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CHAPTER 1
McGraw-Hill/Irwin
Investments Background and
Issues
© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved.
Financial Economics
Why a special area of economics?
– Time is essential: consumption today versus
consumption tomorrow.
Investment is the act of giving up consumption today in
expectation of higher consumption in the future.
– Risk is essential: purchase of a sure thing versus
purchase of a risky chance of the same thing.
Investment involves choosing among alternative risky assets,
with different returns depending on the state of the world
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Real Assets Versus Financial Assets
• Essential nature of investment
– Reduced current consumption
– Planned later consumption
• Real Assets
– Assets used to produce goods and
services
• Financial Assets
– Claims on real assets
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Table 1.1 Balance Sheet of U.S.
Households, 2007
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Table 1.2 Domestic Net Worth
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A Taxonomy of Financial Assets
• Fixed income or debt
– Money market instruments
• Bank certificates of deposit
– Capital market instruments
• Bonds
• Common stock or equity
• Derivative securities
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Financial Markets and the Economy
• Information Role
– The Google effect
• Consumption Timing
• Allocation of Risk
• Separation of Ownership and
Management
– Agency Issues
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Financial Markets and the
Economy Continued
• Corporate Governance and Corporate Ethics
– Accounting Scandals
• Examples – Enron, Rite Aid, HealthSouth
– Auditors—watchdogs of the firms
– Analyst Scandals
• Arthur Andersen
– Sarbanes-Oxley Act
• Tighten the rules of corporate governance
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The Investment Process
• Asset allocation
– Choice among broad asset classes
• Security selection
– Choice of which securities to hold within
asset class
• Security analysis
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Markets are Competitive
• Risk-Return Trade-Off
• Efficient Markets
– Active Management
• Finding mispriced securities
• Timing the market
– Passive Management
• No attempt to find undervalued
securities
• No attempt to time the market
• Holding a highly diversified portfolio
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The Players
• Business Firms– net borrowers
• Households – net savers
• Governments – can be both borrowers and
savers
• Financial Intermediaries
– Investment Companies
– Banks
– Insurance companies
– Credit unions
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The Players Continued
• Investment Bankers
– Perform specialized services for
businesses
– Markets in the primary market
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Table 1.3 Balance Sheet of
Commercial Banks, 2007
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Table 1.4 Balance Sheet of Nonfinancial
U.S. Business, 2007
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Recent Trends—Globalization
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American Depository Receipts (ADRs)
Foreign securities offered in dollars
Mutual funds that invest internationally
Instruments and vehicles continue to
develop (WEBs)
• Exchange Traded Funds (ETFs)
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Figure 1.1 Globalization: A Debt Issue
Denominated in Euros
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Recent Trends—Securitization
• Mortgage pass-through securities
• Other pass-through arrangements
– Car, student, home equity, credit card
loans
• Offers opportunities for investors and
originators
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Figure 1.2 Asset-backed Securities
Outstanding
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Recent Trends—Financial Engineering
• Use of mathematical models and computerbased trading technology to synthesize new
financial products
• Bundling and unbundling of cash flows
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Figure 1.3 Building Creates a Complex
Security
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Figure 1.4 Unbundling of Mortgages into
Principal- and Interest-Only Securities
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Recent Trends—Computer Networks
• Online information dissemination
• Information is made cheaply and widely
available to the public
• Automated trade crossing
– Direct trading among investors
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