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CHAPTER 1

CHAPTER 1. Investments - Background and Issues. The Goals of Chapter 1. This chapter takes an overview of what we will learn in the text book Define an investment Investment targets: financial or real assets Introduce different classes of financial assets (Ch 2 and Parts 3, 4, and 5)

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CHAPTER 1

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  1. CHAPTER 1 Investments - Background and Issues

  2. The Goals of Chapter 1 • This chapter takes an overview of what we will learn in the text book • Define an investment • Investment targets: financial or real assets • Introduce different classes of financial assets (Ch 2 and Parts 3, 4, and 5) • Discuss the role of financial markets (Ch 3) • Something about corporate governance • Introduce the investment process • Risk-return trade-off and efficient markets (Part 2) • Know players in financial markets (Ch 4) • Financial crisis in 2008

  3. 1.1 REAL ASSETS VERSUS FINANCIAL ASSETS

  4. Financial Versus Real Assets • Real Assets (tangible (有形) or intangible(無形)) • Assets used to produce goods and services, e.g., land, building, equipment, or knowledge • Can generate net income to the economy • Financial Assets • Claims on real assets or the income generated by them, e.g., equity shares or debt of firms • Essence of investment • Sacrifice something of value now, invest in real assets or financial assets, and expect to benefit from that sacrifice later • The investment decision of individual investors is associated with smoothing consumption • Invest in good time periods, and realize investments in poor time periods

  5. Balance Sheet of U.S. Households ※ The largest parts of assets and liabilities both come from the house owned ※ The position of deposits is usually maintained for liquidity of consumption ※ Pension reserves is the money or assets invested for future retired life ※ Equity in noncorporatebusiness may come from the investment in sole proprietorship (獨資)or partnership companies(合夥)

  6. Financial Versus Real Assets • Net wealth of the economy • Banks account, corporate stock, or corporate bonds are not only financial assets of households but also the liabilities of the issuers • Banks use the proceeds of deposits to lend to firms or households or to buy some financial asset issued by firms • Firms issue financial assets (e.g., corporate stock or bonds) to pay for the acquirement of real assets • By aggregating balance sheets over all households, firms, and banks, those financial claims cancel out, leaving only real assets as the net wealth of the economy

  7. Domestic Net Worth in the U.S., 2011

  8. 1.2 A CLASSIFICATION OF FINANCIAL ASSETS

  9. Major Classes of Financial Assets • Debt (fixed income securities) (part 3) • Money market instruments (shorter term, lower risk), e.g., Treasury bills or bank certificates of deposit • Capital market instruments (longer term, higher risk), e.g., Treasury or Corporate Bonds • Equity (ownership share of a firm) (part 4) • Shareholders may receive dividends and have prorated ownership in the real assets of the firm • Derivative securities (part 5) • Futures (期貨): an agreement (with both right and obligation) to buy or sell an asset at a certain time point in the future for an agreed price • Options (選擇權): a right to buy or sell an asset at a certain time point in the future for a specified price

  10. 1.3 FINANCIAL MARKETS AND THE ECONOMY

  11. Financial Markets • Provide price information • Market prices reflect the consensus (共識) of investing public • Market prices and allocation of capital resources • For firms with good (poor) prospects, the stock market encourages (discourage) allocation of capital to those firms, whose share prices are bidden up (down) • Shift consumption timing for individual investors • Shift your purchasing power from high-earnings periods to low-earnings periods of life • The goal of investment for individual investors is to smooth their consumption over lifetime

  12. Financial Markets • Allocate risk • Firms can transfer the project risk to investors who buy stock shares or bonds issued by the firms • Allow investors with the greatest taste for risk to bear that risk • Stock shares for more risk-tolerant investors • Bonds for more conservative investors • Another benefit for firms • When investors are able to select security types with the risk-return characteristics that best fit their preference from the financial markets, each security can be sold at the best possible price

  13. Financial Markets • Separate ownership with management • The invention of stock shares and stock markets allows the separation of ownership and management • Meanwhile, shareholders elect a board of directors to supervise the management of the firm • Advantages for this arrangement • Firms’ existence or performance is independent of the status of their shareholders • Can find professional managers to operate the firm • Shareholders can sell shares to others in financial markets without affecting the management

  14. Financial Markets • Agency problems (代理人問題): Conflicts of interest between managers and stockholders • Empire building, avoid risky projects, or overconsume luxuries • All these suboptimal decisions hurt the interests of shareholders • Solutions: • Performance-based compensation plans (link the manager’s income with the performance of the stock price) • Penalty for the poor performance in stock price (force out or fire the manager) • Specialist monitoring (analysts, fund managers, or banks) • Takeovers by other firms (replace the poor-performing managers to enhance the value of the firm)

