Download Investments

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Chapter 1
The Investment
Environment
McGraw-Hill/Irwin
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Chapter Overview
 examine the differences between financial assets
and real assets.
 proceed to the three broad sectors of financial
environment:
Households , businesses, government
 discuss recent trends in financial markets.
 conclude with a discussion of the relationship
between households and the business sector.
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Learning Objectives
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After studying this chapter:
 understand differences in financial and real assets
 identify the major participants in the financial
markets.
 describe the role of financial assets and markets in
the economy
 understand how the financial system meets the
needs of economic participants.
 describe ongoing innovation in the financial
markets.
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Investments & Financial Assets
 Essential nature of investment
- Reduced current consumption:
people aged between 25 and 50 are earning more than they currently wish to spend, and
when they are old or retired they spend more than they can earn. So people need to shift
their purchasing power from high-earnings periods to low-earning periods of life. people
need to invest, people need to reduce current consumption in order to plan later
consumption.
- Planned later consumption
The concept of giving up current consumption to invest fund
in assets that allow greater consumption in the future is the
key notion to start discussion of the chapter material.
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Investments & Financial Assets
Real Assets
- Assets used to produce goods and services:
Assets used to produce goods and services. The material wealth of a
society is determined ultimately by the productive capacity of its
economy----the goods and service that ca be provided to its members. This
productive capacity is a function of the real assets of the economy: the
land ,buildings ,knowledge, and machines and workers. Together, physical
and “human” assets generate the entire spectrum of output produced and
consumed by the society.
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Investments & Financial Assets
Financial Assets
- Claims on real assets:
Financial assets contribute to the productive capacity of the
economy indirectly, because they allow for separation of the
ownership and management of the firm and facilitate the transfer
of funds to enterprises with attractive investment opportunities.
For example , Bondholders, are entitled to a flow of income based
on the interest rate and par value of the bond. Equityholders or
stockholders are entitled to any residual income after bondholders
and other creditors are paid .
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Differences between financial and real assets:
 Ways of distinguishing between financial and real
assets:
1）Real assets appear only on the asset side of the balance sheet; financial
assets always appear on both sides of balance sheet.
2）Real assets are destroyed only by accident or by wearing out over
time; financial assets are created and destroyed in the ordinary course
of doing business.
3）Real assets produce goods and services, whereas financial assets
define the allocation of income or wealth among investors.
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Role of Financial Assets and
Markets in the Economy
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 Consumption Timing
Financial assets and markets allow an individual or firm to
adjust consumption to achieve the highest level of
satisfaction or utility，to shift one’s purchasing power
from high-earnings periods to low-earnings periods of life.
How can you shift your purchasing power from highearnings periods to low-earnings periods of life? One way
is to “store” your wealth in financial assets. In highearnings 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.
McGraw-Hill/Irwin
Role of Financial Assets and
Markets in the Economy
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 Allocation of Risk
Markets and financial assets allow participants to shift risk to the parties
that are most will to bear that risk.
For example, when GM builds its anto plants, its management cannot
know for sure what cash flows those plants will generate. Financial
markets and the diverse financial instruments traded in those markets
allow investors with the greatest taste for risk to bear that risk, while
other less-risk-tolerant individuals can, to a greater extent, stay on the
sidelines. if GM raises the funds to build its antoplant by selling both
stocks and bonds to the public, the more optimistic, or risk-tolerant,
investors buy shares of stock in GM. The more conservative
individuals can buy GM bonds, which promise to provide a fixed
payment.
 Separation of Ownership
McGraw-Hill/Irwin
Role of Financial Assets and
Markets in the Economy
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 Separation of Ownership and management:
Financial markets also allow the separation of ownership from management and increase
the utilization of the assets of the economy.
For example , if some stockholders decide they no longer wish to hold shares in the firm,
they can sell their assets to other investors, with no impact on the management of the
firm.
How can all of the disparate owners of the firm, agree on the objectives of the firm? The
financial markets provide some guidance. All may agree that the firm’s management
should pursue strategies that enhance the value of their shares.
This courses agency problems : because of managers, who are hired as agents of the
shareholders, may pursue their own interests instead.
