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Overview: Investments

Investment Process
Taxonomy of Financial Assets
Players and Vehicles
Market Microstructure
Recent Trends
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Investment process
 Investment
 Trade current benefit for future payoff
 Bank deposit, stock purchase, education
 Real vs Financial Assets
 Real Assets: assets for generating goods
and 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 Assets
 Why financial assets?
 Consumption timing: to shift consumption
needs across time
 Savings to buy a house
 Allocation of risk: real asset too risky
 Amazon’s stock for the brave and bond for the
less adventurous souls
 Separation of ownership & management:
real asset too big
 It’s inefficient for GE’s half-million stock owners
to participate day-to-day operations
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Taxonomy of Financial Assets
 Money and Capital Markets
Debt Instruments Common Stock & Preferred Stock
Maturity < 1 Maturity  1
Money
Market
Capital Market
Derivative Securities
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Investment process
 Five 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 at
some time in the future
Asset allocation decision:
stocks, bonds, real estate
Active strategy,
passive strategy,
structured strategy
Portfolio formation:
market timing or asset
picking
Benchmarking:
S&P500, risk adjustment
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Players and Vehicles
 Who are they?
Financial Intermediaries
Commercial Bank
Taking deposit and making loans
Investment Bank
Selling securities to investors

Consumers/investors
Companies
Government
$
$
$
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Market Microstructure
 Primary Market
 New issue of securities to the public
 Secondary Market
 Trading places for existing securities
OTC Market
(Over-the-Counter)
Exchange (e.g. NYSE)
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Market Microstructure
 Direct Search Market
 Buyers/sellers search each other directly
 Brokered Market
 Brokers search buyers/sellers for sellers/buyers
 Moderate trading activity, e.g., real estate, IPO
 Dealer 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 Trends
 The milestones of modern finance
 Return-Risk Tradeoff
 Markowitz (1952; Nobel Prize in 1990)
 Security selection from a view of overall portfolio Risk
preference (or tolerance)
 Equity Valuation and Asset Allocation
 Tobin’s q (1958; Nobel Prize in 1981)
 Mutual Funds
 Performance Evaluation
 CAPM, Sharpe-Linter (1964; Nobel Prize in 1990).
 Mutual fund performance
 Derivative Security Valuation
 Black and Scholes, Merton (1973, Nobel Prize in 1997).
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Recent Trends
 Globalization
 An Integration of worldwide economic environment
and national capital markets
 Major Activities
 International diversification
 US market down, Asia markets up, average out
 Cross border trading
 Local 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 Trends
 Securitization
 Pooling loans/mortgages/debts to create
standardized securities
 Efficiency gain (in theory…  )
 Improved information flow based on market
activity increases liquidity
 Service and financing separation encourages
specialization and results better risk allocation
 Reduced cost for originator
 Enhanced yield for investor
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Recent Trends
 Financial Engineering
 The process of creating customized
securities tailored to investor’s need
 Bundling
 Combining cash flows together
 Straight bond+call option=convertible bond
 Unbundling
 Slicing and dicing cash flow of an asset to
several classes
 CMO to mortgage pass-through tranches and
treasury strips.
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Recent Debacles
 Subprime mortgage meltdown

 Credit and liquidity crunch

 What went wrong?
 Video (from Britain)
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Wrap-up
 What is investment?
 What are the differences between
financial and real assets?
 What’s hot?
 What’s not?