Chapter One

The Investment
Environment
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 Chapter Overview
• Real Assets versus Financial Assets

• Risk-return trade-off and efficient pricing

• Systematic Risk

• Mortgage Derivatives

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 Real Assets vs. Financial Assets

Real Assets Financial Assets

• Have Productive Capacity • Claims on real assets

• Do not contribute directly

to productive capacity

• Examples: Land, • Examples: Stocks, bonds

buildings, machines,
intellectual property

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 Financial Assets
Financial Assets: Claims on Real Assets

Fixed-Income Securities: Equity:

Promises a fixed stream of income Represents ownership share in a
or a stream of income determined corporation; common Stock
by a specified formula; debt

Derivatives:
Provide payoffs that are determined
by the prices of other assets

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 Other Types of Investment
• Investment in currency

• Commodity futures
• Corporations invest in the commodity futures to
hedge the risk

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 The Investment Process
(1 of 2)

• 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
(2 of 2)

• “Top-down” approach
• Asset allocation followed by security analysis

• “Bottom-up” approach
• Investment based solely on the price-attractiveness

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 Markets Are Competitive
(1 of 3)

Risk-Return Trade-Off
• Higher-risk assets are priced to offer higher
expected returns than lower-risk assets

• Risk and expected return are positively

correlated

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 Markets Are Competitive
(2 of 3)

Efficient Markets
• Efficient markets: prices quickly adjust to all
relevant information

• There should be neither underpriced nor

overpriced securities

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 Markets Are Competitive
(3 of 3)

• 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
Price of Capital (1 of 2)

Who Supplies Capital? Households

What Demands Capital? Firms

Quantity of Capital
Roll of Government?
Can be either borrowers or lenders

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 The Players
(2 of 2)

• 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

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 Mortgage Derivatives
• Collateralized debt obligations (CDOs)
• Mortgage pool divided into tranches to
concentrate default risk:
• Senior tranches:
• Junior tranches:

• Ratings significantly underestimated risk

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 Why Was Credit Risk
Underestimated?
• Default probabilities were misestimated

• Geographic diversification did not reduce risk

sufficiently

• Agency problems with rating agencies

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 Credit Default Swap (CDS)
• A CDS is an insurance contract against
borrower default
• Investors bought sub-prime loans and CDSs

• Some big swap issuers did not have enough capital

to back their CDSs

• This lack of capital resulted in the failure of CDO

insurance
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 Rise of Systemic Risk
(1 of 3)

• Systemic Risk:

Further Defaults
• One default triggers Further Defaults
Further Defaults

• Waves of selling  downward spiral as asset prices

drop

• Potential contagion
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 Rise of Systemic Risk
(2 of 3)

• Banks mismatched maturity/liquidity of their

assets and liabilities:
• Liabilities were short and liquid
• Assets were long and illiquid
• Constant need to refinance

• Banks: highly leveraged  no margin of safety

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 Rise of Systemic Risk
(3 of 3)

• Investors relied too much on credit

enhancement through structured products

• CDS traded mostly over-the-counter

• No posted margin requirements
• Little transparency

• Opaque linkages between instruments and

institutions
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