Chapter 1

The Investment Environment

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McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
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What does Investment mean

– AN INVESTMENT IS the current commitment of
money or other resources in the expectation of
reaping future benefits.
– For example, an individual might purchase shares
of stock anticipating that the future proceeds from
the shares will justify both the time that her money
is tied up as well as the risk of the investment.
– The one key attribute that is central to all
investments: You sacrifice something of value
now, expecting to benefit from that sacrifice later

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Real Assets Versus Financial Assets

• Real Assets
– Determine the productive capacity and
net income of the economy
– Examples: Land, buildings, machines,
knowledge used to produce goods and
services

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• Financial Assets
- are no more than sheets of paper or, more
likely, computer entries, and they do not
contribute directly to the productive capacity
of the economy.
- these assets are the means by which
individuals in well-developed economies hold
their claims on real assets.
- Financial assets are claims to the income
generated by real assets (or claims on income
from the government).
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Financial Assets

• Three types:
1. Fixed income or debt
2. Common stock or equity
3. Derivative securities

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Fixed Income
• Payments fixed or determined by a formula
– For example, a corporate bond typically would promise that the
bondholder will receive a fixed amount of interest
each year.
• Money market debt: the money market refers to debt securities that
are short term, highly marketable, and generally of very low risk.
– Examples of money market securities are U.S. Treasury bills or bank certificates of
deposit (CDs).

• Capital market debt: capital market includes long-term securities such

as Treasury bonds, as well as bonds issued by federal agencies, state
and local municipalities, and corporations.
– These bonds range from very safe in terms of default risk

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Common Stock and Derivatives

• Common Stock is equity or ownership
in a corporation.
– Payments to stockholders (Dividends) are
not fixed, but depend on the success of
the firm

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Common Stock and Derivatives

• Derivatives
– have become an integral part of the investment
environment.
– Value derives from prices of other securities,
such as stocks and bonds
– the primary use, is to hedge risks or transfer them to
other parties. also can be used to take highly
speculative positions.
– Derivatives will continue to play an important role in
portfolio construction and the financial system.

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Financial Markets and the Economy

• Information Role:
• Consumption Timing:
• Allocation of Risk:
• Separation of Ownership and
Management:
• Corporate Governance and Corporate
Ethics
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Financial Markets and the Economy

• Information Role: Capital flows to

companies with best prospects
– In a capitalist system, financial markets play a central
role in the allocation of capital resources.
– Investors in the stock market ultimately decide which
companies will live and which will die.
– If a corporation seems to have good prospects for future
profitability, investors will bid up its stock price. on the
other hand, a company’s prospects seem poor, investors
will bid down its stock price.

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Financial Markets and the Economy

• Consumption Timing: Use securities to store
wealth and transfer consumption to the future
– How can you shift your purchasing power from high-earnings
periods to low-earnings periods of life?
– One way is to “store” your wealth in financial assets.
– 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.
– By so doing, you can “shift” your consumption over the course of
your lifetime, thereby allocating your consumption to periods that
provide the greatest satisfaction.

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Financial Markets and the

Economy (Ctd.)
• Allocation of Risk: Investors can select
securities consistent with their tastes for risk.
– Virtually all real assets involve some risk.
– Financial markets and the diverse financial
instruments traded in those markets allow investors
to bear that risk

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Financial Markets and the

Economy (Ctd.)
• Separation of Ownership and Management: With
stability comes agency problems
– Many businesses are owned and managed by the same individual. This
simple organization is well suited to small businesses and, in fact, was the
most common form of business organization before the Industrial
Revolution.
– Today, with global markets and large-scale production, the size and capital
requirements of firms have skyrocketed.
– large size Corporations simply cannot exist as owner-operated firms.
– Such a large group of individuals obviously cannot actively participate in
the day-today management of the firm. Instead, they elect a board of
directors that in turn hires and supervises the management of the firm.

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Financial Markets and the

Economy (Ctd.)
• Corporate Governance and Corporate Ethics
– Corporate Governance is the set of rules and
procedures by which the company's management and
supervision are carried out through the co-ordination of
relations between the Board of Directors and the
Executive Management and the shareholders and all
other concerned parties including the social and the
environmental responsibilities for the company.
• What are the Principles of Corporate
Governance?

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Financial Markets and the

Economy (Ctd.)
• Corporate Governance and Corporate Ethics
– Accounting Scandals
• Examples – Enron, Rite Aid, HealthSouth
– Auditors
– Analyst Scandals
• Arthur Andersen
– Sarbanes-Oxley Act
• Tighten the rules of corporate governance

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The Investment Process

• Asset allocation
– Choice among broad asset classes
• Security selection
– Choice of which securities to hold within
asset class
– Security analysis to value securities and
determine investment attractiveness

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Markets are Competitive

• Risk-Return Trade-Off
– Investors invest for anticipated future returns, but those returns rarely
can be predicted precisely. There will almost always be risk associated
with investments. Actual or realized returns will almost always deviate
from the expected return anticipated at the start of the investment
period.
– If you want higher expected returns, you will have to pay a price in
terms of accepting higher investment risk.
– If higher expected return can be achieved without bearing extra risk,
there will be a rush to buy the high-return assets

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Markets are Competitive

• Efficient Markets
– One interesting implication of this “efficient market hypothesis” concerns
the choice between active and passive investment-management
strategies.
– Passive management calls for holding highly diversified portfolios
without spending effort or other resources attempting to improve
investment performance through security analysis.
– Active management is the attempt to improve performance either by
identifying mispriced securities or by timing the performance of
broad asset classes
– If markets are efficient and prices reflect all relevant information,
perhaps it is better to follow passive strategies and vice versa.

