1. McGraw-Hill/Irwin © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. CHAPTER 1 Investments - Background and Issues

2. 1-2 Financial Economics Why a special area of economics? –Time is essential: consumption today versus consumption tomorrow. Investment is the act of giving up consumption today in expectation of higher consumption in the future. –Risk is essential: purchase of a sure thing versus purchase of a risky chance of the same thing. Investment involves choosing among alternative risky assets, with different returns depending on the state of the world

3. 1-3 Real Assets Versus Financial Assets Essential nature of investment –Reduced current consumption –Planned later consumption Real Assets –Assets used to produce goods and services Financial Assets –Claims on real assets

4. 1-4 Table 1.1 Balance Sheet of U.S. Households, 2007

5. 1-5 Table 1.2 Domestic Net Worth

6. 1-6 A Taxonomy of Financial Assets Fixed income or debt – Money market instruments Bank certificates of deposit – Capital market instruments Bonds Common stock or equity Derivative securities

7. 1-7 Financial Markets and the Economy Information Role –The Google effect Consumption Timing Allocation of Risk Separation of Ownership and Management –Agency Issues

8. 1-8 Financial Markets and the Economy Continued Corporate Governance and Corporate Ethics –Accounting Scandals Examples – Enron, Rite Aid, HealthSouth –Auditors—watchdogs of the firms –Analyst Scandals Arthur Andersen –Sarbanes-Oxley Act Tighten the rules of corporate governance

9. 1-9 The Investment Process Asset allocation –Choice among broad asset classes Security selection –Choice of which securities to hold within asset class Security analysis

10. 1-10 Markets are Competitive Risk-Return Trade-Off Efficient Markets –Active Management Finding mispriced securities Timing the market –Passive Management No attempt to find undervalued securities No attempt to time the market Holding a highly diversified portfolio

11. 1-11 The Players Business Firms– net borrowers Households – net savers Governments – can be both borrowers and savers Financial Intermediaries –Investment Companies –Banks –Insurance companies –Credit unions

12. 1-12 The Players Continued Investment Bankers –Perform specialized services for businesses –Markets in the primary market

13. 1-13 Table 1.3 Balance Sheet of Commercial Banks, 2007

14. 1-14 Table 1.4 Balance Sheet of Nonfinancial U.S. Business, 2007

15. 1-15 Recent Trends—Globalization American Depository Receipts (ADRs) Foreign securities offered in dollars Mutual funds that invest internationally Instruments and vehicles continue to develop (WEBs) Exchange Traded Funds (ETFs)

16. 1-16 Figure 1.1 Globalization: A Debt Issue Denominated in Euros

17. 1-17 Recent Trends—Securitization Mortgage pass-through securities Other pass-through arrangements –Car, student, home equity, credit card loans Offers opportunities for investors and originators

18. 1-18 Figure 1.2 Asset-backed Securities Outstanding

19. 1-19 Recent Trends—Financial Engineering Use of mathematical models and computer- based trading technology to synthesize new financial products Bundling and unbundling of cash flows

20. 1-20 Figure 1.3 Building Creates a Complex Security

21. 1-21 Figure 1.4 Unbundling of Mortgages into Principal- and Interest-Only Securities

22. 1-22 Recent Trends—Computer Networks Online information dissemination Information is made cheaply and widely available to the public Automated trade crossing –Direct trading among investors