Chapter 1Slide 2Real Versus Financial AssetsTable 1.1. Balance Sheet – U.S. Households, 2008Real versus Financial AssetsTable 1.2 Domestic Net Worth, 2008Slide 7Major Classes of Financial Assets or SecuritiesSlide 9Financial MarketsConsumption TimingAllocation of RiskSeparation of Ownership and ManagementExample 1.1Corporate Governance and Corporate EthicsSlide 16Slide 17Slide 18Slide 19Slide 20Slide 21Active vs. Passive ManagementSlide 23The PlayersThe Players Cont.Investment BankersSlide 27Table 1.3 Balance Sheet of Commercial Banks, 2008Table 1.4 Balance Sheet of Nonfinancial U.S. Business, 20081.7 Recent TrendsGlobalizationSecuritizationSlide 33Figure 1.1 Asset-backed Securities OutstandingFinancial EngineeringFigure 1.2 Building a Complex SecurityFigure 1.3 Mortgage SecurityComputer NetworksThe Future1.8 Text OutlineChapter 1Investments: Background and IssuesCopyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin1-21.1 Real Versus Financial Assets1-21-3Real 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 income1-4Table 1.1. Balance Sheet – U.S. Households, 20081-5Real 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.1-6Table 1.2 Domestic Net Worth, 20081-71.2 A Taxonomy of Financial Assets1-8Major Classes of Financial Assets or Securities•Debto Money market instruments•Bank certificates of deposit, T-bills, commercial paper, etc.o Bondso Preferred stock•Common stockoOwnership stake in the entity, residual cash flow•Derivative securitiesoA contract whose value is derived from some underlying market condition.1-91.3 Financial Markets and the Economy1-10Financial Markets•Informational Role of Financial MarketsoDo market prices equal the fair value estimate of a security’s expected future risky cash flows?oCan we rely on markets to allocate capital to the best uses?•What other mechanism could we use to allocate capital? •What would be the advantages and disadvantages of another system?1-11Consumption TimingoPeople tend to smooth consumption over time. oIf one has more than enough cash to meet their basic needs in the current time period one might shift consumption through time by investing the surplus.1-12Allocation of RiskoInvestors can choose a desired risk level•Bonds versus stock of a given company•Bank CD versus company bond•Tradeoff between risk and return?1-13Separation of Ownership and Management•Large size of firms requires separation of ownership and managementoIn 2008 GE had over $800 billion in assets and over 650,000 stockholdersoOwners (principals) ≠ Managers (agents)oAgency costs: Owners’ interests may not align with managers’ interestsoMitigating factors:•Performance based compensation•Boards of Directors may fire managers•Threat of takeovers1-14Example 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?1-15Corporate Governance and Corporate Ethics•Business and market require trust to operate efficientlyoWithout trust additional laws and regulations are requiredoAll laws and regulations are costly•Governance and ethics failures have cost our economy billions if not trillions of dollars.oEroding public support and confidence in market based systems1-16Corporate Governance and Corporate Ethics•Accounting ScandalsoEnron, WorldCom, Rite-Aid, HealthSouth, Global Crossing, Qwest, •Misleading Research ReportsoCiticorp, Merrill Lynch, others•Auditors: Watchdogs or Consultants?oArthur Andersen and Enron1-17Corporate Governance and Corporate Ethics•Sarbanes-Oxley ActoIncreases the number of independent directors on company boardsoRequires the CFO to personally verify the financial statementsoCreated a new oversight board for the accounting/audit industryoCharged the board with maintaining a culture of high ethical standards1-181.4 The Investment ProcessChoosing the percentage of funds in asset classesChoosing specific securities w/in an asset classStocksBondsAlternative AssetsMoney market securities60%30%6%4%o Asset allocationo The asset allocation decision is the primary determinant of a portfolio’s returno Security selection & analysis1-191.5 Markets Are CompetitiveoRisk-return trade-off: oAssets with higher expected returns have higher risk.A stock portfolio can be expected to lose money about 1 out of every 4 years.oBonds have a much lower average rate of return (under 6%) and have not lost more than 13% of their value in any one year.Average Annual ReturnMinimum (1931)Maximum (1933)Stocks About 12% -46% 55%1-20oHow do we measure risk?oHow does diversification affect risk?oDiscussed in Part 2 of the textRisk-Return Trade- Off1-21Efficient MarketsoMarket efficiency: oSecurities should be neither underpriced nor overpriced on averageoSecurity prices should reflect all information available to investorsoWhether we believe markets are efficient affects our choice of appropriate investment management style.1-22Active vs. Passive ManagementActive Management (inefficient markets)Finding undervalued securitiesTiming the marketPassive Management (efficient markets)No attempt to find undervalued securitiesNo attempt to timeHolding a diversified portfolio:Security SelectionAsset Allocation•Indexing•Constructing an “efficient” portfolio1-231.6 The Players1-24The Players•Business Firms – net borrowers•Households – net savers•Governments – can be both borrowers and savers•Financial Intermediaries “Connectors of borrowers and lenders”oCommercial Banks•Traditional line of business: Make loans funded by depositsoInvestment companiesoInsurance companiesoPension fundsoHedge funds1-25The Players Cont.•Investment BankersoFirms that specialize in primary
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