1. FINC4101 Investment Analysis
Instructor: Dr. Leng Ling
Chapter 1: Course Introduction

2. Investment
The current commitment of money or other resources in the expectation of deriving future benefits.
Examples:
Buying 100 shares of Google.
Taking this course.
In this course, we will look at many types of investments.
Examples:
1) you might buy 100 shares of Google’s stock anticipating that the future price appreciation and dividends will be enough to justify both the time that your money is tied up as well as the risk of the investment.
2) the time you will spend studying this course (& reading the text) is also an investment. You are forgoing either current leisure or the income you could be earning at a job in the expectation that your future career will be sufficiently enhanced to justify this commitment of time and effort.
While these two investments differ in many ways, they share one key attribute that is central to all investments: you sacrifice something of value now, expecting to benefit from that sacrifice later.

3. Financial assets vs. Real assets
In this course, we study investments in financial assets.
Financial asset: A claim on income (cash flow) generated by a real asset.
Examples: stocks, bonds.
Real asset: An asset used to produce goods and services and thereby generate cash flow.
Examples: factories, equipment, land/real estate, commodities buildings, knowledge.
Investors may invest in both financial and real assets.
“Financial assets”, “assets” and “securities” will be used interchangeably.
Having defined financial assets, we next turn to the major types of financial assets you will encounter in the real world and also the types of assets we will study in this course.

4. Types of financial assets
Three broad types of financial assets:
Fixed-income securities
Equity securities
Derivative securities

5. Fixed-income security
A fixed-income security pays:
A stream of fixed cash flows (e.g., fixed coupon bond) OR
A stream of cash flows that is determined according to a specified formula (e.g., floating-rate bond)
Fixed-income securities differ in terms of maturity, payment method, and risk.
Fixed coupon bond: promise to pay a fixed amount of interest (coupon interest) every period (six-months or a year).
A floating-rate bond promise payments that depend on current interest rates. E.g., a bond may pay an interest rate that is fixed at 2% points above the rate paid on US Treasury bills. Of course, the rate paid is determined first and then the interest is paid at the end of the period.
Fixed-income securities differ in terms of maturity, payment method and risk.
Maturity. At one extreme, the money market refers to fixed-income securities that are short term, highly marketable (can sell easily), and generally of very low risk. E.g.,: US Tbills or bank CDs.
In contrast, the fixed income capital market includes long-term securities such as Treasury bonds, bonds issued by federal agencies, state and local municipalities and corporations. These bonds range from very safe in terms of default risk (e.g., Treasury securities) to risky (high-yield or ‘junk’ bonds). These bonds also are designed with extremely diverse provisions regarding payments to the investor and protection against the bankruptcy of the issuer. E.g., some corporate bonds are zero coupon bonds while others fix a fixed coupon. Some bonds have prior/stronger claims on a company’s assets in the event of bankruptcy than other bonds.

6. Equity security An ownership share in a corporation.
Also called “common stock” or simply “equity”.
Cash flows from holding equity security:
Dividends paid by the company.
Proceeds from eventual sale.
These cash flows are highly uncertain.
The equity holder is not promised any particular payment. That is, dividends are not guaranteed. The company may decide not to pay any dividend. Even if dividend is paid, the actual amount paid need not be fixed. Also, the eventual sale price of the stock is not fixed or known with any degree of certainty. Thus, cash flows from holding an equity security is highly uncertain and definitely not fixed.
Equity investments tend to be risky because of the highly uncertain cash flows. Performance is tied directly to the success of the firm.

7. Derivative security
Provides payoffs/cash flows that are determined by the prices of other assets such as bond or stock prices.
E.g., call option on a share of Intel’s stock with an exercise price of $30 and an expiration date of Dec 31,2006.
Gives holder the right to buy Intel at $30 on or before expiration.
The call option gives the holder the right to buy a share of Intel’s stock at a price of $30 on or before the expiration date. if the market price of Intel remains below $30 a share, the right to buy for $30 will be valueless. If price rises above $30 before expiration, the option can be exercised to obtain the share for only $30. This difference between the prevailing market price and the exercise price represents the payoff/cash flow to the investor. This simple example illustrate how a derivative security’s payoff depends on the underlying asset price.

8. Investment process
When people invest, they buy a collection of assets (financial & real assets). Such a collection is called a “portfolio”.
The way in which an investor goes about constructing the portfolio is called the “investment process”.
Investment process requires investor to make two types of decisions:
Asset allocation
Security selection
In Portfolio Theory, we study how investors SHOULD go about forming their portfolios. Using these ideas of portfolio construction, we study how financial assets are valued in equilibrium (asset pricing topic).
Asset allocation: allocation of an investment portfolio across broad asset classes: stocks, bonds, real estate, commodities etc.
Security selection: choosing which particular securities/assets to hold within each asset class. E.g., deciding whether to hold Google or Yahoo in the equity portion of your portfolio. Obviously, to make this decision, you need to decide which asset is the most attractive. This process is called security analysis, which is the valuation of particular securities that might be included in the portfolio.

9. Markets are competitive
Financial markets are highly competitive.
Investors/analysts search markets looking for the best buys.
No-free-lunch: should not expect securities that are so underpriced that they represent obvious bargains.
Risk-return trade-off
Higher risk assets are priced to offer higher expected returns than lower-risk assets.
Market efficiency
Security prices reflect all relevant information available to investors.
Two important implications arise from the competitiveness of financial markets (the no-free-lunch proposition).
Risk-return trade-off: Higher risk assets are priced to offer higher expected returns than lower-risk assets.
The competitiveness of markets lead to the theory of market efficiency which we look at in chapter 8.
Market efficiency: the theory of market efficiency says that financial markets process all relevant information about securities quickly and efficiently, i.e., that the security price usually reflects all the information available to investors concerning the value of the security. According to this hypothesis, as new information about a security becomes available, the price of the security quickly adjusts so that at any time, the security price equals the market consensus estimate of the value of the security. if this were so, there would be neither underpriced nor overpriced securities.

10. Concept Map
FINC4101
Theory
Portfolio
Pricing
Asset
Equity
Fixed Income
Efficiency
Market
Derivative
Exchange
Foreign
Investment process discussion motivates portfolio theory and asset pricing.
Market competitiveness section motivates market efficiency and asset pricing.
Types of financial assets section motivates equity, fixed income and derivative.
Recent trends – Globalization motivates foreign exchange.

11. Summary Definition of investment Financial asset vs. real asset
Types of financial assets
Financial markets are highly competitive.
Topics covered.