CHAPTER 1

Investments - Background
and Issues

McGraw-Hill/Irwin

Copyright 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

1.1 REAL ASSETS VERSUS

FINANCIAL ASSETS

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Financial Versus Real Assets

Real Assets
Assets used to produce goods and
services such as land, building and
equipment.

Financial Assets
Claims on real assets or the income
generated by them such as stocks and
bonds.

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Real assets generate net income to the

economy.
Financial assets allocate income or
wealth among investors.

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Table 1.1. Balance Sheet U.S.

Households, 2006

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Table 1.2 Domestic Net Worth,

2006

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1.2 A TAXONOMY OF FINANCIAL ASSETS

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Major Classes of Financial Assets

or Securities
Fixed Income (Debt) Securities: Pay a specified cash
flow over a specific period.
Money market instruments (Short-term)
Treasury Bills, Commercial papers, Bank certificates of deposit
(CDs)

Capital market instruments (Long-term)

Treasury Bonds and Corporate Bonds

Equity: An ownership share in a corporation.

Common stock

Derivative securities: Provide payoffs that depend on the

values of the other securities
Futures, Options and etc.
Hedging and Speculation

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1.3 FINANCIAL MARKETS AND

THE ECONOMY

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Financial Markets and Economy

Informational Role of Financials Market s:
Fin. Markets play a central role in the
allocation of funds. If the investors think
that the corporation has good prospects
for future profitability, they will bid up its
share price.

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Financial Markets and Economy

Consumption Timing: Some individuals
are eqrning more than they spend or vse
versa. Fin. Markets help to purchase fin.
nstruments when you are earning more
than spend and sell them in order to
satisfy your consumption needs when you
are spending more than currently earning.

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Financial Markets and Economy

Allocation of Risk: Fin markets provide the
allocation of risk among the investors who are
more or less risk averse.
Separation of Ownership and Management : In
todays business owners elect the board of
directors which in turn hires and supervises the
management: owners and managers are
different
Agency Problem: conflict of interest between the
managers and owners.
Bonuses, compansation plans and etc.
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Financial Markets and Economy

Corporate Governance and Ethics: Fin.
Markets play an imp. Role in facilitating
excess funds to their most productive
uses. In order to provide this effectively,
there must be enough transpapency for
investors to make well-informed decisions.
Firms must not mislead public about their
prospects.
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1.4 THE INVESTMENT PROCESS

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The Investors Portfolio

Portfolio: collection of investment assets. Asset classes
consist of stocks, bonds, real estate, commodities and
etc.
Investors make two types of decisions in constructing
portfios:
1. Asset allocation

Choice among broad asset classes such as stocks, bonds, bills,

real estate and commodities.

2. Security selection

Choice of which securities to hold within asset class .

Top-down approach and Bottom-up approach

Security analysis: valuation of particular securities that

might be included in the portfolio.

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1.5 MARKETS ARE COMPETITIVE

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Risk-Return Trade-Off
Assets with higher expected returns have
greater risk.
Diversification means that many assets
are held in the portfolio so that the
exposure to any particular asset is limited.

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Efficient Markets Theory

Securities should be neither underpriced
nor overpriced: fairly priced
Security price should reflect all information
available to investors

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Active Versus Passive Management

Passive Management: Buying and holding a diversified
portfolio without attempting to identfy mispriced
securities
No attempt to find undervalued (mispriced) securities
No attempt to time
Holding an efficient portfolio
Active Management: Attempting to identify mispriced
securities or to forecast broad market trends
Finding undervalued securities
Timing the market

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1.6 THE PLAYERS

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The Players
Business Firms net borrowers
Households net savers
Governments can be both borrowers
and savers

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Financial Institutions
Financial Intermediaries: Institutions that
connect borrowers and lenders by
accepting funds from lenders and loaning
funds to borrowers.
Commercial Banks: accept deposits
(borrowing) and give loans such as credits
(lending)
Investment companies: Firms managing funds
for investors. They manage several mutual
funds.
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Investment Bankers (Investment banks

and brokerage firms) (such as Goldman
Sachs and Merrill Lynch): Firms
specializing in the sale of new securities to
the public.
Primary market: A market in which new issue
of securities are offered to the public.(IPOs:
Initial Public Offerings)
Secondary market: Previously issued
securities are traded among investors.
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Table 1.3 Balance Sheet of

Commercial Banks

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Table 1.4 Balance Sheet of

Nonfinancial U.S. Business

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1.7 RECENT TRENDS

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Globalization
Tendency toward a worldwide investment
environment, and the integration of the international
capital markets.
US investors;
Purchase foreign securities using ADRs (American
Depository Receipts).
Purchase foreign securities that are offered in dollars.
Buy mutual funds that invest internationally.

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Figure 1.1 Global Debt Issue

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Securitization
Pooling loans into standartized securities backed by
those loans, which can then be traded like any other
security.
Asset- backed securities, Mortgage-backed securities
are called as Pass-through securities: Pools of loans
(such as home mortgage loans) sold in one package.
Owners of them receive all the principal and interest
payments made by the borrowers.

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Figure 1.2 Asset-backed Securities

Outstanding

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Financial Engineering
Creation of new securities by unbundlingbreaking up and allocating the cash flows
from one security to create several new
securities or by bundling- combining more
than one security into a composite security.
Examples: strips, principal/interest splits

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Figure 1.3 Building a Complex Security

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Unbundling Mortgage Security

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Computer Networks
Online trading connects a customer
directly to a brokerage firm.
Internet has allowed the information to be
made cheaply and widely available.
Electronic communication networks allow
direct trading among investors

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