1 REAL ASSETS o The real assets of the economy include the land buildings equipment and knowledge that can be used to produce goods and services o In contrast financial assets are things such as stocks and bonds Such securities are no more than a piece of paper or computer entries and do not directly contribute to the productive capacity of the economy These assets are the means by which individuals in well developed economies hold their claims on real assets o EX If we cannot own our own auto plant real asset we can still buy shares in Honda financial assets and thereby hare the income derived from the production of cars o While real assets generate net income to the economy financial assets simply define the allocation of income or wealth among investors 2 Asset Allocation o Asset Allocation Allocation of an investment portfolio across broad asset classes o Investors make 2 types of decisions in constructing their portfolios Asset allocation decision is the choice among these broad asset classes Top down portfolio construction starts with asset allocation o EX an individual who currently holds all of his money in a bank account would first decide what proportion of the overall portfolio ought to be moved into securities Security selection decision is the choice of which particular securities to hold within each asset class o Security analysis involves the valuation of particular securities that might be included in the portfolio Bottom up strategy the portfolio is constructed from the securities that seem attractively priced without as much concern for the resultant asset allocation o Asset allocation and flexible funds Sell both stocks and bonds too Asset allocation funds may dramatically vary the proportions allocated in accordance to the portfolio manager s forecast of the performance of the sector Funds engaged in market timing not designed to be low risk o Asset Allocation across risky and risk free portfolios A simple strategy to control portfolio risk its it specify the fraction of the portfolio invested in broad asset classes such as stocks bonds and safe assets such as treasury bills The most basic form of asset allocation envisions the portfolio into risky versus risk free assets Risky assets called capital allocation Risk free asset called complete portfolio 3 Aspects of to derivatives o Derivative securities such as options and futures contracts provide payoffs that are determined by the prices of other assets such as bond or stock prices Ex a call option on a share of Intel stock might turn out to be worthless if Intel s share price remains below a threshold or exercise price such as 20 a share but it can be quite valuable If it rises above that level Other important derivative securities futures and swap Used to hedge risk transfer risk to other parties contracts o Options Call option Gives its holder the right to purchase an asset for a specified price called the exercise or strike price on or before some specified date EX an October call option on apple stock with exercise price 355 entitles its owner to purchase apple stock for a price of 355 at any time up to and including the options expiration date in October Each option contract is for the purchase of 100 shares When the market price exceeds the exercise price the option holder may call away the asset for the exercise price and reap a benefit equal to the diff between stock price and the exercise price If unexercised before the expiration date then the option expires and no longer has value Gives its holder the right to sell an asset for a specified exercise price on or before specified expiration date EX an October put on an apple with exercise price 355 entitles its owner to sell apple stock to the put writer at a price of 355 at any time before expiration in October even if the market Is lower than 355 The put is exercised only if its holder can deliver an asset worth less than the exercise price Put option 4 Mortgages interest rates o Prior to 1970 most mortgage loans came from a local lender such as a neighborhood bank and they were paid off over a period of time commonly 30 years o This all changed when Fannie Mae Federal National Mortgage Association and Freddie Mac Federal Home Loan Mortgage Corporation began buying Mortgage backed securities large quantities of mortgage loans and bundling them into pools that could be traded like any other asset process was called securitization o EX The loan originator bank would give a loan for 100k the homeowner would repay principal and interest over 30 yrs But then the bank would sell the mortgage to an investor and make its money back while still managing the mortgage and collecting the monthly fees for a small service fee from Frannie Mae and Freddie Mac The loan payments net of that fee would be passed on to the agencies Then the agencies pool them together and sell them to investors such as mutual funds Led to private investors buying mortgages of the banks with bigger risk that the homeowner would default on their loan o People began to borrow the entire amount of their mortgage and banks did not know whether they had the ability to carry a loan o When the housing prices fell people abandoned their homes and loans because their homes were worth less than the loan balance o ARMs adjustable rate mortgages grew they offered low initial interest rates but these rates eventually would reset to current yields Many of these borrowers maxed out their borrowing capacity at the teaser rate o Higher interest rates put payment pressure on homeowners who took out adjustable rate mortgages o Mortgages and Mortgage backed securities Because of the explosion in mortgage backed securities almost anyone can invest in a portfolio of mortgage loans and these securities have become a major component of the fixed income market Subprime Mortgages riskier loans made to financially weaker borrowers bundled by private issuers o Nominal interest rate The interest rate in terms of nominal not adjusted for purchasing power dollars Growth rate of money o Real interest rate The excess of the interest rate over the inflation rate The growth rate of purchasing power derived from an investment o Fisher equation an increase in expected inflation translates directly into an increase in nominal interest rates therefore the correlation between nominal rates and inflation rates should be positive and high 5 Calculate index return o Step 1 o Step 2 o Step 3 o Step 4 o Step 5 Choose the index