Download Financial assets

Investments:
Background and issues
CHAPTER 1
Investments & Financial Assets

Essential nature of investment
 Reduced
current consumption
 Planned later consumption

How to invest
 Real
Assets: Assets used to produce goods
and services

produce income to economy
 Financial
Assets
Claims on real assets or income generated by them
 Allocation of income, real assets among investors,
individuals in the economy

Balance Sheet – U.S. Households
Financial Assets
Financial assets
Fixed-income (Bonds)
Money Market
(Short-term)
Bond Market
(Long-term)
Equity (Stocks)
Common Stocks
Preferred Stocks
Derivatives
Options
Futures
Role of Financial asset and financial
markets in the Economy
Consumption Timing
 Allocation of Risk
 Separation of Ownership and
Management

Consumption Timing
Savers
(earn more
than spend)
Financial
assets: stocks,
bonds,
deposits, etc.
Borrowers
(spend more
than earn)
How do you transfer money from when you do not need to
when you need?
Allocation of risk
Example: GM wants to build a new auto plant, it raised
money by issuing stocks and bonds
Stock
Auto plant
High risk
and low risk
Stock investors
(high risk)
GM
Bond
Bond investors
(low risk)
Separation of ownership and
management

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Example: GE, total asset is $640 bil
Cannot be single owner, must have many
owners
Selling stocks to market
Currently, GE has 500,000 owners
These owners choose managers
Can easily transfer ownership without any
impact on management
The Investment Process
Asset allocation
 Security selection
 Risk-return trade-off
 Market efficiency
 Active vs. passive management

Investment process
Small stock
Stocks
Big stock
corporate bond
Bonds
Broad assets
T-bond, T-bill
Real estate
House
Land
Commodity
(1) Asset allocation
coffee, tea
gold, oil, etc
(2) Security analysis
Example of Asset Allocation
Age
30s
40s
50s
60s
Common
Stocks
70%
60
50
40
Bonds
30%
40
50
60
Example of Security Selection
Your Stock Portfolio
Auto
Retail
Wal-Mart
Nordstroms
Sears
Financial
Bank of America
Berkshire Hathaway
Citibank
There is no free lunch!
Return
more
return
less risk
less
return
more risk
Risk
Market Efficiency



Security prices accurately reflect all relevant
information.
The price in the market is the true price
Earn return just enough to compensate for risk, no
abnormal return
Active vs. 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
Players in the Financial Markets
Business Firms – net borrowers
 Households – net savers
 Governments – can be both borrowers
and savers
 Investment Bankers

Players in the Financial Markets
borrowers
securities
borrowers
securities
fund
securities
financial
intermediaries
savers
borrowing rate
lending rate
securities
securities
borrowers
Savers
savers
investment bank
fund
fund
get commission fees
Recent Trends
Globalization
 Securitization
 Financial Engineering
 Computer Networks

Globalization

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
In 1970, US equity market accounted for about 70
percent of equity in the world
Currently, only 20-30 percent
How to invest globally




Purchase ADRs
Invest directly into international market
Buy mutual fund shares that invest in international market
derivative securities with payoff depends on prices of foreign
market
Securitization
(1) more funds available to borrowers
Banks
(2) Transfer risk of loans to
corresponding investors in the
market
pool all loans
Mortgage loans
auto loans
credit card
student loans
other loans
Benefits of securitization
loans are
securitized
securities
Investors
High risk loan
High risk securities
High risk investors
Low risk loan
low risk securities
low risk investors
Figure 1.2 Asset-backed Securities
Outstanding
Financial engineering



refer to creation of new securities
Bundling: combine more than one security into a
composite security
Unbundling: breaking up and allocating the cash flows
from one security to create several new securities
Collateralized Debt Obligation (CDO)

A CDO is an asset backed security (ABS) whose
underlying collateral is typically a portfolio of bonds
(corporate or sovereign) or bank loan

A CDO cash flow structure allocates
interest income and principal repayments
from a collateral pool of different debt
instruments to a prioritized collection
(tranches) of CDO securities.
Cash CDO Structure Illustration
Mortgage 1
Mortgage 2
Mortgage 3

Tranche 1 (AAA)
Yield = 5%
($25mil)
An
investment
bank creates
a set of
securities
(tranches)
backed by a
mortgage
pool
(CDO)
Mortgage n
Average Yield
12.5%
($100 mil)
Tranche 2 (A)
Yield = 10%
($25mil)
Tranche 3 (BBB)
Yield = 15%
($25mil)
Tranche 4
(junk bond)
Yield = 20%
($25mil)
Investor:
banks,
pension
funds,
college
saving
funds,
universiti
es, cities,
etc.
Collateralized Debt Obligation (CDO)
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In normal time, mortgage borrowers are able to make the
mortgage payments, so the investors will get the interest
payments, the values of slices of CDOs increase
When housing bubble busts, mortgage borrowers,
especially subprime mortgage borrowers are not able to
make payments, investors don’t get their money, values
of CDOs decrease substantially. The value decrease is
write-down and counted as loss in the income statement.
For example, investment bank A, equity: $10 mil, borrow
$90 mil. Invest all $100 mil in CDOs. When mortgage
crisis happens, the market value of these mortgage
backed securities drops substantially say to $80 mil, that
means the income will go down by $80 mil, and at this
point, technically the bank is insolvent.
Subprime Mortgage Crisis: Winners and Losers
 Big losers: http://ml-implode.com/
 Bear Stearns: two hedge funds (>$1 billion)
 Australia: Basis Capital ($1 billion?); Absolute Capital ($200
million?); IKB Deutsche Industriebank …
 May take two more years to completely resolve!
 Big losers:


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Citigroup ($18B+)
Merrill Lynch ($11.5B+)
UBS ($17.8B+)
Morgan Stanley ($9.4B+) …
Bank of China (initial estimate $223 million, now could be $4-5B)
Building a Complex Security
Unbundling – Mortgage Security
2008: Making History
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2008: The End of Wall Street
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A New Legend?
The Wall
Street investor
who shorted
subprime –
and made
$15bn or 600%
return
John Paulson
31
The Largest Ponzi Scheme
Bernard Madoff
$50B
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Computer network
Online trading fee is only $20, compared
with brokerage firm $100.
 Online information: cheap and available
 automated trade crossing

 example:
if IBM price falls below $50, sell the
stock automatically.
Decision Making
1.
2.
3.
4.
Perceive the situation
Possible actions
Evaluate the outcomes
Choose the action with the best outcome
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Summary
Financial assets
 Risk return tradeoff
 Next class: Financial Securities
