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
1-2
Financial Versus Real Assets
Essential nature of investment
– Reduced current consumption
– Planned later consumption
Real Assets
– Assets used to produce goods and
services
Financial Assets
– Claims on real assets
1-3
Table 1.1. Balance Sheet – U.S.
Households, 2006
1-4
Table 1.2 Domestic Net Worth,
2006
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1.2 A TAXONOMY OF FINANCIAL ASSETS
1-6
Major Classes of Financial Assets
or Securities
Debt
– Money market instruments
Bank certificates of deposit
– Capital market instruments
Bonds
Common stock
Preferred stock
Derivative securities
1-7
1.3 FINANCIAL MARKETS AND
THE ECONOMY
1-8
Financial Markets
Informational Role of Financials Markets
– The Google effect
Consumption Timing
Allocation of Risk
Separation of Ownership and
Management
– Agency Issues
1-9
Corporate Governance and Ethics
Accounting Scandals
– Examples – Enron and WorldCom
Misleading research reports
Auditors watchdogs or consultants
– Example – Arthur Andersen and Enron
Sarbanes-Oxley Act
– Tighten the rules of corporate governance
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1.4 THE INVESTMENT PROCESS
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The Investor’s Portfolio
Asset allocation
– Choice among broad asset classes
Security selection
– Choice of which securities to hold within asset
class
Security selection
1-12
1.5 MARKETS ARE COMPETITIVE
1-13
Risk-Return Trade-Off
How should one measure risk
Assets with higher expected returns have
greater risk
What role does diversification play
1-14
Efficient Markets Theory
Should be neither underpriced nor
overpriced securities
Security price should reflect all information
available to investors
1-15
Active Versus Passive Management
Active Management
Finding undervalued securities
Timing the market
Passive Management
No attempt to find undervalued securities
No attempt to time
Holding an efficient portfolio
1-16
1.6 THE PLAYERS
1-17
The Players
Business Firms – net borrowers
Households – net savers
Governments – can be both borrowers and
savers
Financial Intermediaries
– Banks
– Investment companies
– Insurance companies
– Credit unions
Investment Bankers
1-18
Table 1.3 Balance Sheet of
Commercial Banks
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Table 1.4 Balance Sheet of
Nonfinancial U.S. Business
1-20
1.7 RECENT TRENDS
1-21
Globalization
Managing foreign exchange
Diversification to improve performance
Instruments and vehicles continue to
develop (WEBs)
Information and analysis improves
1-22
Figure 1.1 Global Debt Issue
1-23
Securitization
Offers opportunities for investors and
originators
Changes in financial institutions and regulation
Improvement in information capabilities
Credit enhancement and its role
1-24
Figure 1.2 Asset-backed Securities
Outstanding
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Financial Engineering
Repackaging Services of Financial
Intermediaries
Bundling and unbundling of cash flows
Slicing and dicing of cash flows
Examples: strips, CMOs, dual purpose funds,
principal/interest splits
1-26
Figure 1.3 Building a Complex Security
1-27
Unbundling – Mortgage Security
1-28
Computer Networks
Online trading
Information made cheaply and widely
available
Direct trading among investors
1-29
