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Chapter One

Chapter One. The Investment Envirenment. The presentation has been amended/updated by Dr . Mounira Ben Arab. 1.1 REAL ASSETS VERSUS FINANCIAL ASSETS. Real Assets the land, buildings, knowledge, and machines

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Chapter One

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  1. Chapter One The InvestmentEnvirenment The presentation has been amended/updated by Dr. Mounira Ben Arab

  2. 1.1 REAL ASSETS VERSUS FINANCIAL ASSETS • Real Assets • the land, buildings, knowledge, and machines Together, physical and “human” assets generate the entire spectrum of output produced and consumed by the society • Financial Assets • Stocks or bonds are no more than sheets of paper or more likely, computer entries, and do not directly contribute to the productive capacity of the economy. Instead, financial assets contribute to the productive capacity of the economy indirectly

  3. Real Assets and financial Assets are distinguished • operationally by the balance sheets of individuals and firms in the economy: Whereas real assets appear only on the asset side of the balance sheet, financial assets always appear on both sides of balance sheets. • financial assets are created and destroyed in the ordinary course of doing business. For example, when a loan is paid off, both the creditor’s claim (a financial asset) and the debtor’s obligation (a financial liability) cease to exist. In contrast, real assets are destroyed only by accident or by wearing out over time.

  4. 1.2 FINANCIAL MARKETS AND THE ECONOMY • Real assets determine the wealth of an economy, whereas financial assets merely represent claims on real assets. • Financial assets allow us to make the most of the economy’s real assets. • Consumption Timing : How can you shift your purchasing power from high-earnings periods to low-earnings periods of life? • In high-earnings periods, you can invest your savings in financial assets such as stocks and bonds. • In low-earnings periods, you can sell these assets to provide funds for your consumption needs.

  5. Allocation of Risk • Financial markets and the diverse financial instruments traded in those markets allow investors with the greatest taste for risk to bear that risk. • the more optimistic, or risk-tolerant, investors buy shares of stock • the more conservative individuals can buy bonds, which promise to provide a fixed payment. • Separation of Ownership and Management : • Many businesses are owned and managed by the same individual. • with global markets and large-scale production, the size and capital requirements of firms have skyrocketed. General Electric actually has about one-half million stockholders,. Such a large group of individuals obviously cannot actively participate in the day-to-day management of the firm. Instead, they elect a board of directors, which in turn hires and supervises the management of the firm.

  6. 1.3 CLIENTS OF THE FINANCIAL SYSTEM • The Household Sector: are potentially interested in a wide array of assets. Assets that are attractive can vary considerably depending on the household’s economic situation. • - Taxes lead to varying asset demands because people in different tax brackets “transform” before-tax income to after-tax income at different rates • - Risk considerations also create demand for a diverse set of investment alternatives • The Business Sector: businesses typically need to raise money to finance their investments in real assets

  7. The Government Sector • - Like businesses, governments often need to finance their expenditures by borrowing. • - Unlike businesses, governments cannot sell equity shares; they are restricted to borrowing to raise funds when tax revenues are not sufficient to cover expenditures.

  8. 1.4 THE ENVIRONMENT RESPONDS TO CLIENTELE DEMANDS • Financial Intermediation • Evolve to bring the two sectors together (demanders and suppliers) • For example, a bank raises funds by borrowing and lending that money to other borrowers. In this way, lenders and borrowers do not need to contact each other directly. Instead,

  9. All the intermediaries , banks, insurance, investment companies, credit unions ,… offer similar advantages • First, by pooling the resources of many small investors, they are able to lend considerable sums to large borrowers. • Second, by lending to many borrowers, intermediaries achieve significant diversification, • Third, intermediaries build expertise through the volume of business they do. • Economy of scale related to the expense of collecting information • Investment companies and mutual funds arise out the “smallness problem.”

  10. Investment Banking • Because they are constantly in the market, Investment bankers can provide more than just expertise to security issuers • Exemple, Merrill Lynch, Salomon Smith Barney, or Goldman, Sachs advise the issuing firm on the prices it can charge for the securities issued, market conditions, appropriate interest rates, and so forth. • Financial Innovation and Derivatives • The mortgage-backed securities such as : • mortgage pass-through securities (first introduced by the Government National Mortgage Association • the collateralized mortgage obligation, or CMO. • - Derivatives have become an integral part of the investment environment.

  11. 1.5 MARKETS AND MARKET STRUCTURE • Direct search markets, • Brokered markets, • Dealer markets • Auction markets.

  12. 1.6 ONGOING TRENDS • Globalization, • Securitization, • Financial Engineering • Computer Networks.

  13. Globalization of Financial Markets and Institutions Reasons of Growth in Foreign Financial Market • The pool of savings from foreign investors (i.e from EU) is increasing and investors look to diversify globally now more than ever before • Information on foreign markets and investments is becoming readily accessible and deregulation across the globe is allowing even greater access • International mutual funds allow diversified foreign investment with low transactions costs • Euro is also having a notable impact on the global financial sytem. • Global capital flows are larger than ever mainly due to deregulation in many foreign countries. McGraw-Hill/Irwin

  14. Globalization of Financial Markets and Institutions While US financial markets dominate world markets, the growth of US financial markets depends more and more on the growth and development of other economies. The success of other economies depends to a significant extent on their financial market development

  15. Globalization of Financial Markets and Institutions • The Largest Banks in the World • Competition is also increased due to global markets. McGraw-Hill/Irwin

  16. Secondary Mortgage MarketMortgage Sales • Mortgage sellers: money center banks, smaller banks, foreign banks, investment banks • Mortgage sales allow FIs to manage credit risk, achieve better asset diversification, and improve their liquidity and interest rate risk positions • FIs are encouraged to sell loans for economic and regulatory reasons • sold mortgages can still generate fee income for the bank • sold mortgages reduce the cost of reserve and capital requirements • Mortgage buyers: foreign and domestic banks, insurance companies, pension funds, closed-end bank loan mutual funds, and nonfinancial corporations

  17. Secondary Mortgage MarketMortgage Backed Securities • There are 3 different major types of mortgage backed securities. Pass through and CMOs are securitized mortgages • Three agencies are directly involved in the creation of pass-through securities • Fanniemae and Freddiemac is a stockholder owned corporation with a line of credit from the US Treasury. Its bonds are rated AAA. • Pass-through securities“pass through” promised principal and interest payments to investors • Private mortgage pass-through issuers create pass-throughs from nonconforming mortgages

  18. Mortgage Backed Securities • Collateralized mortgage obligations (CMOs) are multiclass pass-throughs with multiple bond holder classes or tranches • Unlike a pass through each bond holder class has a different guaranteed coupon • mortgage prepayments retire only one tranche at a time, so all other trances are sequentially prepayment protected • Mortgage backed bonds (MBBs) • MBBs allow FIs to raise long-term low-cost funds without removing mortgages from their balance sheets • The cash flow on the mortgages backing the bond are not necessarily directly connected to interest and principal payments on the MBB.

  19. WEBSITES http://www.financewise.com This is a finance search engine for other financial sites. http://www.federalreserve.gov/otherfrb.htm This site contains a map that allows you to access all of the Federal Reserve Bank sites. http://www.cob.ohio-state.edu/fin/journal/jofsites.htm This site contains a directory of finance journals and associations related to education in the financial area. http://finance.yahoo.com This investment site contains information on financial markets. Portfolios can be constructed and monitored at no charge. Limited historical return data is available for actively traded securities. http://moneycentral.msn.com/home.asp Similar to Yahoo! finance, this investment site contains very complete information on financial markets.

  20. End of Chapter 1Thanks

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