeoff between risk and return? 1- 12 Separation. managers • Threat of takeovers 1- 13 Corporate Governance and Corporate Ethics • Business and market require trust and transparency to operate efficiently - Without trust additional laws and regulations are