Investments - Background and Issues

CHAPTER 1 1.1 REAL ASSETS VERSUS FINANCIAL ASSETS Investments - Background and Issues Financial Versus Real Assets Essential nature of investment Table 1.1. Balance Sheet – U.S. Households, 2006 – Reduced current consumption – Planned later consumption Real Assets – Assets used to produce goods and services Financial Assets – Claims on real assets Table 1.2 Domestic Net Worth, 2006 1.2 A TAXONOMY OF FINANCIAL ASSETS 1-1 Major Classes of Financial Assets or Securities Debt – Money market instruments Bank certificates of deposit – Capital market instruments 1.3 FINANCIAL MARKETS AND THE ECONOMY Bonds Common stock Preferred stock Derivative securities Financial Markets Corporate Governance and Ethics Informational Role of Financials Markets Accounting Scandals Consumption Timing Allocation of Risk Separation of Ownership and Management Misleading research reports Auditors watchdogs or consultants – The Google effect – Agency Issues – Examples – Enron and WorldCom – Example – Arthur Andersen and Enron SarbanesSarbanes-Oxley Act – Tighten the rules of corporate governance The Investor’s Portfolio 1.4 THE INVESTMENT PROCESS Asset allocation – Choice among broad asset classes Security selection – Choice of which securities to hold within asset class Security selection 1-2 RiskRisk-Return TradeTrade-Off 1.5 MARKETS ARE COMPETITIVE Efficient Markets Theory Should be neither underpriced nor overpriced securities Security price should reflect all information available to investors How should one measure risk Assets with higher expected returns have greater risk What role does diversification play 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 The Players 1.6 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 1-3 Table 1.3 Balance Sheet of Commercial Banks Table 1.4 Balance Sheet of Nonfinancial U.S. Business Globalization 1.7 RECENT TRENDS Figure 1.1 Global Debt Issue Managing foreign exchange Diversification to improve performance Instruments and vehicles continue to develop (WEBs) Information and analysis improves Securitization Offers opportunities for investors and originators Changes in financial institutions and regulation Improvement in information capabilities Credit enhancement and its role 1-4 Figure 1.2 Asset-backed Securities Outstanding Figure 1.3 Building a Complex Security 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 Unbundling – Mortgage Security Computer Networks Online trading Information made cheaply and widely available Direct trading among investors 1-5