For example, they might engage in empire building, or avoid risky projects to protect
their own jobs, or overconsume luxuries such as corporate jets, reasoning that the cost of
such perquisites is largely borne by the shareholders.
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Role of Financial Assets and
Markets in the Economy
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Several mechanisms have evolved to mitigate potential
agency problem:
First, compensation plans tie the income of the success of the firm.
Second, while boards of directors are sometimes portrayed as defenders of top
management, they can, and in recent years increasingly do, force out management teams
that are underperforming.
Third, outsiders such as security analysts and large institutional investors such as pension
funds monitor firms closely and make the life of poor performers at the least
uncomfortable.
Finally, bad performers are subject to the threat of takeover.
McGraw-Hill/Irwin
Financial System Clients
and Their Needs
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 Household Sector
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Primary Need: Invest Funds
Households look to the financial markets primarily for investment
opportunities. household financial decisions are concerned with how
to invest money. Most householders are potentially interested in a
wide array of assets, and the assets that are attractive can vary
considerably depending on the household’s economic situation.
1) taxes lead to varying asset demands because people in different
tax brackets “transform” before-tax income to after-tax income at
different rates.
2）risk consideration also create demand for a diverse set of
investment alternations. At an obvious level, differences in risk
tolerance create demand for assets with a variety of risk-return
combinations.
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Financial System Clients
and Their Needs
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 Business Sector
- Primary Need: Raise Funds
Businesses look to the financial markets to provide an efficient means of
securing financing for investment projects. Businesses need to raise
money to finance their investments in real assets. Broadly speaking, there
are two ways for businesses to raise money－they borrow it, either from
banks or directly from householders by issuing bonds, or they can “take in
new partners” by issuing stocks, which are ownership shares in the firm.
Businesses issuing securities to the public have several objectives: First,
they want to get the best price possible for their securities. Second, they
want to market the issues to the public at the lowest possible cost.
McGraw-Hill/Irwin
Financial System Clients
and Their Needs
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 Government Sector
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Primary Need: Raise Funds
Government look to the financial markets to provide an efficient
means of securing financing for investment projects.
Governments often need to finance their expenditures by
borrowing when tax revenues are not sufficient to cover
expenditures. Governments also can print money, of course, but
this source of funds is limited by its inflationary implications.
Governments have a special advantage in borrowing money
because their taxing power makes them very creditworthy and
therefore, able to borrow at the lowest rates. A second, special
role of the government is in regulating the financial environment.
McGraw-Hill/Irwin
How the Financial System Meets
the Needs of Participants
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Financial Intermediation
Investment Banking
Financial Innovation & Derivatives
Responding to Regulation & Taxes
McGraw-Hill/Irwin
How the Financial System Meets
the Needs of Participants
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 Financial Intermediation
Financial intermediaries such as banks, investment companies, insurance
companies or credit unions meet the needs of investors by pooling small
amounts of investment funds and investing those funds in an efficient fashion.
They provide valuable services of diversification expertise to their clients.
Economies of scale also explain the proliferation of analytic services available
to investors. Newletters, databases, and brokerage house research services all
exploit the fact that the expense of collecting information is best borne by
having a few agents engage in research to be sold to a large client base. This
setup arises naturally. Investors clearly want information, but, with only small
portfolios to manage, they do not find it economical to incur the expense of
collecting it. Hence a profit opportunity emerges: A firm can perform this
service for many clients and charge for it.
McGraw-Hill/Irwin
How the Financial System Meets
the Needs of Participants
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 Investment Banking
Investment bankers provide valuable services to businesses and
government making it more efficient for these firms to raise funds in
the market. Investment bankers such as Merrill lynch, Salomon Smith
Barney, or Goldman, Sachs advise the issuing firm on the prices it can
charge for the securities issued, market conditions, appropriate interest
rates, and so forth. Ultimately, the investment banking firm handles the
marketing of the security issue to the public.
Investment bankers can provide a certification role- a “seal of
approval”- to securities issuers. Their investment in reputation is
another type of scale economy that arises from frequent participation
in the capital markets.
