24 Part ONE Elements of Investments

Part Six is an introduction to active investment management. It shows how different inves-
tors’ objectives and constraints can lead to a variety of investment policies. This part discusses
the role of investment management in nearly efficient markets, considers how one should
evaluate the performance of managers who pursue active strategies, and takes a close look at
hedge funds. It also shows how the principles of portfolio construction can be extended to the
international setting.

SUMMARY ∙ Real assets create wealth. Financial assets represent claims to parts or all of that wealth.
Financial assets determine how the ownership of real assets is distributed among
investors.
∙ Financial assets can be categorized as fixed-income (debt), equity, or derivative
­instruments. Top-down portfolio construction techniques start with the asset allocation
decision—the allocation of funds across broad asset classes—and then progress to more
specific security-selection decisions.
∙ Competition in financial markets leads to a risk-return trade-off, in which securities that
offer higher expected rates of return also impose greater risks on investors. The presence
of risk, however, implies that actual returns can differ considerably from expected returns
at the beginning of the investment period. Competition among security analysts also
results in financial markets that are nearly informationally efficient, meaning that prices
reflect all available information concerning the value of the security. Passive investment
strategies may make sense in nearly efficient markets.
∙ Financial intermediaries pool investor funds and invest them. Their services are in
demand because small investors cannot efficiently gather information, diversify, and
­monitor ­portfolios. The financial intermediary, in contrast, is a large investor that can take
­advantage of scale economies.
∙ Investment banking brings efficiency to corporate fund raising. Investment bankers
develop expertise in pricing new issues and in marketing them to investors. By the end
of 2008, all the major stand-alone U.S. investment banks had been absorbed into or had
­reorganized themselves into bank holding companies. In Europe, where universal banking
had never been prohibited, large banks had long maintained both commercial and invest-
ment banking divisions.
∙ The financial crisis of 2008 demonstrated the links between the real and the f­ inancial
sides of the economy and the importance of systemic risk. Systemic risk can be
­limited by transparency that allows traders and investors to assess the risk of their
­counterparties, capital requirements to prevent trading participants from being brought
down by potential losses, frequent settlement of gains or losses to prevent losses from
­accumulating beyond an institution’s ability to bear them, incentives to ­discourage
excessive risk taking, and accurate and unbiased analysis by those charged with
­evaluating ­security risk.

KEY TERMS active management, 12 investment, 2 securitization, 19

agency problems, 8 investment bankers, 15 security analysis, 10
asset allocation, 10 investment companies, 14 security selection, 10
derivative securities, 5 passive management, 12 systemic risk, 22
equity, 5 primary market, 15 venture capital (VC), 16
financial assets, 3 private equity, 16
financial intermediaries, 13 real assets, 3
fixed-income (debt) risk-return trade-off, 11
­securities, 5 secondary market, 15
 Chapter 1 Investments: Background and Issues 25

®
Select problems are available in McGraw-Hill’s PROBLEM SETS
­Connect. Please see the Supplements section of the
book’s frontmatter for more information.
  1. What are the differences between equity and fixed-income securities? (LO 1-5)
  2. What is the difference between a primary asset and a derivative asset? (LO 1-1)
  3. What is the difference between asset allocation and security selection? (LO 1-4)
  4. What are agency problems? What are some approaches to solving them? (LO 1-3)
  5. What are the differences between real and financial assets? (LO 1-2)
  6. How does investment banking differ from commercial banking? (LO 1-5)
  7. For each transaction, identify the real and/or financial assets that trade hands. Are any
financial assets created or destroyed in the transaction? (LO 1-2)
a. Toyota takes out a bank loan to finance the construction of a new factory.
b. Toyota pays off its loan.
c. Toyota uses $10 million of cash on hand to purchase additional inventory of spare
auto parts.
  8. Suppose that in a wave of pessimism, housing prices fall by 10% across the entire
­economy. (LO 1-2)
a. Has the stock of real assets of the economy changed?
b. Are individuals less wealthy?
c. Can you reconcile your answers to (a) and (b)?
  9. Lanni Products is a start-up computer software development firm. It currently owns
­computer equipment worth $30,000 and has cash on hand of $20,000 contributed by
Lanni’s owners. For each of the following transactions, identify the real and/or financial
assets that trade hands. Are any financial assets created or destroyed in the transac-
tion? (LO 1-2)
a. Lanni takes out a bank loan. It receives $50,000 in cash and signs a note promising to
pay back the loan over three years.
b. Lanni uses the cash from the bank plus $20,000 of its own funds to finance the devel-
opment of new financial planning software.
c. Lanni sells the software product to Microsoft, which will market it to the public
under the Microsoft name. Lanni accepts payment in the form of 1,000 shares of
Microsoft stock.
d. Lanni sells the shares of stock for $140 per share and uses part of the proceeds to pay
off the bank loan.
10. Reconsider Lanni Products from Problem 9. (LO 1-2)
a. Prepare its balance sheet just after it gets the bank loan. What is the ratio of real
assets to total assets?
b. Prepare the balance sheet after Lanni spends the $70,000 to develop its software
product. What is the ratio of real assets to total assets?
c. Prepare the balance sheet after Lanni accepts the payment of shares from Microsoft.
What is the ratio of real assets to total assets?
11. What reforms to the financial system might reduce its exposure to systemic risk?
(LO 1-6)
12. Examine the balance sheet of commercial banks in Table 1.3. (LO 1-2)
a. What is the ratio of real assets to total assets?
b. What is that ratio for nonfinancial firms (Table 1.4)?
c. Why should this difference be expected?
13. Why do financial assets show up as a component of household wealth, but not of
national wealth? Why do financial assets still matter for the material well-being of an
economy? (LO 1-2)
26 Part ONE Elements of Investments

