You are on page 1of 18

Lecture 1 Objective

General Concepts of Investment


Difference between real and financial
assets
Major participants in financial markets
Role of financial assets
Ongoing innovation

1-1
What is Investment?

Essential nature of investment


– Reduced current consumption
– Planned later consumption
– Current commitment of money or
resources to assets that allows greater
consumption in the future
– ex: education, art, wine, etc.

1-2
Real vs Financial Assets
Real Assets
– Assets used to produce goods and services
– ex: property, land, building, machines, human
capital, knowledge, etc

Financial Assets
– Claims on returns by real assets
– No direct contribution to productive capacity
– ex: stocks, bonds, derivative securities, etc
1-3
Real versus Financial Assets

Financial Assets:
Claims on Real Assets or
Real Asset Income
Productive
Capacity

Property,
plants and
equipment,
human
capital, etc.

1-4
Role of Financial Assets
Efficient separation of ownership and
management
Efficient risk sharing
Efficient allocation of fund and timing
When basic needs are met, shift
consumption by investing surplus

1-5
Balance Sheet, U.S. Households, 2017
Assets $ Billion % Total Liabilities and Net Worth $ Billion % Total

Real assets
Real estate $26,528 24.6% Mortgages $9,994 9.3%
Consumer durables 5,418 5.0% Consumer credit 3,765 3.5%
Other 485 0.4% Bank and other loans 998 0.9%
Total real assets $28,330 29.6% Other 348 0.3%

Total liabilities $15,104 14.0%


Financial assets
Deposits 10369 9.6%
Life insurance reserves 1,368 1.3%
Pension reserves 22,259 20.6%
Corporate equity 15,874 14.7%
Equity in noncorp. business 11,249 10.4%

Mutual fund shares 7,875 7.3%


Debt securities 5,239 4.9%
Other 1,244 1.2%
Total financial assets 75,478 69.9% Net worth 92,805 86.0%
TOTAL $107,910 100.0% $107,910 100.0%

Note: Column sums may differ from total because of rounding error.
SOURCE: Flow of Funds Accounts of the United States, Board of Governors of the Federal Reserve System, March 2017.
1-6
Financial Assets vs Liabilities
• Financial Assets and Liabilities must balance.
Financial Assets
(Owner of the claim)

Financial Liability
(Issues of the Claim)

• When balance sheets are all aggregated, only


real assets remain
• Domestic Net Worth = Sum of real assets

1-7
Domestic Net Worth, 2017
Assets $ Billion
Commercial real estate $18,335
Residential real estate 33,061
Equipment and IP 8,449
Inventories 2,523
Consumer durables 5,418

TOTAL $67,786
Note: Column sums may differ from total because of rounding error.

SOURCE: Flow of Funds Accounts of the United States, Board of Governors of the
Federal Reserve System, March 2017.

1-8
Financial Assets
Common Stock
Ownership stake in entity,
residual cash flow

Asset
Classes

Derivative Securities Fixed Income


Securities
Contract, value derived
from underlying market Money market instruments,
condition Bonds, Preferred stock

1-9
The Investment Process

Asset allocation
- Percentage of fund in asset classes
Security selection
Choosing specific securities within a class
Top-down vs Bottom-up approaches
Risk-return trade-off
Market efficiency (market is fair!)
Active vs. passive management

1-10
Active vs. Passive Management

Active Management (inefficient market)


Finding undervalued securities
Timing the market

Passive Management (efficient markets)


No attempt to find undervalued securities
No attempt to time
Holding an efficient portfolio (indexing)

1-11
Players in Financial Markets

Business Firms – net borrowers


Households – net savers
Governments – can be both borrowers
and savers
Financial intermediaries (connectors of
borrowers and lenders) e.g. commercial
banks, investment companies, pension
fund, hedge funds, insurance companies.

1-12
Players in Financial Markets
Investment Bankers - firms that specialize
in primary market transactions
In primary markets, newly issued
securities offered to public
– Investment banker typically “underwrites”
issue
In secondary markets, preexisting
securities traded among investors

1-13
Functions of Financial System
Transfer resources across time and region
Manage uncertainty and control risk
Provide ways of settling payments for
goods and services
Provide information on macroeconomic
variables and market expectations
Agency problem

1-14
Corporate Governance

Problems in ownership and management


separation
Businesses require trust to operate
efficiently
Law and regulations are required but
costly
Create a culture with high standards

1-15
Key Trends - Globalization

International and Global Markets Continue


Developing
Managing foreign exchange
Diversification to improve performance
Instruments and vehicles continue to develop
Information and analysis improves

1-16
Key Trends - Securitization

Offers opportunities for investors and


originators
Collect mortgages into a pool
Issue securities, claims on its cash flow
Convert illiquid loan into liquid securities to
be bought by many investors
Lower borrowing cost
No constraint by local imbalance

1-17
Conclusion
Always think the financial system in terms
of financial function not the institution
Make sure to understand functions and
regulations when making investment
decisions

1-18

You might also like