  15. Corporate Governance and Ethics • What is corporate governance (公司治理)? • Corporate governance is the set of processes, policies, or institutional systems affecting how a corporation is directed, administered, or controlled • It is associated with the interests among all the stakeholders (利害關係人) in a company, including shareholders, debtholders, and the management • Corporate governance arises from the information asymmetry among stakeholders • Without trust among stakeholders, additional laws and regulations are required • They are in general designed to protect the investing public, who is with less information and control power for firms • They can build the confidence of the investing public, which is the essential pillar to support financial markets

  16. Corporate Governance and Ethics • Good corporate governance does matter: McKinsey surveyed more than 200 institutional investors as to the value they place on good governance ※ The premium as the percentage of the stock price that institutional investors would like to pay for companies with good governance in different countries

  17. Poor Corporate Governance • Accounting scandals (Enron, WorldCom, Rite-Aid, HealthSouth, Global Crossing, Qwest, etc.) • Enron in 2001 • In late 2001, Enron was one of the world's leading electricity, natural gas, communications and pulp and paper companies, with claimed revenues of nearly $101 billion in 2000 • Using special purpose entities (SPEs) (also known as special purpose vehicle (SPV)) to hide debt which should be in its own books (by selling non-performing assets to SPEs) • WorldCom in 2002 • The United States's second largest long distance phone company (after AT&T) • Classify expenses as investments to enhance net income or even hide losses

  18. Poor Corporate Governance • Misleading research reports by stock analysts (Citibank, Merrill Lynch, etc.) • Instead of providing fair reports, their favorable reports are traded for the promise of future investment banking business for the firm, e.g., participating the allocation of public offerings • Auditors: watchdogs or consultants • Example of Arthur Andersen (AA) in Enron case: due to the fact that the profit from consulting is higher than that from auditing, AA, in order to protect its consulting profits, had to weak its function of auditing

  19. Reform of Corporate Governance • Sarbanes-Oxley Act in 2002 (tightening the rules of corporate governance in the U.S.) • More independent directors are required in boards of directors • CFOs need to personally vouch for the truth of corporate accounting statements • A new quasi-public agency, Public Company Accounting Oversight Board, is created to monitor the accounting/auditing industry • Prohibit auditors from providing various other services to clients

  20. 1.4 THE INVESTMENT PROCESS

  21. Investment Philosophies and Strategies • Asset allocation • Choice among a broad classes of assets • Decide the weight of various classes of assets 1. According to your return-risk preference 2. According to the portfolio theory: to construct a well-diversified portfolio to generate the desired expected return but bear lower degree of risk (taking the correlation into account) • Top down strategy • The investment portfolio is constructed starting with asset allocation • For example, deposits vs. securities, stocks vs. bonds, automobile industry vs. electronic industry, Treasury bills vs. Treasury bonds, and so on

  22. Investment Philosophies and Strategies • Security selection • Perform the security analysis to evaluate securities and find distorted ones • Bottom up strategy • Find securities with distorted prices but ignore the resulting asset allocation • In an efficient market • Distortions exist for a short time period because many investors try to benefit from selling overvalued and buying undervalued securities • Theoretically, there are almost no distorted securities and the bottom up strategy is difficult to make profit

  23. 1.5 MARKETS ARE COMPETITIVE AND RISK-RETURN TRADE-OFF

  24. Financial Markets are Competitive • The performance in financial markets is determined only by gains or losses in money • This unique characteristic causes that the only criteria for selecting securities are high expected returns and low riskiness • The pursuance for those securities makes financial markets extremely competitive • Another source of competition: • Many well-trained or knowledgeable investors constantly survey the financial market for the best buys (the most underpriced securities)

  25. Risk-Return Trade-Off • Assets with higher expected returns have greater risk (risk-return trade-off) • The consequence of market competition • If investors continuously buy the high-return-low-risk assets, their prices will rise and the expected returns (=profit/price) are lowered until the expected returns are commensurate with risk • As a result, if you want higher expected returns, you need to bear higher investment risks • Stocks: high average annual return (12%) and high degree of risk (min: –46% and max: 55% for one year) • Bonds: low average annual return (<6%) and low degree of risk (never lost more than 13% in any one year)

  26. Risk-Return Trade-Off • What role does diversification play • Diversification means reducing risk by investing in a variety of assets • Diversification can reduce the risk of the portfolio without hurting the expected return of the portfolio • The effect of portfolio diversification, the proper measurement of risk, and the risk-return relationship are the topics in modern portfolio theory and will be mentioned in Part 2

  27. Efficient Markets Theory • In an efficient market, security price should reflect all information available to investors concerning the value of the security • A market can be further classified as weak-form, semistrong-form, and strong-form efficient market (discussed in Chapter 8) • The price of the security in an efficient market adjusts quickly to reflect the new information, i.e., there would be neither underpriced nor overpriced securities in an efficient market theoretically (discussed in Chapter 8)

