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What do we mean by an “investment”?
• Give up something today -- but expect something better tomorrow
– “Current commitment of money or other resources in the expectation of reaping
future benefits.”
• Earliest investments
– Gathering nuts for winter
– Farming
– Gold
• Common investments
Savings account
Mutual funds
Life insurance
Gold, Jewelry, and Art
Oil and Gasoline
“Real Assets” versus “Financial Assets”?
• Real Assets
– Assets used to produce goods and services
• Examples of Real Assets
Inventions and patents
“Goodwill” in financial statements
Oil refineries and auto plants, equipment, computers
• Financial Assets
– Claims on real assets or income they generate
– Examples →
“Real Assets” versus “Financial Assets”?
Examples of Financial Assets
• Debt (or “Fixed Income”)
– “Money market” instruments (< 1 year to maturity)
• Bank certificates of deposit
– “Capital market” instruments (1+ year to maturity)
• Bonds
• Common stock
– “Listed” (IBM, GE, GM)
– “Over-the-counter” (“penny” stocks)
• Preferred stock
• Derivative securities
– Futures, options, swaps
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.
Financial Markets and the
What do we mean by “allocation of capital”?
- Financial markets allow for the “allocation of capital”.
- Investor “capital” is the money they invest.
- The money “allocated” to companies (or governments) determines their future.
• Initial public offerings
– Microsoft example
– AT&T bonds example
– Mortgage-backed securities example
• Subsequent stock offerings
– Corporations sometimes issue more of their own stock
• Stock buybacks
– Corporations sometimes by back some of their own stock
• Financial markets: Prices are determined by buyers and sellers
What do we mean by “shifting your consumption”?
• Financial markets allow for “consumption shifting”.
• “Consumption” means using something up
– Example: spend $$ on food and gas.
• “Shifting your consumption” means you don’t have to spend
everything you earn today on things you will consume today.
– Example: most people borrow money to get started (education, home) and then
work and save, and then hope to retire and spend
• What is the impact of inflation?
– What if you save your money under your bed or in “risk-free” Treasury bills?
– What happens if people can’t trust savings accounts or “safe” investments?
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?
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?
• Separation of Ownership and Management
• Large size of firms requires separate
principals and agents
• Mitigating Factors
• Performance-based compensation
• Boards of directors may fire managers
• Threat of takeovers
• Corporate Governance and Corporate Ethics
• Businesses and markets require trust to operate
• Without trust additional laws and regulations are
• Laws and regulations are costly
• Governance and ethics failures cost the economy
billions, if not trillions
• Eroding public support and confidence
• Corporate Governance and Corporate Ethics
• Accounting scandals
• Enron, WorldCom, Rite-Aid, HealthSouth, Global
Crossing, Qwest
• Misleading research reports
• Citicorp, Merrill Lynch, others
• Auditors: Watchdogs or consultants?
• Arthur Andersen and Enron
• Corporate Governance and Corporate Ethics
• Sarbanes-Oxley Act:
• Requires more independent directors on company
• Requires CFO to personally verify the financial
• Created new oversight board for the accounting/audit
• Charged board with maintaining a culture of high
ethical standards
The Investment Process
o Asset allocation
Choosing the percentage of funds in asset classes
Alternative Assets
Money market securities
o Security selection & analysis
Choosing specific securities w/in an asset class
o The asset allocation decision is the primary
determinant of a portfolio’s return
Markets Are Competitive
o Risk-return trade-off:
o Assets with higher expected returns have higher risk.
Average Annual
About 12%
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.
Risk-Return Trade- Off
o How do we measure risk?
o How does diversification affect risk?
o Discussed in Part 2 of the text
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.
Active vs. Passive Management
Active Management (inefficient markets)
Finding undervalued securities Security Selection
Asset Allocation
Timing the market
Passive Management (efficient markets)
No attempt to find undervalued
• Indexing
No attempt to time
• Constructing an
Holding a diversified portfolio: “efficient” portfolio
The Players
The Players
• Business Firms – net borrowers
• Households – net savers
• Governments – can be both borrowers and
• Financial Intermediaries “Connectors of
borrowers and lenders”
o Commercial Banks
• Traditional line of business: Make loans funded by
Investment companies
Insurance companies
Pension funds
Hedge funds
The Players Cont.
• Investment Bankers
o Firms that specialize in primary market
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