FIN4504 Investments Ch 1 5 19 MC questions 3 open space questions bring a 2 pencil calculator is ok Exam 1 Study Guide 1 Financial Assets Real assets the land buildings equipment and knowledge that can be used to produce goods and services Generate net income to the economy Financial assets stocks and bonds Securities that are no more than sheets of paper or more likely computer entries Don t directly contribute to the productive capacity of the economy The means by which individuals in well developed economies hold their claims on real assets Claims to the income generated by real assets Claims on income from the government Define the allocation of income or wealth among investors Individuals choose between consuming their wealth today or investing in the future If they choose to invest they may place their wealth in financial assets by purchasing various securities When investors buy these securities from companies the firms use the money raised to pay for real assets Investors returns on securities come from the income produced by the real assets that were financed by the issuance of those securities Distinction between real and financial assets View balance sheet Table 1 1 Household wealth includes financial assets such as bank accounts corporate stock or bonds These securities are financial assets of households but are liabilities of the issuers of the securities your asset is the issuers liability When you aggregate overall balance sheets the claims cancel out Only real assets are left and are the net wealth of the economy The success or failures of the financial assets we choose to purchase ultimately depend on the performance of the underlying real assets Types of Financial Assets Debt fixed income securities promise either a fixed stream of income or a stream of income that is determined according to a specified formula Money market refers to fixed income securities that are short term highly marketable and generally of very low risk Capital market includes long term securities such as Treasury bonds as well as bonds issued by federal agencies state and local municipalities and corporations These bonds range from very safe Treasury securities to relatively risky high yield or junk bonds Designed with extremely diverse provisions regarding payments provided to the investor and protection against the bankruptcy of the issuer Equity represents an ownership share in a corporation Equity holders are not promised any particular payment Receive any dividends the firm may pay Prorated ownership in the real assets of the firm If the firm is successful the value of the equity will increase FIN4504 Investments Ch 1 5 If not the value will decrease The performance of equity investments is tied directly to the success of the firm and its real assets Equity investments tend to be riskier than investments in debt securities Derivative securities options and futures contracts provide payoffs that are determined by the prices of other assets such as bond or stock prices Named this because their values derive from the prices of other assets Investors and corporations regularly encounter other financial markets as well Firms engaged in international trade regularly transfer money back and forth between dollars and other currencies than trillions of dollars are traded each day in the market for foreign exchange Investors might also invest directly in some real assets You can buy or sell corn wheat natural gas gold silver etc Commodity and derivative markets allow firms to adjust their exposure to various business risks Wherever there is uncertainty investors may be interested in trading either to speculate or to lay off their risks and a market may arise to meet that demand 2 Asset Allocation Process Investors make two types of decisions in constructing their portfolios The asset allocation decision The choice among the broad asset classes stocks bonds real estate commodities etc The security selection decision The choice of which particular securities to hold within each asset class Top down portfolio construction starts with asset allocation Security analysis the valuation of particular securities that might be included in the portfolio Both bonds and stocks must be evaluated for investment attractiveness Bottom up strategy the portfolio is constructed from the securities that seem attractively priced without as much concern for the resultant asset allocation Can result in unintended bets on one or another sector of the economy Focuses the portfolio on the assets that seem to offer the most attractive investment opportunities The asset allocation decision is the primary determinant of a portfolio s return Primary use is to hedge risks or transfer them to other parties Can also be used to take highly speculative positions Every so often one of these positions blows up Results in well publicized losses of hundreds of millions of dollars Though these losses attract a lot of attention they don t negate the potential of these securities as risk management tools 3 Securitization The landscape in housing finance began to change in the 1970s Fannie Mae FNMA Federal National Mortgage Association Freddie Mac FHLMC Federal Home Loan Mortgage Corporation Fannie Mae and Freddie Mac began buying large quantities of mortgage loans from originators and bundling them into pools that could be traded like any other financial asset The pools were soon dubbed mortgage backed securities The process was called securitization FIN4504 Investments Ch 1 5 The loan originator the savings and loan might make a 100 000 loan to a homeowner The homeowner repays the principal and interest on the loan over 30 years The originator would sell the mortgage to Freddie Mac or Fannie Mae and recover the cost of the loan The originator could continue to service the loan e g collect monthly payments from the homeowner for a small servicing fee The loan payments net of that fee would be passed along to the agency In turn Freddie or Fannie would pool the loans into mortgage backed securities and sell the securities to investors such as pension funds or mutual funds the agency would typically guarantee the credit or default risk of the loans included in each pool It would retain a guarantee fee before passing along the rest of the cash flow to the ultimate investor Because the mortgage cash flows were passed along from the homeowner to the lender and to the investor the mortgage backed securities were also called pass throughs New