Chapter One

The Investment Environment

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 Chapter Overview

Role of financial assets in the economy: Real

vs. financial assets
Riskreturn trade-off and the efficient pricing
Financial crisis 2008
Connections between the financial system
and the real side of the economy
Lessons learned for evaluating systemic risk

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 Real Assets vs. Financial Assets

Real Assets Financial Assets

Determine the Claims on real assets,
productive capacity and do not contribute
net income of the directly to the
economy productive capacity of
Examples: Land, the economy.
buildings, machines, Examples: Stocks, bonds
knowledge used to
produce goods and
services

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 Financial Assets

Fixed income or debt

Promise either a fixed stream of income or a
stream of income determined by a specified
formula
Common stock or equity
Represent an ownership share in the corporation
Derivative securities
Provide payoffs that are determined by the prices
of other assets
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 Other Types of Investment

Investment in currency
Investment in real assets through commodity
futures
Corporations invest in the commodity futures
to hedge the risk

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 Financial Markets and the Economy

The Informational Role

Capital flows to companies with best prospects
Consumption Timing
Use securities to store wealth and transfer consumption
to the future
Allocation of Risk
Investors can select securities consistent with their tastes
for risk, which benefits the firms that need to raise
capital as security can be sold for the best possible price

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 Financial Markets and the Economy
Separation of Ownership and Management
Agency problems arise when managers start pursuing
their own interests instead of maximizing firm's value
Mechanisms to mitigate agency problems:
Tie managers' income to the success of the firm (stock
options)
Monitoring from the board of directors
Monitoring from the large outside investors and
security analysts
Takeover threat

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 Financial Markets and the Economy

Corporate Governance and Corporate Ethics

Accounting Scandals
Examples Enron, Rite Aid, HealthSouth
Auditors: Watchdogs of the firms
Analyst Scandals
Arthur Andersen
Sarbanes-Oxley Act
Tighten the rules of corporate governance

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 The Investment Process

Portfolio: Collection of investment assets.

Asset allocation
Choice among broad asset classes
Security selection
Choice of securities within each asset class

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 The Investment Process

Top-down approach
Asset allocation followed by security analysis to
evaluate which particular securities to be included
in the portfolio
Bottom-up approach
Investment based solely on the price-
attractiveness, which may result in unintended
heavy weight of a portfolio in only one or another
sector of the economy

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 Markets Are Competitive

Risk-Return Trade-Off
Higher-risk assets are priced to offer higher
expected returns than lower-risk assets
Efficient Markets
In fully efficient markets when prices quickly
adjust to all relevant information, there should be
neither underpriced nor overpriced securities

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 Markets Are Competitive

Passive Management
Holding a highly diversified portfolio
No attempt to find undervalued securities
No attempt to time the market
Active Management
Finding mispriced securities
Timing the market

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 The Players

Demanders of capital Firms

Suppliers of capital Households
Governments Can be both borrowers or
lenders

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 The Players

Financial Intermediaries: Pool and invest funds

Investment Companies
Banks
Insurance companies
Credit unions

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 Universal Bank Activities

Investment Banking Commercial Banking

Underwrite new Take deposits and make
securities issues loans
Sell newly issued
securities to public in the
primary market
Investors trade previously
issued securities among
themselves in the
secondary markets

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 Financial Crisis of 2008

Antecedents of the Crisis:

The Great Moderation: A time in which
the U.S. had a stable economy with low
interest rates and a tame business cycle
with only mild recessions
Historic boom in housing market

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 1-17
Interest Rates (%)

0
1
2
3
4
5
6
7
8
Jan-96

Jul-96

Jan-97

Jul-97

Jan-98

Jul-98

Jan-99

Jul-99

Jan-00

Jul-00

Jan-01

Jul-01

Jan-02

Jul-02

Jan-03

Jul-03

Jan-04

Jul-04
Rates and the TED Spread

Jan-05

Jul-05

Jan-06

Jul-06

Jan-07
TED spread
Figure 1.1 Short-Term LIBOR and Treasury-Bill

Jul-07
3-month T-bill
3-month LIBOR

Jan-08

Jul-08
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 Figure 1.3 The Case-Shiller Index of U.S.
Housing Prices
Index (January 2 0 0 0 = 1 0 0 )

250

200

150

100

50

0
1987

1989

1991

1993

1995

1997

1999

2001

2003

2005

2007

2009

2011

2013
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 Changes in Housing Finance
Old Way
Local thrift institution made
mortgage loans to
homeowners
Thrifts major asset: A
portfolio of long-term
mortgage loans
Thrifts main liability:
Deposits
Originate to hold
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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
Originate to distribute
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 Changes in Housing Finance
Securitization: Buying mortgage loans from
originators and bundling them into mortgage-backed
securities
Replacement of low-risk conforming mortgages with
nonconforming subprime loans
Trend toward low-documentation and then no-
documentation loans and rising allowed leverage on
home loans (loan-to-value ratio)
Low adjustable-rate mortgages (ARMs) that maxed
out borrowers' paying capacity at low rates
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 Figure 1.4 Cash Flows in a Mortgage Pass-
Through Security

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 Mortgage Derivatives

Collateralized debt obligations (CDOs)

Mortgage pool divided into slices or tranches to
concentrate default risk
Senior tranches: Lower risk, highest rating (AAA)
Junior tranches: High risk, low or junk rating
Estimated ratings significantly underestimated the
inherent risk

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Why Was Credit Risk Underestimated?

Default probabilities were estimated on the

historical data covering the rising housing
market
Geographic diversification did not reduce risk
as much as anticipated
Agency problems with rating agencies

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 Credit Default Swap (CDS)

A CDS is an insurance contract against the

default of the borrower
Investors bought sub-prime loans and used CDSs
to insure their safety
Some big swap issuers did not have enough capital
to back their CDSs when the market collapsed
resulting in the failure of CDO insurance

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 Rise of Systemic Risk

Systemic Risk: A potential breakdown of the

financial system in which problems in one
market spill over and disrupt others.
One default may set off a chain of further defaults
Waves of selling may occur in a downward spiral
as asset prices drop
Potential contagion from institution to institution,
and from market to market

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 Rise of Systemic Risk

Banks had a mismatch between the maturity

and liquidity of their assets and liabilities
Liabilities were short and liquid
Assets were long and illiquid
Constant need to refinance the asset portfolio
Banks were very highly levered, giving them
almost no margin of safety

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 Rise of Systemic Risk

Investors relied too much on credit

enhancement through structured products like
CDS
CDS traded mostly over-the-counter, with no
posted margin requirements and little
transparency
Opaque linkages between financial
instruments and institutions

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 The Shoe Drops

2000-2006: Sharp increase in housing prices

caused many investors to believe that
continually rising home prices would bail out
poorly performing loans
2004: Interest rates began rising
2006: Home prices peaked
2007: Housing defaults and losses on
mortgage-backed securities surged

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 The Shoe Drops

2008: Troubled firms include Bear Stearns,

Fannie Mae, Freddie Mac, Merrill Lynch,
Lehman Brothers, and AIG
Money market breaks down
Credit markets freeze up
Federal bailout to stabilize financial system

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 The Dodd-Frank Reform Act

Mechanisms to mitigate systemic risk

Stricter rules for bank capital, liquidity, and risk
management practices
Increased transparency, especially in derivatives
markets (eg.: standardize CDS contracts so they
can trade in centralized exchanges)
Office of Credit Ratings within the SEC to oversee
the credit rating agencies

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