Chapter 1

Investments: Background
and Issues

McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.
1.1 Real Versus Financial
Assets

1-2
 Real Versus Financial Assets
• Essential nature of investment
• Reduce current consumption in hopes of greater
future consumption

• Real Assets
• Used to produce goods and services: Property,
plant & equipment, human capital, etc.

• Financial Assets
• Claims on real assets or claims on asset income
Table 1.1. Balance Sheet –
U.S. Households, 2008
 Real versus Financial Assets
• All financial assets (owner of the claim) are offset by
a financial liability (issuer of the claim).
• When we aggregate over all balance sheets, only
real assets remain.
• Hence the net wealth of an economy is the sum of its
real assets.
Table 1.2 Domestic Net Worth, 2008
1.2 A Taxonomy of
Financial Assets
Major Classes of Financial Assets or
Securities
• Debt
o Money market instruments
• Bank certificates of deposit, T-bills, commercial
paper, etc.
o Bonds
o Preferred stock
• Common stock
o Ownership stake in the entity, residual cash flow
• Derivative securities
o A contract whose value is derived from some
underlying market condition.
1.3 Financial Markets and
the Economy
 Financial Markets
• Informational Role of Financial Markets
o Do market prices equal the fair value estimate of a
security’s expected future risky cash flows?
o Can we rely on markets to allocate capital to the
best uses?
• What other mechanism could we use to
allocate capital?
• What would be the advantages and
disadvantages of another system?
 Consumption Timing
o People tend to smooth consumption over time.

o If one has more than enough cash to meet their

basic needs in the current time period one might
shift consumption through time by investing the
surplus.
 Allocation of Risk
o Investors can choose a desired risk level

• Bonds versus stock of a given company

• Bank CD versus company bond

• Tradeoff between risk and return?

 Separation of Ownership and
Management
• Large size of firms requires separation of ownership
and management
o In 2008 GE had over $800 billion in assets and over
650,000 stockholders
o Owners (principals) ≠ Managers (agents)
o Agency costs: Owners’ interests may not align with
managers’ interests
o Mitigating factors:
• Performance based compensation
• Boards of Directors may fire managers
• Threat of takeovers
 Example 1.1
• In February 2008, Microsoft offered to buy Yahoo at $31 per
share when Yahoo was trading at $19.18.

• Yahoo rejected the offer, holding out for $37 a share.

• Billionaire Carl Icahn led a proxy fight to seize control of

Yahoo’s board and force the firm to accept Microsoft’s
offer.

• He lost, and Yahoo stock fell from $29 to $21.

• Did Yahoo managers act in the best interests of their
shareholders?
 Corporate Governance and
Corporate Ethics
• Business and market require trust to operate
efficiently
o Without trust additional laws and regulations are
required
o All laws and regulations are costly
• Governance and ethics failures have cost our
economy billions if not trillions of dollars.
o Eroding public support and confidence in market
based systems
 Corporate Governance and
Corporate Ethics
• Accounting Scandals
o Enron, WorldCom, Rite-Aid, HealthSouth, Global
Crossing, Qwest,
• Misleading Research Reports
o Citicorp, Merrill Lynch, others
• Auditors: Watchdogs or Consultants?
o Arthur Andersen and Enron
 Corporate Governance and
Corporate Ethics
• Sarbanes-Oxley Act
o Increases the number of independent directors on
company boards
o Requires the CFO to personally verify the
financial statements
o Created a new oversight board for the
accounting/audit industry
o Charged the board with maintaining a culture of
high ethical standards
 1.4 The Investment Process
o Asset allocation
Choosing the percentage of funds in asset classes
Stocks 60%
Bonds 30%
Alternative Assets 6%
Money market securities 4%
o Security selection & analysis
Choosing specific securities w/in an asset class

o The asset allocation decision is the primary

determinant of a portfolio’s return
1.5 Markets Are Competitive
o Risk-return trade-off:
o Assets with higher expected returns have higher risk.