14. Discuss the advantages and disadvantages of the following forms of managerial com-
pensation in terms of mitigating agency problems, that is, potential conflicts of interest
between managers and shareholders. (LO 1-3)
a. A fixed salary.
b. Stock in the firm that must be held for five years.
c. A salary linked to the firm’s profits.
15. Oversight by large institutional investors or creditors is one mechanism to reduce agency
problems. Why don’t individual investors in the firm have the same incentive to keep an
eye on management? (LO 1-3)
16. Wall Street firms have traditionally compensated their traders with a share of the trad-
ing profits they generated. How might this practice have affected traders’ willingness to
assume risk? What agency problem can this practice can engender? (LO 1-3)
17. Why would you expect securitization to take place only in highly developed capital mar-
kets? (LO 1-6)
18. What would you expect to be the relationship between securitization and the role of
financial intermediaries in the economy? For example, what happens to the role of
local banks in providing capital for mortgage loans when national markets in mortgage-
backed securities become highly developed? (LO 1-6)
19. Give an example of three financial intermediaries, and explain how they act as a bridge
between small investors and large capital markets or corporations. (LO 1-5)
20. Firms raise capital from investors by issuing shares in the primary markets. Does this
imply that corporate financial managers can ignore trading of previously issued shares in
the secondary market? (LO 1-4)
21. The average rate of return on investments in large stocks has outpaced that on
­investments in Treasury bills by about 8% since 1926. Why, then, does anyone invest in
­Treasury bills? (LO 1-1)
22. You see an advertisement for a book that claims to show how you can make $1 million
with no risk and with no money down. Will you buy the book? (LO 1-1)

WEB master 1. Log on to finance.yahoo.com and enter the ticker symbol “RRD” in the Quote Lookup
box to find information about R.R. Donnelley & Sons.
a. Click on company Profile. What is Donnelly’s main line of business?
b. Now go to Statistics. How many shares of the company’s stock are outstanding?
What is the total market value of the firm? What were its profits in the most recent
fiscal year?
c. Look up the major Holders of the company’s stock. What fraction of total shares is
held by insiders?
d. Now go to Analysis. What is the average estimate for next quarter’s earnings per
share of the analysts covering this firm? How does that compare to the current quar-
ter’s earnings?
e. Look at the company’s balance sheet under the Financials tab. What were its total
assets at the end of the most recent fiscal year?
2. Visit the website of the Securities and Exchange Commission, www.sec.gov. What is
the mission of the SEC? What information and advice does the SEC offer to beginning
investors?
3. Now visit the website of FINRA (the Financial Industry Regulatory Authority) at
www.finra.org. What is its mission? What information and advice does it offer to
beginners?
4. Now visit the website of the IOSCO, www.iosco.org. What is its mission? What infor-
mation and advice does it offer to beginners?
 Chapter 1 Investments: Background and Issues 27

1.1 a. Real S O LU T I O N S TO
b. Financial
c. Real CONCEPT
d. Real checks
e. Financial
1.2 The central issue is the incentive and ability to monitor the quality of loans both when
originated and over time. Freddie and Fannie clearly had incentive to monitor the
­quality of conforming loans that they had guaranteed, and their ongoing ­relationships
with mortgage originators gave them opportunities to evaluate track records over
extended periods of time. In the subprime mortgage market, the ultimate ­investors
in the ­securities (or the CDOs backed by those securities), who were bearing the
credit risk, should not have been willing to invest in loans with a disproportional
­likelihood of default. If they properly understood their exposure to default risk, then
the ­(correspondingly low) prices they would have been willing to pay for these securi-
ties would have imposed discipline on the mortgage originators and servicers. The fact
that they were willing to hold such large positions in these risky securities suggests
that they did not appreciate the extent of their exposure. Maybe they were led astray
by overly optimistic projections for housing prices or by biased assessments from
the credit reporting agencies. While in principle either arrangement for default risk
could have provided the appropriate ­discipline on the mortgage originators, in practice
the ­informational advantages of ­Freddie and Fannie probably made them the better
­“recipients” of default risk. The lesson is that information and transparency are some of
the preconditions for well-functioning markets.