Chapter 1: Investments - Background and Issues

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Chapter 1: Investments

- Background and Issues

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• Essential nature of investment– Reduced current consumption– Planned later consumption

• Real Assets– Material wealth of a society is ultimately determined by the productive

capacity of its economy, that is, the goods and services its members can create. This capacity is a function of the real assets of the economy. Real assets mean the land, buildings, machines, inventories and knowledge that can be used to produce goods and services

• Financial Assets– Claims on real assets like stocks and bonds that are no more than

sheets of paper or, computer entries and do not contribute directly or indirectly to the productive capacity of the economy.

1.1 REAL ASSETS VERSUS FINANCIAL ASSETS

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Table 1.1. Balance Sheet – U.S. Households, 2006

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Table 1.3 Balance Sheet of Commercial Banks

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1.2 A TAXONOMY OF FINANCIAL ASSETS Major Classes of Financial Assets or Securities

• Debt– Money market instruments

• Bank certificates of deposit, treasury bills– Capital market instruments

• Bonds (Treasury bonds, municipal bond, high yield junk bonds)

• Common stock: ownership• Preferred stock: Hybrid• Derivative securities: Option & Future: to

hedge risk

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1.3 FINANCIAL MARKETS & THE ECONOMYFunctions of Financial Markets

• Bridging the gap between net borrowers and net savers (Slide 7)

• Providing the equilibrium interest rate (Slide 8)• Consumption Timing: Separation Principle (Slide 9)• Allocation of Risk (Slide 10)

– How does a risky project get financed?

• Allocation of liquidity: Opposite liquidity preferences of borrowers and savers. – Law of large number

• Separation of Ownership and Management– Agency Issues (Slide 11 & 12)

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Bridging the gap

Financial

Market

.Net

savers:Surplus sector

Net Borrowers:

Deficit sector

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Equilibrium interest rate: (Loanable Fund Theory)

i

D (Investment)

S (Savings)

k

Quantity of Loanable Fund

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Intertemporal consumption:Separation Principle

C1

Co

210

190.9100

100

Lending

Borrowing

i=10%

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Risk-Return trade-off

• Return=f(Risk)

Return

Risk

Rf

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Agency Cost

• Managers are naturally inclined to act in their own best interests. Expensive perquisites like high salaries and allowances of the agency (rationalized on motivational point) increases cost.

• High short term profit adds to the credentials of board of directors.

• High scale investment makes the firm dependent on the present agency.

• Risky investment. If successful, credit goes to the agency, if failure loss goes to the shareholders.

• Less payout of dividends to facilitate more investment

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Solution to agency problem

• Performance shares

• Hostile takeover (Example: Compaq take-over

of Hewlett-Packard, Microsoft take-over of

Yahoo)

• Formal contract

• Market effects

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1.4 THE INVESTMENT PROCESS(Concept of portfolio)

• Asset allocation– Choice among broad asset classes

• Security selection– Choice of which securities to hold within

asset class

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1.5 MARKETS ARE COMPETITIVEa. Risk-Return Trade-Off

• How should one measure risk• Assets with higher expected returns have greater

risk• What role does diversification play:

– intelligent versus random diversification

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Effect of random diversification on risk: Systematic and Unsystematic

Systematic Risk: m

Nonsystematic Risk:

n

2

Total risk

We can break down the total risk of holding a stock into two components: systematic risk and unsystematic risk:

Ris

k

Number of securities in the portfolio

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1.5 MARKETS ARE COMPETITIVE b. Efficient Markets Theory

• There should be neither underpriced nor overpriced securities (Why? see the next slide)

• Security price should reflect all information available to investors

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Why Technical Analysis FailsS

tock

Pri

ce

Time

Investor behavior tends to eliminate any profit opportunity associated with stock price patterns.

If it were possible to make big money simply by finding “the pattern” in the stock price movements, everyone would do it, and the profits would be competed away.

Sell

Sell

Buy

Buy

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Active Versus Passive Management

Active Management• Attempting to identify mispriced securities or to forecast

broad market trends– Finding undervalued securities– Timing the market

Passive Management• Buying and holding a diversified portfolio without

attempting to identify mispriced securities.– No attempt to find undervalued securities– No attempt to time– Holding an efficient portfolio

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1.6 THE PLAYERS • Business Firms – net borrowers• Households – net savers• Governments – can be both borrowers and savers. In case of deficit

financing government issues treasury bills, notes, and bonds to borrow from public.

• Financial Intermediaries:– Banks: Deals with other people’s money with interest margin. The

balance sheet is characterized by very small amount of tangible assets.

– Mutual funds : pool and manage the scattered savings of many investors, and invest in well-diversified portfolios

– Investment companies design portfolio for large investors with particular risk preferences

– Insurance companies handle risk– Credit unions: cooperative financial institutions owned and controlled

by its members for the purpose of different financial services including investment

• Investment Bankers: such as Goldman, Sachs, Merrill Lynch advise the issuing corporation on the prices it can charge for the securities issued, appropriate interest rates, and so forth.

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1.7 MARKETS AND MARKET STRUCTURE

• Direct search markets: Direct placement• Brokered markets: Investment bank markets a firm’s

securities to the public in the primary markets.• Dealer markets: OTC market like NASDAQ

(National Association of Securities Dealers Automatic Quotation)

• Auction markets: All traders converge at one place to buy and sell an asset. example, NYSE, DSE, etc.

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1.8 RECENT TRENDS

a. Globalization • Managing foreign exchange

– American Depository Receipts (ADRs): Domestically traded securities that represent claims to shares of foreign stocks

– foreign securities offered in dollars– mutual funds that invest internationally– derivative securities with payoffs that depends on prices in foreign security

markets• Motivation: Diversification to improve performance• Instruments and vehicles continue to develop (WEBS, World Equity Benchmark

Shares): Like ADR, WEBS facilitates diversification in international markets. Each WEBS security tracks the performance of an index of share returns for a particular country

• Information and analysis improves

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1.8 RECENT TRENDS b. Securitization

• Pools of loans (such as home mortgage loans) sold in one

package. This also includes car loans, student loans, credit card loans, and debts of firms. Owners of pass-through receive all of the principal and interest payments made by the borrowers.

• Offers opportunities for investors and originators• Changes in financial institutions and regulation• Improvement in information capabilities• Credit enhancement and its role

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1.8 RECENT TRENDS c. Financial Engineering

• Repackaging Services of Financial Intermediaries• Bundling (combining more than one security into a

composite security) and unbundling of cash flows• Slicing and dicing of cash flows• Examples: strips, CMOs (Collateral Mortgage

Obligations) , dual purpose funds, principal/interest splits

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1.8 RECENT TRENDS

d. Computer Networks

• Online trading• Information made cheaply and widely

available• Direct trading among investors