  28. Active Versus Passive Management • Whether we believe markets are efficient affects our choice of appropriate investment management style • Active management (inefficient markets) • Find undervalued securities by fundamental analysis • Market timing strategy: to develop strategies based on the prediction of future market movement by technical analysis • Passive management (efficient markets) • No attempt to find undervalued securities • No attempt to time the market • Holding a well-diversified portfolio

  29. 1.6 THE PLAYERS

  30. The Players • Five major players in the financial markets • Business firms – net borrowers (raising funds by issuing stocks or bonds) • Households – net savers • Government – can be either net borrower or net saver (depending on tax revenue and government expenditures) • tax revenue > government expenditures  net saver • tax revenue < government expenditures  issuing Treasury bonds to raise money  net borrower • Financial institutions and financial intermediaries • Investment bankers

  31. The Players • Financial institutions and financial intermediaries • They both are institutions that “connect” borrowers and lenders by accepting funds from lenders and loaning funds to borrowers • Their social function is to channel household savings to business sectors • For financial institutions, they can make profit by taking risk and providing service (e.g., commercial and investment banks, insurance companies) • For financial intermediaries, they only provide service and thus earn fees (e.g., investment companies, mutual funds, pension funds, hedge funds)

  32. The Players • The reason for the existence of financial institutions or intermediaries 1. It is comparatively inefficient for the small-size households to make direct investment • Higher transaction cost • No economic scale to manage portfolios or survey markets • Difficult to achieve diversification for small-size portfolios 2. For households (net savers), it is also difficult to find borrowers by themselves 3. An individual lender is not equipped with the ability to estimate and monitor the credit risk of borrowers

  33. The Players • Advantages of the roles of financial institutions or intermediaries 1. Pool sources of small investors and lend considerable amount to firms or conduct large-scale trading 2. By lending to many borrowers to achieve the diversification and reduce the risk they bear 3. Due to economies of scale, financial institutions and intermediaries can build expertise to manage portfolios or to estimate and monitor risk • The next two slides show significant differences between the balance sheets of financial institutions and nonfinancial business

  34. Balance Sheet of Commercial Banks ※ Financial institutions earn interest rate spread at the expense of suffering default risk of business firms ※ Financial institutions are usually with a high percentage level of liability, which can increase the profitability for shareholders substantially ※ The risk for financial institutions is high, so they need rigorous risk management systems

  35. Balance Sheet of Nonfinancial U.S. Business Firms

  36. The Players • Investment bankers (introduced in Ch. 3) • Financial institutions specializing in the sale of new securities to the public, typically by underwriting (承銷)the issue • Firms do not directly market their securities to the public. Instead, they hire investment bankers to represent them to the investing public • Primary market: a market in which new issues of securities are offered to the public • Players: business firms, investment bankers, and institutional or individual investors • Secondary market: previously issued securities are traded among investors • Players: institutional and individual investors

  37. The Players • Commercial and investment banks’ functions were separated by laws in the U.S. from 1933 to 1999 • Glass-Steagall Act in 1933: Prohibited banks from both accepting retail deposits and underwriting securities • Commercial banks can accept deposits • Investment banks do not accept deposits, but raise their funds through issuing corporate bonds or borrowing money from other financial institutions • Investment banks do not undertake the business of retail loans • Gramm-Leach-Bliley Act (Financial Services Modernization Act) in 1999: allowed commercial banks, investment banks, securities firms, and insurance companies to consolidate to form financial holding companies (金控公司) • Post 1999 large investment banks still operated independently from commercial banks, but many large commercial banks increased their investment banking activities, pressuring profit margins of traditional investment banks

  38. The Players • Money invested to finance a new firm is called venture capital (創投) • A start-up company relies on bank loans and investors who are willing to stake (押注) on the future of this small and young companies • Note that smaller and younger companies do not have options to issue publicly-traded securities for raising funds • Two sources of venture capital: venture capital funds or wealthy individuals known as angel investors • Venture capital funds and angel investors usually engage in the operation of the invested company, e.g., help to recruit managers or provides business advice

  39. The Players • In practice, there are a lot of fails for venture capital investments, but a successful case can bring million profits • These investments in firms that do not trade on public stock exchanges are known as private equity investment

  40. 1.7 Financial Crisis in 2008

  41. Securitization (證券化) • Pooling loans and issuingstandardized securities backed by those loans, which can then be traded like any other security • The payments from borrowers will pass to holders of securitization securities, rather than the lending banks • Meanwhile, the credit risk of borrowers also transferred to holders of securitization securities • In some cases, instead of selling securitization securities to other investors, the initiating banks can purchase part of securitization securities back for themselves • Increase the liquidity of the asset of the bank by replacing the illiquid loan assets with liquid securitization securities

