C31CM

LECTURE 1 - THE
INVESTMENT ENVIRONMENT
Dr Jia (Lucy) Lu

J.Lu@hw.ac.uk
 Learning Outcomes of this session:

At the end of this session, you should be able to:

❑ Distinguish between real assets and financial assets;

❑ Explain the economic functions of financial markets

❑ Describe the investment process

❑ Identify different types of financial markets and the major players

❑ Discuss the financial crisis of 2008

Reading List:

Core textbook:
❖ Bodie, Z., Kane, A. and Marcus, A.J. (2020) Investments, 12th Edition, McGraw-Hill Education, chapter
1, pp. 1-24.

Further reading:
❖ Carlson, M. and Macchiavelli, M. (2020) Emergency Loans and Collateral Upgrades: How Broker-
dealers Used Feredal Reserve Credit During the 2008 Financial Crisis. Journal of Financial
Economics, In Press, Corrected Proof.
❖ Eisenhardt, K.M. (1989) Agency Theory: An Assessment and Review. The Academy of Management
Review, 14 (1), pp. 57-74.
❖ Kilincarslan, E. (2019) Smoothed or not Smoothed: The Impact of the 2008 Global Financial Crisis on
Dividend Stability in the UK. Finance Research Letters, In Press, Corrected Proof.
Overview
1.1 Real versus Financial Assets
1.2 Financial Assets
1.3 Financial Markets & the Economy
1.4 The investment Process
1.5 Markets are competitive
1.6 The players
1.7The Financial Crisis of 2008-2009
 1.1 Real versus Financial Assets
❑ Nature of Investment: Reduce current consumption for greater future

consumption

Real
Assets

Financial Assets:
Productive Claims on Real Assets or
Capacity
Real Asset Income
Stocks and Bonds
Property, plants
and equipment,
human capital,
etc.
 Table 1.1 Balance Sheet, U.S. Households,
Assets 2017 $ Billion % Total Liabilities and Net Worth $ Billion % Total

Real assets
Real estate $26,528 24.6% Mortgages $9,994 9.3%
Consumer durables 5,418 5.0% Consumer credit 3,765 3.5%
Other 485 0.4% Bank and other loans 998 0.9%
Total real assets $28,330 29.6% Other 348 0.3%

Total liabilities $15,104 14.0%

Financial assets
Deposits 10369 9.6%
Life insurance reserves 1,368 1.3%
Pension reserves 22,259 20.6%
Corporate equity 15,874 14.7%
Equity in noncorp. business 11,249 10.4%

Mutual fund shares 7,875 7.3%

Debt securities 5,239 4.9%
Other 1,244 1.2%
Total financial assets 75,478 69.9% Net worth 92,805 86.0%
TOTAL $107,910 100.0% $107,910 100.0%

Note: Column sums may differ from total because of rounding error.
SOURCE: Flow of Funds Accounts of the United States, Board of Governors of the Federal Reserve System, March 2017.
Financial Assets = Financial Liabilities
▪ Financial Assets and Liabilities must
balance.
Financial Assets
(Owner of the claim)

Financial Liability
(Issues of the Claim)

▪ Aggregated balance sheets only real

assets remain
▪ Domestic Net Worth = Sum of real assets
 1.2 Financial Assets

Common Stock/Equity
Ownership share in the
corporation.

Asset
Classe
s

Derivative Securities Fixed Income

Securities
Contract, value derived
from underlying market Money market instruments
condition and capital market
instruments
 1.3 Financial Markets and the
Economy
❑ Informational Role of Financial Markets

▪ Stock prices reflect investor’s assessment of a firm’s

current performance and future prospects.

▪ Do capital markets channel resources to the most

efficient use?
❑ Consumption Timing

▪ Use securities to store wealth (high-earnings & low-earnings periods)

▪ Transfer consumption to the future

Dollars

Consumption

Savings
Dissavings Dissavings

Income

Age
❑ Risk Allocation

▪ capital markets allow the risk that is inherent to all

investments to be borne by the investors most willing to

bear it.
▪ risk allocation benefits the firms that need to raise capital.

▪ is there always a Risk/Expected Return trade-off?

❑ Separation of Ownership and Management

▪ separation Agency Problems

▪ Mitigating factors

• Performance-based compensation

• Boards of directors may fire managers

• Outsiders (security analysts and large institutional investors)

• Threat of takeovers
❑ Corporate Governance and Corporate Ethics
▪ businesses and markets require trust

• no trust additional costly laws and regulations

▪ governance and ethics failures cost the economy

• erodes public support and confidence

▪ 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

https://www.youtube.com/watch?v=jrEf8uabe7E
▪ Sarbanes-Oxley Act (S0X):
• Requires more independent directors on

• CFO to personally verifies the financial statements

• Oversight board for the accounting/audit industry

• Charged board with maintaining a culture of high ethical

standards
 1.4 The Investment Process:
Asset Allocation
❑ Asset Allocation
▪ Primary determinant of a portfolio's return

▪ Percentage of fund in asset classes, for example:

▪ Top-down investment strategies starts with asset allocation

 1.4 The Investment Process: Security Selection

❑ Security Selection
▪ Choice of particular securities within asset class

▪ Security Analysis

• Analysis of the value of securities.

▪ Bottom-up investment strategies starts with security selection

 1.5 Markets Are Competitive
❑ Risk-Return Trade-Off

▪ Investors invest for anticipated future returns, but those

returns rarely can be predicted precisely.