McGraw-Hill/Irwin
How the Financial System Meets
the Needs of Participants
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Financial Innovation & Derivatives
Significant innovation has taken place in the last few
decades with the development of derivative securities.
Derivative securities (pass-through security, collateralized
mortgaged obligation) make is possible for firms to secure
capital at the lowest possible cost and make it more
efficient for firms to manage risk. The financial system
constantly innovates to minimize the costs associated with
taxes and regulation. Examples of such innovation include
the zero coupon bond and development of the Eurodollar
market.
McGraw-Hill/Irwin
How the Financial System Meets
the Needs of Participants
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 Responding to Regulation & Taxes
Much financial innovation and security creation may be viewed as a
natural innovation is the ongoing game played between governments
and investors on taxation and regulation.
For example, the Regulation Q which limited bank deposit interest
rates, spurred the growth of the money market industry, it also was one
reason for the birth of the Eurodollar market; Zero-coupon bond is
another innovation attributable largely to tax avoidance motives; The
Eurobond market came into existence as a response to changes in U.S.
tax law.
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Key Trends –revolution in information and
communication networks
Technology and Delivery of Service
 Computer advancements:The complex cash flow bundling and
unbundling would not be possible without accessible computing power.
 On-line trading:On-line trading connects a customer directly to a
brokerage firm.The development of on-line trading capabilities and financial
information that is available on the web has increased capabilities of individual
investors.
 More complete and timely information:The internet has
also allowed vast amounts of information to be made cheaply and widely
available to the public.
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Investments and Innovation
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 US investors commonly participate in foreign
investment opportunities in several ways:
 1）purchase foreign securities that represent American Depositary
Receipts(ADRs), which are domestically traded securities that
represent claims to shares of foreign stocks;
 2） purchase foreign securities that are offered in dollars;
 3） buy mutual funds that invest internationally;
 4） buy derivative securities with payoffs that depend on prices in
foreign security market.
McGraw-Hill/Irwin
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Key Trends - Globalization
International and Global Markets Continue
Developing
 Managing foreign exchange:The globalization that has
taken place in the last several decades has increased the risk
associated with foreign exchange. The discussion of foreign
exchange is related to both domestic and international
investments. Since more of most firms’ sales are now
international, foreign exchange has implications for performance
of US investments. When diversification is expanded to
international stocks, performance depends not only on
performance of the stock but also performance of the currency.
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Key Trends - Globalization
Diversification to improve performance:A
wider range of investment choices can benefit investors.
Instruments and vehicles continue to
develop:Globalization requires efficient communication
technology and the dismantling of regulatory constraints.
Information and analysis improves:Improved
information has played and continues to play an important role in the
expansion of international investing.
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Key Trends - Securitization & Credit Enhancement
Securitization & Credit Enhancement
 Offers opportunities for investors and
originators
 Changes in financial institutions and
regulation
 Improvement in information capabilities
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Key Trends - Securitization & Credit Enhancement
Credit enhancement and its role
The importance of credit enhancement, the process of
some additional party guaranteeing the performance on the
securities, was apparent from the initial development of the
market. Initially, performance was partially guaranteed by
the government or an agency of the government. As the
market developed to other assets such as charge card
receivables and automobile loans, private firms became
involved in the credit enhancement process.
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Key Trends Financial Engineering
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Repackaging Services of Financial Intermediaries
Bundling and unbundling of cash flows
Slicing and dicing of cash flows:The process of financial
engineering involves repackaging the cash flows from a security or an asset to
enhance their marketability to different classes of investors. This activity will
continue as long as financial intermediaries can add value to the total by repackaging
the cash flows. Some of the more creative securitization experienced problems when
interest rates rose rather abruptly in 1995. One of the more exotic forms of debt
instruments, inverse floaters, experienced large declines in value with the large and
unanticipated rise in interest rates. While these instruments do offer expanded
capabilities for investment, they also demand improved risk management and
assessment capabilities.
Examples: strips, CMOs, dual purpose funds,
principal/interest splits
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The Future
 Globalization continues and offers more
opportunities.
 Securitization continues to develop.
 Continued development of derivatives and
exotics.
 Strong fundamental foundation is critical.
 Integration of investments & corporate
finance.
McGraw-Hill/Irwin