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Transcript
Chapter 1: Investments
- Background and Issues
1-1
1.1 REAL ASSETS VERSUS FINANCIAL ASSETS
• Essential nature of investment
– Reduced current consumption
– Planned later consumption
• Real Assets
– Material wealth of a society is ultimately determined by the
productive capacity of its economy, that is, the goods and services
its members can create. This capacity is a function of the real
assets of the economy. Real assets mean the land, buildings,
machines, inventories and knowledge that can be used to produce
goods and services
• Financial Assets
– Claims on real assets like stocks and bonds that are no more than
sheets of paper or, computer entries and do not contribute directly
or indirectly to the productive capacity of the economy.
1-2
Table 1.1. Balance Sheet – U.S. Households, 2006
1-3
Table 1.3 Balance Sheet of Commercial Banks
1-4
1.2 A TAXONOMY OF FINANCIAL ASSETS
Major Classes of Financial Assets or Securities
• Debt
– Money market instruments
• Bank certificates of deposit, treasury bills
– Capital market instruments
• Bonds (Treasury bonds, municipal bond,
high yield junk bonds)
• Common stock: ownership
• Preferred stock: Hybrid
• Derivative securities: Option & Future: to
hedge risk
1-5
1.3 FINANCIAL MARKETS & THE ECONOMY
Functions of Financial Markets
• Bridging the gap between net borrowers and net savers
(Slide 7)
• Providing the equilibrium interest rate (Slide 8)
• Consumption Timing: Separation Principle (Slide 9)
• Allocation of Risk (Slide 10)
– How does a risky project get financed?
• Allocation of liquidity: Opposite liquidity preferences of
borrowers and savers.
– Law of large number
• Separation of Ownership and Management
– Agency Issues (Slide 11 & 12)
1-6
Bridging the gap
.
Net
savers:
Surplus
sector
Financial
Market
Net
Borrowers:
Deficit
sector
1-7
Equilibrium interest rate:
(Loanable Fund Theory)
i
S (Savings)
k
D (Investment)
Quantity of Loanable Fund
1-8
Intertemporal consumption:
Separation Principle
C1
210
Lending
100
i=10%
Borrowing
100
190.9
Co
1-9
Risk-Return trade-off
• Return=f(Risk)
Return
Rf
Risk
1-10
Agency Cost
• Managers are naturally inclined to act in their own
best interests. Expensive perquisites like high
salaries and allowances of the agency (rationalized
on motivational point) increases cost.
• High short term profit adds to the credentials of
board of directors.
• High scale investment makes the firm dependent on
the present agency.
• Risky investment. If successful, credit goes to the
agency, if failure loss goes to the shareholders.
• Less payout of dividends to facilitate more
investment
1-11
Solution to agency problem
• Performance shares
• Hostile takeover (Example: Compaq take-over
of Hewlett-Packard, Microsoft take-over of
Yahoo)
• Formal contract
• Market effects
1-12
1.4 THE INVESTMENT PROCESS
(Concept of portfolio)
• Asset allocation
– Choice among broad asset classes
• Security selection
– Choice of which securities to hold within
asset class
1-13
1.5 MARKETS ARE COMPETITIVE
a. Risk-Return Trade-Off
• How should one measure risk
• Assets with higher expected returns have greater
risk
• What role does diversification play:
– intelligent versus random diversification
1-14
Effect of random diversification on risk:
Systematic and Unsystematic
We can break down the total risk of holding a stock into
two components: systematic risk and unsystematic risk:
2
Risk
Total risk

Nonsystematic Risk:
Systematic Risk: m
Number of securities in the portfolio
n
1-15
1.5 MARKETS ARE COMPETITIVE
b. Efficient Markets Theory
• There should be neither underpriced nor
overpriced securities (Why? see the next slide)
• Security price should reflect all information
available to investors
1-16
Stock Price
Why Technical Analysis Fails
Investor behavior tends to eliminate any profit
opportunity associated with stock price patterns.
Sell
Sell
Buy
Buy
If it were possible to make
big money simply by
finding “the pattern” in the
stock price movements,
everyone would do it, and
the profits would be
competed away.
Time
1-17
Active Versus Passive Management
Active Management
• Attempting to identify mispriced securities or to forecast
broad market trends
– Finding undervalued securities
– Timing the market
Passive Management
• Buying and holding a diversified portfolio without
attempting to identify mispriced securities.
– No attempt to find undervalued securities
– No attempt to time
– Holding an efficient portfolio
1-18
1.6 THE PLAYERS
• Business Firms – net borrowers
• Households – net savers
• Governments – can be both borrowers and savers. In case of deficit
financing government issues treasury bills, notes, and bonds to borrow
from public.
• Financial Intermediaries:
– Banks: Deals with other people’s money with interest margin. The
balance sheet is characterized by very small amount of tangible
assets.
– Mutual funds : pool and manage the scattered savings of many
investors, and invest in well-diversified portfolios
– Investment companies design portfolio for large investors with
particular risk preferences
– Insurance companies handle risk
– Credit unions: cooperative financial institutions owned and
controlled by its members for the purpose of different financial
services including investment
• Investment Bankers: such as Goldman, Sachs, Merrill Lynch advise
the issuing corporation on the prices it can charge for the securities
issued, appropriate interest rates, and so forth.
1-19
1.7 MARKETS AND MARKET
STRUCTURE
• Direct search markets: Direct placement
• Brokered markets: Investment bank markets a firm’s
securities to the public in the primary markets.
• Dealer markets: OTC market like NASDAQ
(National Association of Securities Dealers
Automatic Quotation)
• Auction markets: All traders converge at one place
to buy and sell an asset. example, NYSE, DSE, etc.
1-20
1.8 RECENT TRENDS
a. Globalization
•
•
•
•
Managing foreign exchange
– American Depository Receipts (ADRs): Domestically
traded securities that represent claims to shares of foreign
stocks
– foreign securities offered in dollars
– mutual funds that invest internationally
– derivative securities with payoffs that depends on prices
in foreign security markets
Motivation: Diversification to improve performance
Instruments and vehicles continue to develop (WEBS, World
Equity Benchmark Shares): Like ADR, WEBS facilitates
diversification in international markets. Each WEBS security
tracks the performance of an index of share returns for a
particular country
Information and analysis improves
1-21
1.8 RECENT TRENDS
b. Securitization
• Pools of loans (such as home mortgage loans) sold
in one package. This also includes car loans, student
loans, credit card loans, and debts of firms. Owners
of pass-through receive all of the principal and
interest payments made by the borrowers.
•
•
•
•
Offers opportunities for investors and originators
Changes in financial institutions and regulation
Improvement in information capabilities
Credit enhancement and its role
1-22
1.8 RECENT TRENDS
c. Financial Engineering
• Repackaging Services of Financial Intermediaries
• Bundling (combining more than one security into a
composite security) and unbundling of cash flows
• Slicing and dicing of cash flows
• Examples: strips, CMOs (Collateral Mortgage
Obligations) , dual purpose funds, principal/interest
splits
1-23
1.8 RECENT TRENDS
d. Computer Networks
• Online trading
• Information made cheaply and widely
available
• Direct trading among investors
1-24