1st Meeting

st
1 Meeting
The Investment
Environment
INVESTMENTS | BODIE, KANE, MARCUS
©2021 McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom.
No reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education.
Chapter Overview
• “Real” versus financial assets
• Risk-return trade-off and efficient pricing of

financial assets
• Financial crisis of 2008

• Illustrated connections between financial system
and “real” side of the economy
• Lessons about systemic risk

©2021 McGraw-Hill Education 1-2
Real Assets vs. Financial Assets
Real Assets Financial Assets

• Used to produce goods • Claims to the income
and services generated by real assets
or claims on income from
the government
• Examples: Land, • Do not directly contribute
buildings, machines, to the productive capacity
intellectual property of the economy
• Examples: Stocks, bonds

Types of Financial Assets
• Fixed-income / Debt securities
• Promises either a fixed stream of income or a stream
of income determined by a specified formula (e.g.,
corporate bond)
• Equity
• Represents ownership share in a firm (e.g., common
stock)
• Derivative securities
• Payoff depends on the value of other financial
variables such as stock prices, interest rates, or
exchange rates
©2021 McGraw-Hill Education
Other Types of Financial Markets
• Currency
• $2 trillion of currency traded each day in London
alone
• Commodities
• E.g., corn, wheat, natural gas

Financial Markets and the Economy
• The Informational Role
• Consumption Timing
• Allocation of Risk
• Separation of Ownership and Management

• Agency problems

(Continued)
• Mechanisms to mitigate potential agency

problems
• Compensation plans tie the income of managers
to the success of the firm
• Monitoring from the board of directors
• Monitoring by large investors and security
analysts
• Threat of takeover for poor performers

(Concluded)
• Corporate Governance and Corporate Ethics

• Accounting scandals
• Enron, Rite Aid, HealthSouth
• Auditing scandals
• Arthur Andersen (Enron’s auditor)
• Sarbanes-Oxley Act (aka “SOX”)
• Passed in 2002 in response to ethics scandals
• Focused on corporate governance

The Portfolio Management Process
1. Policy statement - Focus: Investor’s short-term and
long-term needs, familiarity with capital market history,
and expectations
2. Examine current and project financial, economic,
political, and social conditions - Focus: Short-term and
intermediate-term expected conditions to use in
constructing a specific portfolio
3. Implement the plan by constructing the portfolio - Focus:
Meet the investor’s needs at the minimum risk levels
4. Feedback loop: Monitor and update investor needs,
environmental conditions, portfolio performance

What is a Portfolio Management Process?

1. Policy statement
• specifies investment goals and
acceptable risk levels
• should be reviewed periodically
• guides all investment decisions

What is a Planning Step?
• Planning Step – Stages:
A. Identification and specifying the Investor’s
Objectives and Constraints
B. Creating the Investment Policy Statement
C. Forming Capital Market Expectation
D. Creating the Strategic Asset Allocation

A. Identification and specifying the Investor’s
Objectives and Constraints
• Investment Objectives – Desired investment
Outcomes
• Constraints – Limitations (Internal & External)
• Internal – Client’s Specific Liquidity needs,
time and unique
• External – Tax issues and legal & regulatory
requirements

• Governing document for all investment decision making
• Includes –
• Brief client description
• Purpose of establishing policies and guidelines
• Duties and responsibilities of parties
• Statement of investment goals, objectives and
constraints
• Schedule of review
• Performance measures
• Guidelines for rebalancing the portfolio on feedback

• Elaboration of Investment Strategy – Clarifies
the basis for investment Decisions.
• Three Approaches:
a. Passive Investment Approach – Does not
react to changes in Capital market
expectations
b. Active Investment Approach – Portfolio manager
will respond to changing CME
c. Semi active , risk-controlled active or
enhanced index approach
C. Forming Capital Market Expectation
• Long run forecast
• Risk and return characteristics
• Asset classes
• Maximize expected return and minimize risk

D. Creating the Strategic Asset Allocation
• Determine target asset class weights
• Combine IPS and Capital market expectations
• Specification of risk control mechanism
(Single-period and Multi-period perspectives)
• Single period – Advantage of Simplicity
• Multi-period – Liquidity and Tax
considerations

2. Study current financial and
economic conditions and forecast
future trends
• determine strategies to meet goals
• requires monitoring and updating

3. Construct the portfolio
• allocate available funds to minimize
investor’s risks and meet investment
goals

4. Monitor and update
• evaluate portfolio performance
• Monitor investor’s needs and market
conditions
• revise policy statement as needed
• modify investment strategy
accordingly

The Need For A Policy Statement
• Helps investors understand their own

needs, objectives, and investment
constraints
• Sets standards for evaluating portfolio
performance
• Reduces the possibility of
inappropriate behavior on the part of
the portfolio manager
Constructing A Policy Statement
Questions to be answered:
• What are the real risks of an adverse financial
outcome, especially in the short run?
• What probable emotional reactions will I have to
an adverse financial outcome?
• How knowledgeable am I about investments and
the financial markets?

