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Chapter 1

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

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Chapter 1

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  1. Chapter 1 Investments: Background and Issues

  2. 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

  3. Table 1.1. Balance Sheet – U.S. HouseholdsTable 1.2 Domestic Net WorthMost Current http://www.federalreserve.gov/releases/z1/current/ 1-3

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

  5. 1.3 Financial Markets and the Economy 1-5

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

  7. Separation of Ownership and Management; Ethics • Agency costs: Owners’ interests may not align with managers’ interests • 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. • Eroding public support and confidence in market based systems 1-7

  8. Example 1.1 In February 2008, Microsoft offered to buy Yahoo at $31 per share when Yahoo was trading at $19.18. 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

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

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

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

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

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

  14. 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

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

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

  17. 1.7 Recent Trends • Globalization • Managing foreign exchange • International diversification reduces risk • 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

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