  42. Securitization (證券化) • Securitization securities vs. original loans

  43. Asset-backed Securities Outstanding • ※ Securitization has grown rapidly due to • Turning illiquid loan assets into a liquid and saleable asset • Changes in financial regulation permitting its growth, particularly lower capital requirements on securitization securities • The development of credit enhancement techniques, e.g., over collateralization (超額抵押), which can increases prices and marketability of ABSs

  44. Mortgage-Backed Securities • Mortgage Loans and Mortgage-Backed Securities (MBS) (抵押借款與抵押擔保證券) • A mortgage loan is a loan with the real properties as the collateral (抵押品) • A MBS is the security generated from the securitization process, which represents the ownership of a pool of mortgages loans • In 1970s, Fannie Mae (FNMA) and Freddie Mac (FHLMC) guarantee the timely payment of principal and interest (即時償付本息) even if the borrowers default and then issue MBSs based on portfolios of these loans • The simplest type of the mortgage-backed securities is the pass-through MBSs • The intermediaries (banks and FNMA or FHLMC) collects the monthly payments from the household borrower, and after deducting a fee, passes the cash flows through to the holders of the pass-through security

  45. Financial Crisis in 2008 • Traditionally all MBSs were based on conforming (符合條件) mortgage loans, but since 2006, Alt-A and subprime mortgage loans were included in pools • A-prime mortgages are conforming or conventional loans, meaning it would meet the guarantee requirement and can be resale to government-sponsored institutions (like FNMA and FHLMC) • The Alt-A loans are still with low risk, but for some reasons are not initially conforming, e.g., the size is too large or the required documents are not complete • Subprime mortgage loans reflect borrowers who do not meet the underwriting criteria (e.g., loans above 80% of house valueor the income of the borrower is not stable) and have a high perceived risk of default (Note that subprime mortgage loans are commonly arranged in the form of adjustable-rate loans)

  46. Financial Crisis in 2008 • The reasons for the growth of the subprime mortgage loans • The growing house prices • The low interest rate to aid the U.S. economy in its recovery from the 2000-2001 recession reduces the overall interest rate paid by the subprime borrowers • Political encouragement to spur affordable housing led to increase in subprime lending

  47. Financial Crisis in 2008 • Subprime crisis: • Financial institutions assumed housing prices would continue to rise, but they began to fall rapidly since the middle of 2006 • The interest rate rises from 2004 to 2007, which increases the payment burden of subprime borrowers • Consequently, MBSs backed with subprime mortgage loans, widely held by financial institutions, lost most of their value • The result has been a large loss in the capital of many banks worldwide and U.S. government sponsored institutions ※Note that MBSs are the transmission media to spread this crisis worldwide  spill-over effects (外溢效果)from one market into others  This is also the reason for the name of “financial tsunami” (金融海嘯)

  48. Financial Crisis in 2008 • Collateralized debt obligation (CDO) • The CDO is a type of structured asset-backed security, which consolidated default risk of loans onto one class of investor (or said tranches) • CDOs claim to create high rating securities from the pools with a high degree of default risk (However, it does not work in a widespread downturn) • Credit default swaps (CDS) • The CDS is an insurance contract against the default of the reference entity • AIG sold $400 billion in CDS contracts and it is one of the reason to result in its defaultcrisis (Both CDO and CDS will be introduced in Ch. 10)

  49. Financial Crisis in 2008 • The failure of famous financial institutions frozethe lending business of banks and caused the following credit crisis • In March 2008, Bear Stearns (an investment bank) failed, and the Federal Reserve System (美國聯邦儲備系統) arranged the sale of Bear Stearns to JPMorgan Chase with the agreement to cover the lose of $29 billion • On September 7 of 2008, the U.S. government took over FNMA and FHLMC • On September 14 of 2008, Lehman Brothers, one of the oldest investment banks, filed for the largest single bankruptcy in American history • Lehman Brothers borrowed considerable funds by issuing commercial paper (CP) (introduced in Ch. 2) • The CP market (short-term financing market) was essentially shut down after the default of Lehman Brothers • On September 17 of 2008, the U.S. government lends $85 billion to AIG (American International Group, a multinational insurance corporation)

  50. Financial Crisis in 2008 • Dodd-Frank Wall Street Reform and Consumer Protection Act passed in 2010: • Call for stricter rules for bank capital, liquidity, risk management practices (especially for large banks) • Mandate increased transparency, especially in derivative markets (e.g., suggest to standardize CDS contracts and trade them on exchanges) • Unify regulatory authority and clarify responsibility in one or a smaller number of government agencies • Volcker rule: Limited banks’ ability to trade for their own accounts (if it does not benefit their customers) and to investin speculative hedge funds or private equity funds • Named after a former chairman of the Federal Reserve, Paul Volcker

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