Constructing A Policy Statement
• What other capital or income sources do I
have? How important is this particular
portfolio to my overall financial position?
• What, if any, legal restrictions may affect
my investment needs?
• What, if any, unanticipated consequences
of interim fluctuations in portfolio value
might affect my investment policy?
Investment Objectives
• Risk Tolerance
• Absolute or relative percentage
return
• General goals

General Goals
• Capital preservation
• minimize risk of real loss
• Capital appreciation
• Growth of the portfolio in real terms to meet
future need
• Current income
• Focus is in generating income rather than
capital gains
General Goals
• Total return
• Increase portfolio value by capital gains and by
reinvesting current income
• Maintain moderate risk exposure

Investment Constraints
• Liquidity needs
• Vary between investors depending upon age,
employment, tax status, etc.
• Time horizon
• Influences liquidity needs and risk tolerance

• Tax concerns
• Capital gains or losses – taxed differently from
income
• Unrealized capital gain – reflect price appreciation
of currently held assets that have not yet been sold
• Realized capital gain – when the asset has been
sold at a profit
• Trade-off between taxes and diversification – tax
consequences of selling company stock for
diversification purposes

• Tax concerns (continued)

• interest on municipal bonds exempt from
federal income tax and from state of issue
• interest on federal securities exempt from
state income tax
• contributions to an IRA may qualify as
deductible from taxable income
• tax deferral considerations - compounding

1. Policy statement - Focus: Investor’s short-term and
long-term needs, familiarity with capital market history,
and expectations
2. Examine current and project financial, economic,
political, and social conditions - Focus: Short-term and
intermediate-term expected conditions to use in
constructing a specific portfolio
3. Implement the plan by constructing the portfolio - Focus:
Meet the investor’s needs at the minimum risk levels
4. Feedback loop: Monitor and update investor needs,
environmental conditions, portfolio performance

The Investment Process
• Portfolio: Collection of investment assets
• Asset allocation
• Choice among broad asset classes (e.g., stocks,
bonds, real estate, etc.)
• Security selection
• Choice of securities within each asset class

The Investment Process
(Continued)
• Security analysis involves the valuation of

particular securities that might be included in
the portfolio
• “Top-down” approach
• Asset allocation followed by determination of
particular securities to be held in each asset class
• “Bottom-up” approach
• Investment based on attractively priced securities
without as much concern for asset allocation
Markets Are Competitive
• Financial markets are highly competitive
• There will almost always be risk associated
with investments
• Risk-return trade-off - Higher-risk assets are

priced to offer higher expected returns than
lower-risk assets

(Continued)
• You should rarely expect to find bargains in

the security markets
• See Ch. 11 for a discussion of the theory and
evidence of the efficient market hypothesis
• Efficient market hypothesis

• The prices of securities fully reflect available
information
• If this were true, there would exist neither
underpriced nor overpriced securities
(Concluded)
• Passive management
• Highly diversified portfolio
• No attempt to improve investment performance
by identifying mispriced securities
• Active management
• Focus on improving performance by finding
mispriced securities or by timing the performance
of broad asset classes
The Players
(1 of 4)
1. Firms
• Net demanders of capital
• Raise capital now to pay for investments in plant and
equipment
2. Households
• Typically net suppliers of capital
• Purchase securities issued by firms that need to raise
funds
3. Governments
• Can function as borrowers or lenders, depending on
the relationship between tax revenue and
government expenditures
©2021 McGraw-Hill Education
The Players
(2 of 4)
• Financial intermediaries bring the suppliers of

capital (investors) together with the
demanders of capital (primarily corporations
and the federal government)
• Examples
• Investment companies
• Banks
• Insurance companies
• Credit unions


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st

• Risk-return trade-off and efficient pricing of

• Financial crisis of 2008

INVESTMENTS | BODIE, KANE, MARCUS

Real Assets Financial Assets

• Examples: Stocks, bonds

INVESTMENTS | BODIE, KANE, MARCUS

INVESTMENTS | BODIE, KANE, MARCUS

• Separation of Ownership and Management

INVESTMENTS | BODIE, KANE, MARCUS

• Mechanisms to mitigate potential agency

INVESTMENTS | BODIE, KANE, MARCUS

• Corporate Governance and Corporate Ethics

INVESTMENTS | BODIE, KANE, MARCUS

INVESTMENTS | BODIE, KANE, MARCUS

INVESTMENTS | BODIE, KANE, MARCUS

INVESTMENTS | BODIE, KANE, MARCUS

INVESTMENTS | BODIE, KANE, MARCUS

INVESTMENTS | BODIE, KANE, MARCUS

INVESTMENTS | BODIE, KANE, MARCUS

INVESTMENTS | BODIE, KANE, MARCUS

INVESTMENTS | BODIE, KANE, MARCUS

INVESTMENTS | BODIE, KANE, MARCUS

INVESTMENTS | BODIE, KANE, MARCUS

INVESTMENTS | BODIE, KANE, MARCUS

• Helps investors understand their own

INVESTMENTS | BODIE, KANE, MARCUS

INVESTMENTS | BODIE, KANE, MARCUS

INVESTMENTS | BODIE, KANE, MARCUS

INVESTMENTS | BODIE, KANE, MARCUS

INVESTMENTS | BODIE, KANE, MARCUS

• Tax concerns (continued)

INVESTMENTS | BODIE, KANE, MARCUS

INVESTMENTS | BODIE, KANE, MARCUS

INVESTMENTS | BODIE, KANE, MARCUS

• Security analysis involves the valuation of

• Risk-return trade-off - Higher-risk assets are

INVESTMENTS | BODIE, KANE, MARCUS

• You should rarely expect to find bargains in

• Efficient market hypothesis

• Financial intermediaries bring the suppliers of

INVESTMENTS | BODIE, KANE, MARCUS

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