Chapter 1

Investments:

Background and

Issues

Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

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1.1 Real Versus Financial

Assets

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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

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Table 1.1. Balance Sheet –

U.S. Households, 2008

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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.

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Table 1.2 Domestic Net Worth, 2008

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1.2 A Taxonomy of

Financial Assets

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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.

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1.3 Financial Markets and

the Economy

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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?

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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.

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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?

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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

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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?

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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

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Corporate Governance and

Corporate Ethics

• Accounting Scandals

o Enron, WorldCom,

• Misleading Research Reports

o Citicorp, Merrill Lynch, others

• Auditors: Watchdogs or Consultants?

o Arthur Andersen and Enron

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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

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1.4 The Investment Process

Choosing the percentage of funds in asset classes

Choosing specific securities w/in an asset class

Stocks

Bonds

Alternative Assets

Money market securities

60%

30%

6%

4%

o Asset allocation

o The asset allocation decision is the primary

determinant of a portfolio’s return

o Security selection & analysis

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1.5 Markets Are Competitive

o Risk-return trade-off: o Assets with higher expected returns have higher risk.

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.

Average Annual

Return

Minimum

(1931)

Maximum

(1933)

Stocks About 12% -46% 55%

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o How do we measure risk?

o How does diversification affect risk?

To be studied in the later chapters

Risk-Return Trade- Off

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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.

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Active vs. Passive Management

Active Management (inefficient markets)

Finding undervalued securities

Timing the market

Passive Management (efficient markets)

No attempt to find undervalued

securities

No attempt to time

Holding a diversified portfolio:

Security Selection

Asset Allocation

• Indexing

• Constructing an

“efficient” portfolio

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1.6 The Players

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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

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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.

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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.

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• 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?

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Table 1.3 Balance Sheet of

Commercial Banks, 2008

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Table 1.4 Balance Sheet of

Nonfinancial U.S. Business, 2008

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1.7 Recent Trends

• Globalization

• Securitization

• Financial Engineering

• Information and Computer Networks

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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

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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

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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.

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Financial Engineering

• Repackaging cash flows of a security to enhance

marketability

• Bundling and unbundling of cash flows

oBundling:

Combining more than one asset into a composite

security, for example securities sold backed by a

pool of mortgages.

oUnbundling

Selling separate claims to the cash flows of one

security, for example a CMO

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Figure 1.2 Building a Complex

Security

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Figure 1.3 Mortgage Security

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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?

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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