Chapter 1 Investments: Background and Issues

1.1 Real Versus Financial Assets Real Assets Used to produce goods and services: Property, plant & equipment, human capital, etc. the net wealth of an economy is the sum of its real assets. Financial Assets Claims on real assets or claims on asset income 1-2

Table 1.1. Balance Sheet – U.S. Households Table 1.2 Domestic Net Worth Most Current

Major Classes of Financial Assets or Securities Debt o Money market instruments Bank certificates of deposit, T-bills, commercial paper, etc. o Bonds o Preferred stock Common stock o Ownership stake in the entity, residual cash flow Derivative securities o A contract whose value is derived from some underlying market condition. 1-4

1.3 Financial Markets and the Economy 1-5

Financial Markets Informational Role of Financial Markets o Do market prices equal the fair value estimate of a security’s expected future risky cash flows? o Or any thing? – Intrade.com 1-6

Separation of Ownership and Management; Ethics o Agency costs: Owners’ interests may not align with managers’ interests o Mitigating factors: Performance based compensation Boards of Directors may fire managers Threat of takeovers – M&A FINC 350 Governance and ethics failures have cost our economy trillions of dollars. o Eroding public support and confidence in market based systems 1-7

Example 1.1 In February 2008, Microsoft offered to buy Yahoo at $31 per share when Yahoo was trading at $ 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? 1-8

Other examples Accounting Scandals o Enron, WorldCom, Rite-Aid, HealthSouth, Global Crossing, Qwest, Misleading Research Reports o Citicorp, Merrill Lynch, others Auditors: Watchdogs or Consultants? o Arthur Andersen and Enron 1-9

Corporate Governance and Corporate Ethics Sarbanes-Oxley Act (SOX) o Increases the number of independent directors on company boards o Requires the CFO to personally verify the financial statements o Created a new oversight board for the accounting/audit industry o Charged the board with maintaining a culture of high ethical standards 1-10

1.4 The Investment Process Choosing the percentage of funds in asset classes Choosing specific securities w/in an asset class Stocks Bonds Alternative Assets Money market securities 60% 30% 6% 4% o Asset allocation The asset allocation decision is the primary determinant of a portfolio’s return o The asset allocation decision is the primary determinant of a portfolio’s return o Security selection & analysis 1-11

o How do we measure risk? o How does diversification affect risk? o Discussed in Part 2 of the text o Investors can choose a desired risk level Bonds versus stock of a given company Bank CD versus company bond Tradeoff between risk and return? Risk-Return Trade- Off 1-12

Efficient Markets o Market efficiency: o Securities should be neither underpriced nor overpriced on average o Security prices should reflect all information available to investors o Whether we believe markets are efficient affects our choice of appropriate investment management style. o 3 forms – strong, semi-strong, weak 1-13

Active vs. Passive Management Active Management (inefficient markets) Finding undervalued securities Timing the market Passive Management (efficient markets) No attempt to find undervalued securities No attempt to time Holding a diversified portfolio: Security Selection Asset Allocation Indexing Constructing an “efficient” portfolio 1-14

The Players Business Firms – net borrowers Households – net savers Governments – can be both borrowers and savers Financial Intermediaries “Connectors of borrowers and lenders” o Commercial Banks Traditional line of business: Make loans funded by deposits o Investment companies o Insurance companies o Pension funds o Hedge funds 1-15

The Players Cont. Investment Bankers aka Wall Street o Firms that specialize in primary market transactions o Primary market vs Secondary o After 2008, no more pure investment bankers, annulling 1933 Act o As a result, they face much stricter banking regulations, e.g. deleveraging 1-16

1.7 Recent Trends Globalization o Managing foreign exchange o International diversification reduces risk o Instruments and vehicles continue to develop (ADRs and WEBs) Securitization Financial Engineering Information and Computer Networks Nasdaq as of Feb 2011 has the fastest network: 98ms/trade, Soon Singapore 90ms/trade Deleveraging 1-17