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CHAPTER 1 Investments - Background and Issues McGraw-Hill/Irwin Copyright © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1.1 REAL ASSETS VERSUS FINANCIAL ASSETS 1-2 Financial Versus Real Assets Real Assets – Assets used to produce goods and services Financial Assets – Claims on real assets or the income generated by them 1-3 Real assets generate net income to the economy. Financial assets define the allocation of income and wealth among investors. 1-4 Table 1.1. Balance Sheet – U.S. Households, 2006 1-5 Table 1.2 Domestic Net Worth, 2006 1-6 1.2 A TAXONOMY OF FINANCIAL ASSETS 1-7 Major Classes of Financial Assets or Securities Fixed Income (Debt) Securities: Pay a specified cash flow over a specific period. – Money market instruments Bank certificates of deposit – Capital market instruments Bonds Equity: An ownership share in a corporation. – Common stock Derivative securities: Provide payoffs that depend on the values of the other securities – Futures, Options and etc. 1-8 1.3 FINANCIAL MARKETS AND THE ECONOMY 1-9 Financial Markets Informational Role of Financials Markets Consumption Timing Allocation of Risk Separation of Ownership and Management – Agency Issues 1-10 1.4 THE INVESTMENT PROCESS 1-11 The Investor’s Portfolio Asset allocation – Choice among broad asset classes such as stocks, bonds, bills, real estate and commodities. Security selection – Choice of which securities to hold within asset class. – Top-down approach and Bottom-up approach Security analysis: valuation of particular securities that might be included in the portfolio. 1-12 1.5 MARKETS ARE COMPETITIVE 1-13 Risk-Return Trade-Off Assets with higher expected returns have greater risk. Diversification means that many assets are held in the portfolio so that the exposure to any particular asset is limited. 1-14 Efficient Markets Theory Should be neither underpriced nor overpriced securities Security price should reflect all information available to investors 1-15 Active Versus Passive Management Active Management Finding undervalued securities Timing the market Passive Management No attempt to find undervalued securities No attempt to time Holding an efficient portfolio 1-16 1.6 THE PLAYERS 1-17 The Players Business Firms – net borrowers Households – net savers Governments – can be both borrowers and savers 1-18 Financial Institutions Financial Intermediaries: Institutions that “connect” borrowers and lenders by accepting funds from lenders and loaning funds to borrowers. – Banks – Investment companies: Firms manageing funds for investors such as mutual funds. – Insurance companies 1-19 Investment Bankers: Firms specializing in the sale of new securities to the public. – Primary market: A market in which new issue of securities are offered to the public.(IPOs: Initial Public Offerings) – Secondary market: Previously issued securities are traded among investors. 1-20 Table 1.3 Balance Sheet of Commercial Banks 1-21 Table 1.4 Balance Sheet of Nonfinancial U.S. Business 1-22 1.7 RECENT TRENDS 1-23 Globalization Tendency toward a worldwide investment environment, and the integration of the international capital markets. US investors; – Purchase foreign securities using ADRs (American Depository Receipts). – Purchase foreign securities that are offered in dollars. – Buy mutual funds that invest internationally. 1-24 Figure 1.1 Global Debt Issue 1-25 Securitization Pooling loans into standartized securities backed by those loans, which can then be traded like any other security. Asset- backed securities, Mortgage-backed securities are called as Pass-through securities: Pools of loans (such as home mortgage loans) sold in one package. Owners of them receive all the principal and interest payments made by the borrowers. 1-26 Figure 1.2 Asset-backed Securities Outstanding 1-27 Financial Engineering Creation of new securities by unbundlingbreaking up and allocating the cash flows from one security to create several new securities or by bundling- combining more than one security into a composite security. Examples: strips, principal/interest splits 1-28 Figure 1.3 Building a Complex Security 1-29 Unbundling – Mortgage Security 1-30 Computer Networks Online trading Information made cheaply and widely available Direct trading among investors 1-31