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Transcript
1-1 Chapter 1 The Investment Environment McGraw-Hill/Irwin 1-2 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. McGraw-Hill/Irwin Learning Objectives 1-3 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. McGraw-Hill/Irwin 1-4 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. McGraw-Hill/Irwin 1-5 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. McGraw-Hill/Irwin 1-6 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 . McGraw-Hill/Irwin 1-7 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. McGraw-Hill/Irwin Role of Financial Assets and Markets in the Economy 1-8 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 1-9 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 1-10 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. McGraw-Hill/Irwin Role of Financial Assets and Markets in the Economy 1-11 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 1-12 Household Sector - 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. McGraw-Hill/Irwin Financial System Clients and Their Needs 1-13 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 1-14 Government Sector - 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 1-15 Financial Intermediation Investment Banking Financial Innovation & Derivatives Responding to Regulation & Taxes McGraw-Hill/Irwin How the Financial System Meets the Needs of Participants 1-16 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 1-17 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 1-18 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 1-19 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. McGraw-Hill/Irwin 1-20 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. McGraw-Hill/Irwin Investments and Innovation 1-21 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 1-22 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. McGraw-Hill/Irwin 1-23 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. McGraw-Hill/Irwin 1-24 Key Trends - Securitization & Credit Enhancement Securitization & Credit Enhancement Offers opportunities for investors and originators Changes in financial institutions and regulation Improvement in information capabilities McGraw-Hill/Irwin 1-25 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. McGraw-Hill/Irwin Key Trends Financial Engineering 1-26 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 McGraw-Hill/Irwin 1-27 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