Chapter One

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

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 Other Types of Financial Markets
• Currency
• $2 trillion of currency traded each day in London
alone

• Commodities
• E.g., corn, wheat, natural gas

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 Financial Markets and the Economy
• The Informational Role

• Consumption Timing

• Allocation of Risk

• Separation of Ownership and Management

• Agency problems
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 Financial Markets and the Economy
(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

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 Financial Markets and the Economy
(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

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 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

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 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
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 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

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 Markets Are Competitive
(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
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 Markets Are Competitive
(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
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 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
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 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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 The Players
(3 of 4)

• Investment bankers specialize in the sale of

new securities to the public, typically by
underwriting the issue
• Advise the issuing corporation on appropriate
price, interest rates, etc.
• New issues of securities are offered to the
public in the primary market
• Investors trade previously issued securities
amongst themselves in the secondary market
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 The Players
(4 of 4)

• Venture capital (VC) refers to money invested

to finance a new, not yet publicly traded firm
• VC investors commonly take an active role in the
management of a start-up firm

• Private equity refers to investments in

companies whose shares are not publicly
traded in a stock market

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 The Financial Crisis of 2008
• Antecedents of the Crisis
• Fed response to high-tech bubble of 2000-2002
was an aggressive reduction in interest rates
• T-bill rates dropped drastically between 2001 and 2004
• As a result, this recession was mild and brief,
engendering a new term, the “Great Moderation”
• Historic boom in housing market resulted from
seemingly stable economy and dramatically
reduced interest rates
• Greater tolerance for risk, such as securitized mortgages

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Cumulative Returns of S&P 500 Index

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 Short-term LIBOR and
Treasury-bill Rates and the TED Spread

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The Case-Shiller Index of U.S.
Housing Prices

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 Changes in Housing Finance
(1 of 2)
Old Way
• Mortgage loans came from a
local lender, such as a
neighborhood savings bank or
credit union
• Typical thrift institution would
have as its major asset a
portfolio of these long-term
home loans
• Thrift’s main liability would be
accounts of its depositors
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New Way
• Securitization is the pooling of
loans for various purposes into
standardized securities backed
by those loans, which can then
be traded like any other
security
• Fannie Mae and Freddie Mac
became the behemoths of the
mortgage market
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 Changes in Housing Finance
(2 of 2)

• Conforming mortgages were pooled almost

entirely through Freddie Mac and Fannie Mae
• Low-risk requiring demonstration of ability to repay
loan
• New product resulting from securitization model
• Securitization by private firms of nonconforming
“subprime” loans with higher default risk
• Trend towards low- and no-documentation loans
• Little verification of borrower’s ability to repay

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Cash Flows in a Mortgage Pass-
Through Security

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 Mortgage Derivatives
• Collateralized debt obligations (CDOs)
• Designed to concentrate the credit risk of a bundle of loans
on one class of investors, leaving the other investors in the
pool relatively protected from that risk
• Prioritization of claims on loan repayments by dividing the
pool into senior versus junior tranches
• Senior tranches – first claim on repayments from the entire pool
• Junior tranches – paid only after the senior tranches had received
their cut

• Ratings significantly underestimated credit risk

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 Why Was Credit Risk
Underestimated?
• Default probabilities had been estimated using
historical data from both an unrepresentative
period of time and a very different borrower
pool

• Cross-regional 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 one of more borrowers
• Purchaser of the swap pays an annual premium
for protection from credit risk
• Investors bought CDSs to insure safety against
subprime loans
• Some swap issuers did not have enough capital to
back their CDSs
• E.g., AIG alone sold more than $400b of CDS contracts
on subprime mortgages
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 Rise of Systemic Risk
(1 of 3)

• Sources of fragility in 2007

• Many highly leveraged, large banks were relying
primarily on short-term loans for funding
• Widespread investor reliance on “credit
enhancement” via CDOs

• Systemic risk is the risk of breakdown in the

financial system, particularly due to spillover
effects from one market into others
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 The Shoe Drops
• Fall 2007
• Housing price declines were widespread
• Mortgage delinquencies increased
• Stock market entered its own free fall
• Many investment banks, which had large investments in
mortgages, began to suffer
• Crisis peaked in September 2008
• Fannie Mae and Freddie Mac put into conservatorship
• Lehman bankruptcy, AIG bailout, and Merrill Lynch sold to BOA
• Crisis not limited to the U.S.
• Greece was hardest hit
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 The Dodd-Frank Reform Act
• Dodd-Frank Wall Street Reform and Consumer
Protection Act passed in 2010
• Partial rollback in 2018
• Mechanisms to mitigate systemic risk
• Stricter rules for bank capital, liquidity, and risk
management practices
• E.g., stress tests for large banks
• Limit risky activities in which banks can engage
• Creation of the Office of Credit Ratings within the
SEC to oversee the credit rating agencies
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