INVESTMENTS | BODIE, KANE, MARCUS Chapter One The Investment Environment Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or.

INVESTMENTS | BODIE, KANE, MARCUSINVESTMENTS | BODIE, KANE, MARCUS

Chapter One

The Investment Environment

Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.


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• Role of financial assets in the economy: Real vs. financial assets

• Risk–return trade-off and the efficient pricing • Financial crisis 2008 • Connections between the financial system

and the “real” side of the economy• Lessons learned for evaluating systemic risk

Chapter Overview

INVESTMENTS | BODIE, KANE, MARCUS

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Real Assets vs. 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

Financial Assets• Claims on real assets,

do not contribute directly to the productive capacity of the economy.

• Examples: Stocks, bonds


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• Fixed income or debt • Promise either a fixed stream of income or a

stream of income determined by a specified formula

• Common stock or equity• Represent an ownership share in the corporation

• Derivative securities• Provide payoffs that are determined by the prices

of other assets

Financial Assets


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• Investment in currency• Investment in real assets through commodity

futures • Corporations invest in the commodity futures

to hedge the risk

Other Types of Investment


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• The Informational Role• Capital flows to companies with best prospects

• Consumption Timing • Use securities to store wealth and transfer

consumption to the future• Allocation of Risk • Investors can select securities consistent with their

tastes for risk, which benefits the firms that need to raise capital as security can be sold for the best possible price

Financial Markets and the Economy


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• Separation of Ownership and Management• Agency problems arise when managers start pursuing

their own interests instead of maximizing firm's value• Mechanisms to mitigate agency problems:• Tie managers' income to the success of the firm (stock

options)• Monitoring from the board of directors• Monitoring from the large outside investors and

security analysts• Takeover threat



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• Corporate Governance and Corporate Ethics• Accounting Scandals • Examples – Enron, Rite Aid, HealthSouth

• Auditors: Watchdogs of the firms• Analyst Scandals• Arthur Andersen

• Sarbanes-Oxley Act• Tighten the rules of corporate governance



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• Portfolio: Collection of investment assets.• Asset allocation• Choice among broad asset classes

• Security selection• Choice of securities within each asset class

The Investment Process


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• “Top-down” approach• Asset allocation followed by security analysis to

evaluate which particular securities to be included in the portfolio

• “Bottom-up” approach• Investment based solely on the price-

attractiveness, which may result in unintended heavy weight of a portfolio in only one or another sector of the economy

The Investment Process


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• Risk-Return Trade-Off• Higher-risk assets are priced to offer higher

expected returns than lower-risk assets• Efficient Markets• In fully efficient markets when prices quickly

adjust to all relevant information, there should be neither underpriced nor overpriced securities

Markets Are Competitive


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• Passive Management• Holding a highly diversified portfolio• No attempt to find undervalued securities• No attempt to time the market

• Active Management• Finding mispriced securities• Timing the market

Markets Are Competitive


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• Demanders of capital – Firms• Suppliers of capital – Households• Governments – Can be both borrowers or

lenders

The Players


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• Financial Intermediaries: Pool and invest funds• Investment Companies• Banks• Insurance companies• Credit unions

The Players


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Universal Bank Activities

Investment Banking• Underwrite new

securities issues• Sell newly issued

securities to public in the primary market

• Investors trade previously issued securities among themselves in the secondary markets

Commercial Banking• Take deposits and make

loans


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• 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

Financial Crisis of 2008


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Figure 1.1 Short-Term LIBOR and Treasury-Bill Rates and the TED Spread

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96

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3-month LIBOR3-month T-billTED spread

Inte

rest

Rat

es (%

)


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

1987

1989

1991

1993

1995

1997

1999

2001

2003

2005

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2009

2011

2013

0

50

100

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Inde

x (J

anua

ry 2

000

= 10

0)


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Changes in Housing Finance

Old Way• Local thrift institution made

mortgage loans to homeowners

• Thrift’s major asset: A portfolio of long-term mortgage loans

• Thrift’s main liability: Deposits

• “Originate to hold”

New Way• Securitization: Fannie Mae

and Freddie Mac bought mortgage loans and bundled them into large pools

• Mortgage-backed securities are tradable claims against the underlying mortgage pool

• “Originate to distribute”


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• Securitization: Buying mortgage loans from originators and bundling them into mortgage-backed securities

• Replacement of low-risk conforming mortgages with nonconforming “subprime” loans

• Trend toward low-documentation and then no-documentation loans and rising allowed leverage on home loans (loan-to-value ratio)

• Low adjustable-rate mortgages (ARMs) that “maxed out” borrowers' paying capacity at low rates

Changes in Housing Finance


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Figure 1.4 Cash Flows in a Mortgage Pass-Through Security


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• Collateralized debt obligations (CDOs)• Mortgage pool divided into slices or tranches to

concentrate default risk• Senior tranches: Lower risk, highest rating (AAA)• Junior tranches: High risk, low or junk rating

• Estimated ratings significantly underestimated the inherent risk

Mortgage Derivatives


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• Default probabilities were estimated on the historical data covering the rising housing market

• Geographic diversification did not reduce risk as much as anticipated

• Agency problems with rating agencies

Why Was Credit Risk Underestimated?


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• A CDS is an insurance contract against the default of the borrower• Investors bought sub-prime loans and used CDSs

to insure their safety• Some big swap issuers did not have enough capital

to back their CDSs when the market collapsed resulting in the failure of CDO insurance

Credit Default Swap (CDS)


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• 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

Rise of Systemic Risk


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• 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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• Investors relied too much on credit enhancement through structured products like CDS

• CDS traded mostly over-the-counter, with no posted margin requirements and little transparency

• Opaque linkages between financial instruments and institutions



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• 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• 2007: Housing defaults and losses on

mortgage-backed securities surged

The Shoe Drops


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• 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

The Shoe Drops


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• Mechanisms to mitigate systemic risk• Stricter rules for bank capital, liquidity, and risk

management practices • Increased transparency, especially in derivatives

markets (eg.: standardize CDS contracts so they can trade in centralized exchanges)

• Office of Credit Ratings within the SEC to oversee the credit rating agencies

The Dodd-Frank Reform Act

INVESTMENTS | BODIE, KANE, MARCUS Chapter One The Investment Environment Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or.

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