▪ Assets with higher expected returns have higher risk

Average Annual Return Minimum (1931) Maximum (1933)

Stocks About 12% −46% 55%
❑ Efficient Markets

▪ be neither underpriced nor overpriced on average

▪ reflect all information available to investors

Choice of
Your Belief in Investment-
Market Management
Efficiency Style
 Passive
Active Management
Management

Markets are… Inefficient Efficient

No Attempt to Find
Actively Seek
Security Selection: Undervalued
Undervalued Stocks
Securities

No Attempt to Time
Asset Allocation Market Timing
Market
 1.6 The Players
❑ Three major players

Net demanders Net suppliers of capital

Household
Firms s

Governments

Borrowers or lenders
❑ Financial Intermediaries (connectors of borrowers and

lenders)

Surplus Units Deficit units

Invest/deposit/lend funds

Borrow Funds
Table 1.2: Balance Sheet of Commercial Banks, 2017
Assets $ Billion % Total Liabilities and Net Worth $ Billion % Total

Real assets Liabilities

Equipment and premises $120.2 0.7% Deposits $12,894.7 76.8%
Other real estate 10.9 0.1% Debt and other borrowed funds 1,170.9 7.0%
Total real assets $125.2 0.7% Federal funds and repurchase agreements 233.7 1.4%
Other 611.1 3.6%

Total liabilities $14,910.4 88.9%

Financial assets
Cash $1,810.0 10.8%
Investment securities 3,559.5 21.2%
Loans and leases 9,183.9 54.7%
Other financial assets 1,059.2 6.3%
Total financial assets $15,612.5 93.0%

Other assets
Intangible assets $350.4 2.1%
Other 692.1 4.1%
Total other assets $1,042.5 7.2% Net worth 1,869.8 11.1%

TOTAL $15,164.6 100.0% $16,780.2 100.0%

Note: Column sums may differ from total because of rounding error.
SOURCE: Federal Deposit Insurance Corporation, www.fdic.gov, March 2017.
Table 1.3: Balance Sheet of Nonfinancial U.S. Business,
2017

Assets $ Billion % Total Liabilities and Net Worth $ Billion % Total

Real assets Liabilities

Equipment and software $6,936 16.6% Bonds and mortgages $6,299 15.1%

Real estate 13,319 31.9% Bank loans 985 2.4%

Inventories 2,280 5.5% Other loans 1,140 2.7%

Total real assets $18,569 54.0% Trade debt 2,146 5.1%

Other 7,495 17.9%

Financial assets Total liabilities $18,065 43.3%

Deposits and cash $1,070 2.6%

Marketable securities 1,011 2.4%

Trade and consumer credit 2,800 6.7%

Other 14,344 34.3%

Total financial assets $19,224 46.0%

TOTAL $41,759 100.0% Net worth 23,694 56.7%

$41,759 100.0%

Note: Column sums may differ from total because of rounding error.
SOURCE: Flow of Funds Accounts of the United States, Board of Governors of the Federal Reserve System, March, 2017.
▪ Advantages of financial intermediary role

Re-packaging or pooling
finance

Liquidity transformation

Risk reduction
▪ Financial intermediaries include
• Investment Companies – pool and manage the money of many
investors, also arise out of economics of scale.
• Investment Bankers - specialize in primary market transactions.

Preexisting securities traded

Secondary
market among investors

Newly issued securities offered to

Primary market public
Investment banker “underwriters”
issue
• Venture Capital and Private Equity

o Venture capital - equity investment to finance new firm

o Private equity - investments in privately-held companies

• Fintech and Financial Innovation – the application of technology to

financial markets
o Peer-to-peer
o Cryptocurrencies
 1.7 The Financial Crisis of 2008
❑ Changes in Housing Finance
Old Way
• Local thrift institution made
mortgage loans to homeowners
• Thrift’s possessed a portfolio of
long-term mortgage loans
• Thrift’s main liability: Deposits
• “Originate to hold”
New Way
• Securitization: Fannie Mae and
Freddie Mac bought mortgage loans
and bundled them into large pools
• Mortgage-backed securities are
tradable claims against the underlying
mortgage pool
• “Originated to distribute”
Cash Flows in a Mortgage Pass-
Through Security
Changes in Housing Finance (Continued)
▪ Inclusion of nonconforming “subprime” loans

▪ Low/No-documentation loans

▪ Rising loan-to-value ratio

▪ Adjustable-Rate Mortgages
Figure 1.1: Case-Shiller Index of U.S. Housing
Prices
❑ Mortgage Derivatives

▪ CDOs (Collateralized debt obligations): Consolidated default risk

of loans onto one class of investor, divided payment into tranches

✔ Senior tranches – first claim on repayments from the entire
pool
✔ Junior tranches – paid only after the senior tranches had
received their cut
▪ Ratings agencies paid by issuers; pressured to give high ratings
❑ Credit Default Swaps
▪ Insurance contract against the default of borrowers

▪ Issuers ramped up risk to unsupportable levels

❑ Systemic Risk
▪ Risk of breakdown in financial system — spillover effects from

one market into others

▪ Banks highly leveraged; assets less liquid

▪ Formal exchange trading replaced by over-the-counter markets

— no margin for insolvency protection

❑ The Shoe Drops
▪ 7th September, 2008: Fannie Mae and Freddie Mac put into

conservatorship
▪ Lehman Brothers and Merrill Lynch verged on bankruptcy

▪ 17th September: Government lent $85 billion to AIG (American

International Group)
▪ Money market panic freezes short-term financing market
❑ Dodd-Frank Reform Act
▪ Stricter rules for bank capital, liquidity, risk management

▪ Mandated increased transparency

▪ Clarified regulatory system

▪ Volcker Rule:

✔ Prohibits banks from trading their own accounts and limits

total investments in hedge funds or private equity funds.

Thanks for Your Attention
Asset Classes & Financial
Instruments
Please read the Core textbook:
Chapter 2