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The Players

• From a bird’s-eye view, there would appear to

be three major players in the financial
markets:

• Business Firms– net borrowers

• Households – net savers
• Governments – can be both borrowers and
savers

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The Players
• 1. Firms are net borrowers. They raise capital now to
pay for investments in plant and equipment. The income
generated by those real assets provides the returns to
investors who purchase the securities issued by the
firm.
2. Households typically are net savers. They
purchase the securities issued by firms that need to
raise funds.
3. Governments can be borrowers or lenders,
depending on the relationship between tax revenue and
government expenditures.

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The Players (Ctd.)

• Financial Intermediaries: Pool and invest funds
– Corporations and governments do not sell all or
even most of their securities directly to
individuals.
– For example, about half of all stock is held by
large financial institutions such as pension funds,
mutual funds, insurance companies, and banks.
– These financial institutions stand between the
security issuer (the firm) and the ultimate owner
of the security (the individual investor).

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The Players (Ctd.)

• Financial Intermediaries: Pool and invest
funds
– Investment Companies: pool and manage the
money of many investors.
– Banks
– Insurance companies
– Credit unions: a non-profit-making money
cooperative whose members
can borrow from pooled deposits at low interest rates.
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Universal Bank Activities

Investment Banking Commercial Banking
• Underwrite new stock and
bond issues • Take deposits and
• Sell newly issued make loans
securities to public in the
primary market
• Investors trade previously
issued securities among
themselves in the
secondary markets

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Financial Crisis of 2008

• Antecedents of the Crisis:
– “The Great Moderation”: a time in which the
U.S. had a stable economy with low interest
rates and a tame business cycle with only
mild recessions

– Historic boom in housing market

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Figure 1.3 The Case-Shiller Index of U.S.

Housing Prices

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Changes in Housing Finance

Old Way New Way

• Local thrift institution • Securitization: Fannie

made mortgage loans to Mae and Freddie Mac
homeowners bought mortgage loans
• Thrift’s major asset: a and bundled them into
large pools
portfolio of long-term
mortgage loans • Mortgage-backed
• Thrift’s main liability: securities are tradable
deposits claims against the
underlying mortgage pool
• “Originate to hold”
• “Originate to distribute”

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Figure 1.4 Cash Flows in a Mortgage

Pass-Through Security

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Changes in Housing Finance

(Ctd.)
• At first, Fannie Mae and Freddie Mac
securitized conforming mortgages, which
were lower risk and properly documented.
• Later, private firms began securitizing
nonconforming “subprime” loans with
higher default risk.
– Little due diligence
– Placed higher default risk on investors
– Greater use of ARMs and “piggyback” loans
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Mortgage Derivatives
• Collateralized debt obligations (CDOs)
– Mortgage pool divided into slices or tranches
to concentrate default risk

– Senior tranches: Lower risk, highest rating

– Junior tranches: High risk, low or junk rating

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Mortgage Derivatives
• Problem: Ratings were wrong! Risk was
much higher than anticipated, even for the
senior tranches

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Why was Credit Risk

Underestimated?
• No one expected the entire housing
market to collapse all at once
• Geographic diversification did not
reduce risk as much as anticipated
• Agency problems with rating agencies
• Credit Default Swaps (CDS) did not
reduce risk as anticipated

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Credit Default Swap (CDS)

• A CDS is an insurance contract against
the default of the borrower

• Investors bought sub-prime loans and

used CDS to insure their safety

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Credit Default Swap (CDS)

• Some big swap issuers did not have
enough capital to back their CDS when the
market collapsed.

• Consequence: CDO insurance failed

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Rise of Systemic Risk

• Systemic Risk: a potential breakdown of the
financial system in which problems in one
market spill over and disrupt others.
– One default may set off a chain of further
defaults
– Waves of selling may occur in a downward
spiral as asset prices drop
– Potential contagion from institution to
institution, and from market to market
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Rise of Systemic Risk (Ctd.)

• Banks had a mismatch between the
maturity and liquidity of their assets and
liabilities.
– Liabilities were short and liquid
– Assets were long and illiquid
– Constant need to refinance the asset portfolio
• Banks were very highly levered, giving
them almost no margin of safety.

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Rise of Systemic Risk (Ctd.)

• Investors relied too much on “credit

enhancement” through structured
products like CDS
• CDS traded mostly “over the counter”,
so less transparent, no posted margin
requirements
• Opaque linkages between financial
instruments and institutions
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The Shoe Drops

• 2000-2006: Sharp increase in housing prices
caused many investors to believe that
continually rising home prices would bail out
poorly performing loans

• 2004: Interest rates began rising

• 2006: Home prices peaked

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The Shoe Drops

• 2007: Housing defaults and losses on
mortgage-backed securities surged

• 2007: Bear Stearns announces trouble at

its subprime mortgage–related hedge
funds

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The Shoe Drops

• 2008: Troubled firms include Bear
Stearns, Fannie Mae, Freddie Mac, Merrill
Lynch, Lehman Brothers, and AIG
– Money market breaks down
– Credit markets freeze up
– Federal bailout to stabilize financial system

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Systemic Risk and the Real Economy

• Add liquidity to reduce insolvency risk and

break a vicious circle of valuation
risk/counterparty risk/liquidity risk
• Increase transparency of structured
products like CDS contracts
• Change incentives to discourage
excessive risk-taking and to reduce
agency problems at rating agencies
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