Average Annual Minimum Maximum

Return (1931) (1933)
Stocks About 12% -46% 55%
A stock portfolio can be expected to lose money about 1
out of every 4 years.

o Bonds have a much lower average rate of return (under

6%) and have not lost more than 13% of their value in
any one year.
Risk-Return Trade- Off

o How do we measure risk?

o How does diversification affect risk?

o Discussed in Part 2 of the text

Efficient Markets
o Market efficiency:
o Securities should be neither underpriced
nor overpriced on average

o Security prices should reflect all information

available to investors

o Whether we believe markets are efficient

affects our choice of appropriate investment
management style.
Active vs. Passive Management
Active Management (inefficient markets)
Finding undervalued securities Security Selection
Timing the market Asset Allocation

Passive Management (efficient markets)

No attempt to find undervalued
securities
• Indexing
No attempt to time
• Constructing an
Holding a diversified portfolio: “efficient” portfolio
1.6 The Players
 The Players
• Business Firms – net borrowers
• Households – net savers
• Governments – can be both borrowers and
savers
• Financial Intermediaries “Connectors of
borrowers and lenders”
o Commercial Banks
• Traditional line of business: Make loans funded by
deposits
o Investment companies
o Insurance companies
o Pension funds
o Hedge funds
 The Players Cont.
• Investment Bankers
o Firms that specialize in primary market
transactions

o Primary market:
• A market where newly issued securities are offered to
the public.
• The investment banker typically ‘underwrites’ the issue.

o Secondary market
• A market where pre-existing securities are traded among
investors.
Investment Bankers
• Investment Bankers
o Commercial and investment banks’ functions and
organizations were separated by law from 1933 to 1999.

o Post 1999 large investment banks, collectively known

as “Wall Street,” operated independently from
commercial banks, although many of the large
commercial banks increased their investment banking
activities, pressuring profit margins of investment
banks.

o In September 2008 major investment banks either went

bankrupt, reorganized as commercial banks or were
purchased by commercial banks as a result of the
collapse of the mortgage markets.
• Investment Bankers
o Some investment banks chose to become
commercial banks to obtain deposit funding and
government assistance

o All of the major investment banks are now under

the much stricter commercial bank regulations.
• What are the implications for innovation and capital
issuance resulting from these changes?
Table 1.3 Balance Sheet of
Commercial Banks, 2008
Table 1.4 Balance Sheet of
Nonfinancial U.S. Business, 2008
 1.7 Recent Trends
• Globalization

• Securitization

• Financial Engineering

• Information and Computer Networks

Globalization
• Domestic firms compete in global markets

• Performance in one country or region depends on

other regions

• Opportunities for better returns & implications for risk

o Managing foreign exchange
o International diversification reduces risk
o Instruments and vehicles continue to develop
(ADRs and WEBs)
o Information and analysis improves
Securitization
• Loans of a given type such as mortgages are
placed into a ‘pool’ and new securities are issued
that use the loan payments as collateral.

• The securities are marketable and are purchased

by many institutions.
• “Shadow banking system”

• End result is more investment opportunities for

purchasers, and spreading loan credit risk among
more institutions
Securitization
• Securitization has grown rapidly due to
• Changes in financial institutions and regulation
permitting its growth, particularly lower capital
requirements on securitized loans,

• Improvement in information capabilities,

• Credit enhancement provided by pool issuers has

improved marketability.
Figure 1.1 Asset-backed
Securities Outstanding
Financial Engineering
• Repackaging cash flows of a security to enhance
marketability
• Bundling and unbundling of cash flows
o Bundling:
Combining more than one asset into a composite
security, for example securities sold backed by a
pool of mortgages.
o Unbundling
Selling separate claims to the cash flows of one
security, for example a CMO
Figure 1.2 Building a Complex
Security
Figure 1.3 Mortgage Security
Computer Networks
• Online low cost trading
• Information made cheaply and widely available
• Direct trading among investors via electronic
communication networks

• What have been the effects on Wall Street firms’

profit margins?
o How has Wall Street responded?
The Future
• Globalization will continue and investors will have
far more investment opportunities than in the past
• Securitization will continue to grow after the crisis
• Continued development of derivatives and
exotics, more regulation for “over the counter”
derivatives
• Strong fundamental foundation of understanding
is critical
• Understanding corporate finance requires
understanding investments
1.8 Text Outline
• Part One: Introduction to Financial Markets,
Securities and Trading Methods
• Part Two: Modern Portfolio Theory
• Part Three: Debt Securities
• Part Four: Equity Security Analysis
• Part Five: Derivative Markets
• Part Six: Active Investment Management
Strategies: Performance Evaluation, Global
investing, Taxes, and the Investment Process