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‡ Essential nature of investment
± Reduced current consumption
± Planned later consumption

‡ To forego spending cash today in


the hopes of increasing wealth in
the future

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Financial Versus Real Assets
‡ Real Assets
± Assets used to produce goods and services
± E.g. land, buildings, equipment, and
knowledge
‡ Financial Assets
± Claims to income generated by real assets
± E.g. stocks and bonds

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Table 1.1. Balance Sheet ± U.S.
Households, 2006

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Are the following assets real
or financial?
‡ A. Patents
‡ B. Lease obligations
‡ C. Customer goodwill
‡ D. A college education
‡ E. A $5 bill

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ºajor Classes of Financial
Assets or Securities
‡ Debt
± ºoney market instruments
‡ Bank certificates of deposit
± Capital market instruments
‡ Bonds
‡ Equity
± Common stock
± Preferred stock
‡ Derivative securities
± E.g. Option, futures

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Financial ºarkets
1. Informational Role of Financials
ºarkets
±HSBC rebound from $33 to $85 in
(1.6 times) after the right issue
±Google climb to $400 per share in
2005, P/E ratio 70,market cap $120
billion

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Financial ºarkets
2. Consumption Timing
±Shifting purchasing power from high-
earnings periods to low-earnings
periods

 
   
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"#" %

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Financial ºarkets
4. Separation of Ownership and
ºanagement
± Agency Issues: conflicts of interest
between managers and stockholders
± Solutions:
‡ Compensation link to performance
‡ Control by board of directors
‡ ºonitor by outsiders
‡ Threat of takeover

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Corporate Governance and Ethics
‡ Accounting Scandals
± Examples ± Enron and WorldCom
‡ ºisleading research reports
‡ Auditors watchdogs or consultants
± Example ± Arthur Andersen and Enron
‡ Sarbanes-Oxley Act
± Tighten the rules of corporate
governance

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The Investor¶s Portfolio

‡ Asset allocation
± Choice among broad asset classes
± E.g. stocks, bonds, real estate, commodities
‡ Security selection
± Choice of which securities to hold within asset
class
± E.g. HSBC, China ºobile
‡ Portfolio construction
± Top-down strategies
± Bottom-up strategies

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ÎÎÎÎÎÎÎÎÎÎ portfolio construction
starts with selecting attractively
priced securities.

a. Top-down
b. Bottom-up
c. Upside-down
d. Side-to-side

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Risk--Return Trade
Risk Trade--Off

‡ Assets with higher expected returns


have greater risk

Questions unanswered
‡ How should one measure risk
‡ What role does diversification play

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Efficient ºarkets Theory
‡ Should be neither underpriced nor
overpriced securities
‡ Security price should reflect all
information available to investors

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Active Versus Passive
ºanagement
Active ºanagement
‡ Finding undervalued securities
‡ Timing the market

Passive ºanagement
‡ No attempt to find undervalued securities
‡ No attempt to time
‡ Holding an efficient portfolio

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The Players
‡ Business Firms ± net borrowers
‡ Households ± net savers
‡ Governments ± can be both
borrowers and savers
± Issuing of Treasury bills, notes or bonds
to borrow funds when budget deficits
± Retire some outstanding debt when
budget surplus

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The Players
‡ Financial Intermediaries
± Institutions that ³ connect´ borrowers
and lenders by accepting funds from
lenders and loaning funds to borrowers
‡Banks
‡Investment companies
‡Insurance companies
‡Credit unions

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Computer networks have made it
much cheaper and easier for small
investors to trade for their own
accounts and perform their own
security analysis.
What will be the likely effect on
financial intermediation?

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The Players
‡ Investment Bankers
± Firms specializing in the sale of new
securities to the public, typically by
underwriting the issue
± E.g. Goldman Sachs, ºerrill Lynch,
Citigroup
± Investment banking firm handles the
marketing of security in primary market
and investors can trade these securities
in the secondary market

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Recent Trends

‡ Globalization
‡ Securitization
‡ Financial Engineering
‡ Information and computer networks

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Globalization

‡ Diversification to improve
performance
‡ Instruments and vehicles continue to
develop (WEBs)
‡ Information and analysis improves
‡ Concerns: ºanaging foreign
exchange

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Globalization
Investors can participant via
± Trading of NASDAQ stocks e.g.
Starbucks, Intel, Dell, ºicrosoft
± Purchase foreign securities e.g.
Citibank
± Buy mutual funds invest internationally
± Buy derivative securities with payoffs
depending on prices in foreign security
market

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Securitization
‡ Securitization: pooling loans into
standardized securities backed by
those loans, which can then be
traded like any other security
‡ Pass-thorough securities e.g.
mortgage, students loans, credit card
loans, and debt of firms

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Securitization

‡ Offers opportunities for investors and


originators
‡ Changes in financial institutions and
regulation
‡ Improvement in information
capabilities
‡ Credit enhancement and its role

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Figure 1.2 Asset-backed Securities
Outstanding

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Financial Engineering
‡Repackaging Services of Financial
Intermediaries
‡Bundling and unbundling of cash flows
‡Slicing and dicing of cash flows
‡Examples: strips, CºOs, dual purpose
funds, principal/interest splits

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Building a Complex Security

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Unbundling ± ºortgage Security

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Computer Networks
‡ Online trading
‡ Information made cheaply and
widely available
‡ Direct trading among investors

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U.S. Treasury bonds pay interest
every six months and repay the
principle at maturity. The U.S.
Treasury routinely sells individual
interest payments on these bonds to
investors. This is an example of
ÎÎÎÎÎÎÎÎÎÎÎÎ.

a. Unbundling
b. Bundling
c. Securitization
d. Security selection

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References
‡ Bodie, Kane, and ºarcus, P  
 
    , 7th Edition, ºcGraw-
Hill, pp 2-23

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