Download Real versus Financial Assets

Chapter 1
Investments:
Background and
Issues
McGraw-Hill/Irwin
Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.
1.1 Real Versus Financial
Assets
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Investment
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 Capital market instrument
Treasury Bonds
• Common stock
o Ownership stake in thecorporation, residual cash flow
• Derivative securities
o Securities providing payoffs that depend on the
values of other assets
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1.3 Financial Markets and
the Economy
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Financial Markets
Informational Role of Financial Markets
• If a firm performing well, investors will bid up ,on
the other hand, a company’s prospects seem
poor, investors will bid down
• However, Some companies can be “hot” for a
short period of time, attract a large flow of
investor capital, and then fail after only a few
years
• Hence, professionals analyse the prospects of
firms whose shares trade on the stock market.
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Consumption Timing
• In high-earnings periods, you can invest your savings
in financial assets such as stocks and bonds.
• In low-earnings periods, you can sell these assets to
provide funds for your consumption needs.
– Thus, financial markets allow individuals to separate
decisions concerning current consumption from
constraints that otherwise would be imposed by
current earnings.
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Allocation of Risk
Investors can choose a desired risk level
Bonds versus stock of a given company
• The risk-tolerant investors can buy stock why?
• the more conservative ones buy bonds why?
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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 Agency problem : Conflicts of interest between
managers and stockholders
o Several 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
• If firms can mislead the public about their prospects,
then much can go wrong.
• 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.
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Corporate Governance and
Corporate Ethics
• Accounting Scandals and Misleading Research
Reports
o Enron, WorldCom, Rite-Aid, HealthSouth,
Global Crossing, Qwest.
• 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
o Asset allocation
Choosing the percentage of funds in asset classes
Stocks
60%
Bonds
Alternative Assets
Money market securities
30%
6%
4%
o Security selection & analysis
Choosing specific securities within an asset class
The asset allocation decision is the primary determinant of
a portfolio’s return
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1.5 Markets Are Competitive
o Risk-return trade-off:
Average Annual
Return
Stocks
About 12%
Minimum (1931)
Maximum
(1933)
-46%
55%
o We conclude that there should be a risk-return
trade-off in the securities markets, with higherrisk assets priced to offer higher expected returns
than lower-risk assets.
o Note: Bonds have a much lower average rate of
return (under 6%)
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Risk-Return Trade- Off
o How do we measure risk?
o How does diversification affect risk?
o Discussed in Part 2 of the text
o Modern Portfolio theory
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Efficient Markets
o Security prices should reflect all
information available to investors
o Securities should be neither underpriced
nor overpriced on average
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 Security Selection
Asset Allocation
Timing the market
Passive Management (efficient markets)
No attempt to find undervalued securities
No attempt to time
Holding a diversified portfolio
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
o
o
o
o
Banks
Investment companies
Insurance companies
Pension funds
Mutual 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
more strict commercial bank regulations.
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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 Information and analysis improves
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Securitization
• Loans of a given type such as mortgages are
placed into a ‘pool’ and then can be traded like
any other security
• Securitization has grown rapidly due to changes
in financial institutions and regulation
• improved marketability.
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Financial Engineering
• Repackaging cash flows of a security to enhance
marketability applying mathematics, computer
sciences and economic theory
• Bundling and unbundling of cash flows
o Bundling:
o combining more than one security into a composite
security
Unbundling
breaking up and allocating the cash flows from one
security to create several new securities
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Computer Networks
• Online low cost trading
• Information made cheaply and widely available
• Direct trading among investors via electronic
communication networks
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