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Slide1 - Chapter 1 The Investment Environment • ...

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Unformatted text preview: Chapter 1 The Investment Environment •  What is Investment? –  Commitment of current resources in the expecta9on of deriving greater resources in the future –  Time and risk components in investment –  We focus on investment in financial assets •  Investment environment –  Role of financial assets and financial markets –  Players –  Investment process: top ­down vs boFom up •  Principle: risk ­return tradeoff 1.1 Real Versus Financial Assets Real Versus Financial Assets • Essen9al nature of investment • Reduce current consump9on in hopes of greater future consump9on • Real Assets • Used to produce goods and services: Property, plant & equipment, human capital, etc. • Financial Assets • Claims on real assets or claims on the income generated by them Table 1.1. Balance Sheet – U.S. Households, 2008 Real versus Financial Assets •  All financial assets (owner of the claim) are offset by a financial liability (issuer of the claim). •  When we aggregate over all balance sheets, only real assets remain. •  Hence the net wealth of an economy is the sum of its real assets. Financial Assets do not determine the wealth of the economy. Table 1.2. Domes9c Net Worth, 2008 I 1.2 A Taxonomy of Financial Assets Major Classes of Financial Assets or Securi9es •  Debt (fixed ­income) security o  Money market instruments: •  Generally short ­term, highly marketable, low risk •  Bank cer9ficates of deposit, T ­bills, commercial paper, etc. o  Bonds: longer term, risk varies from Treasury bonds to high yield bonds o  Preferred stock: a fixed dividend but no principal repayment •  Common stock o  Ownership stake in the en9ty, uncertain residual cash flow •  Deriva9ve securi9es o  A contract whose value is derived from some underlying market condi9on. E.g. Op9ons, futures 1.3 Financial Markets and the Economy Financial Markets •  Informa9onal Role of Financial Markets o Market prices reflect the fair value es9mate of a security’s expected future risky cash flows o Financial markets help allocate capital resources to the best uses Consump9on Timing o People tend to smooth consump9on over 9me. E.g. safe net o If one has more than enough cash to meet their basic needs in the current 9me period one might shib consump9on through 9me by inves9ng the surplus. Alloca9on of Risk o  Investors can choose a desired risk level •  Bonds versus stock of a given company •  Bank CD versus company bond •  Tradeoff between risk and return? Separa9on of Ownership and Management •  Large size of firms requires separa9on of ownership and management o  In 2008 GE had over $800 billion in assets and over 650,000 stockholders o  Owners (principals) ≠ Managers (agents) o  Agency costs: Owners’ interests may not align with managers’ interests o  Mi9ga9ng factors: •  Performance based compensa9on •  Boards of Directors may fire managers •  Threat of takeovers Example 1.1 •  In February 2008, Microsob offered to buy Yahoo at $31 per share when Yahoo was trading at $19.18. •  Yahoo rejected the offer, holding out for $37 a share. •  Billionaire Carl Icahn led a proxy fight to seize control of Yahoo’s board and force the firm to accept Microsob’s offer. •  He lost, and Yahoo stock fell from $29 to $21. •  Did Yahoo managers act in the best interests of their shareholders? Corporate Governance and Corporate Ethics •  Business and market require trust to operate efficiently o  Without trust addi9onal laws and regula9ons are required o  All laws and regula9ons are costly •  Governance and ethics failures have cost our economy billions if not trillions of dollars. o  Eroding public support and confidence in market based systems Corporate Governance and Corporate Ethics •  Accoun9ng Scandals o  Enron, WorldCom, Rite ­Aid, HealthSouth, Global Crossing, Qwest, •  Misleading Research Reports o  Ci9corp, Merrill Lynch, others •  Auditors: Watchdogs or Consultants? o  Arthur Andersen and Enron Corporate Governance and Corporate Ethics •  Sarbanes ­Oxley Act o  Increases the number of independent directors on company boards o  Requires the CFO to personally verify the financial statements o  Created a new oversight board for the accoun9ng/audit industry o  Charged the board with maintaining a culture of high ethical standards 1.4 The Investment Process The Investment Process •  Asset alloca9on: –  Choosing the percentage of funds across asset classes –  E.g. 50% in stocks, 30% in bonds, 10% in real estate, and 10% in money market securi9es. •  Security selec9on and security analysis –  Pick securi9es within an asset class –  Might be biased toward a par9cular sec9on •  The asset alloca9on decision is the primary determinant of a porqolio’s return. 1.5 Markets Are Compe99ve Monthly Price Series of Dow Jones Industrial Average from 1928 to 2010 Markets Are Compe99ve •  Risk ­return trade ­off: Average Annual Return Stocks About 12% o  Assets with higher expected returns have higher risk. Minimum (1931)  ­46% Maximum (1933) 55% On average, A stock porLolio can be expected to lose money about 1 out of every 4 years. •  Bonds have a much lower average rate of return (under 6%) and have not lost more than 13% of their value in any one year. Risk ­Return Trade ­ Off •  How do we measure risk? •  How does diversifica9on affect risk? •  Discussed in Part 2 of the text Efficient Markets •  Market efficiency: –  Security prices should reflect all informa9on available to investors –  Securi9es should be neither underpriced nor overpriced on average –  Whether we believe markets are efficient affects our choice of appropriate investment management style. Ac9ve vs. Passive Management AcVve Management (inefficient markets) "   Finding undervalued securiVes: security selecVon "   Timing the market: asset allocaVon Passive Management (efficient markets) "   No aZempt to find undervalued securiVes "   No aZempt to Vme "   Holding a diversified porLolio: indexing and construcVng an “efficient” porLolio 1.6 The Players The Players •  •  •  •  Business Firms – net borrowers Households – net savers Governments – can be both borrowers and savers Financial Intermediaries: Connect the borrowers and lenders o  Commercial Banks •  Tradi9onal line of business: Make loans funded by deposits o  Investment companies o  Insurance companies o  Pension funds o  Hedge funds The Players •  Investment Bankers o  Firms that specialize in primary market transac9ons o  Primary market: •  A market where newly issued securi9es are offered to the public. •  The investment banker typically ‘underwrites’ the issue. o  Secondary market •  A market where pre ­exis9ng securi9es are traded among investors. Investment Bankers •  Investment Bankers o  Commercial and investment banks’ func9ons and organiza9ons were separated by law from 1933 to 1999. o  Post 1999 large investment banks, collec9vely known as “Wall Street,” operated independently from commercial banks, although many of the large commercial banks increased their investment banking ac9vi9es, pressuring profit margins of investment banks. o  In September 2008 major investment banks either went bankrupt, reorganized as commercial banks or were purchased by commercial banks as a result of the collapse of the mortgage markets. •  Investment Bankers o  Some investment banks chose to become commercial banks to obtain deposit funding and government assistance o  All of the major investment banks are now under the much stricter commercial bank regula9ons. Table 1.3 Balance Sheet of Commercial Banks, 2008 Table 1.4 Balance Sheet of Nonfinancial U.S. Business, 2008 1.7 Recent Trends 1.7 Recent Trends •  GlobalizaVon •  SecuriVzaVon •  Financial Engineering •  InformaVon and Computer Networks Globaliza9on •  Domes9c firms compete in global markets •  Performance in one country or region depends on other regions •  Opportuni9es for beFer returns & implica9ons for risk o  Managing foreign exchange o  Interna9onal diversifica9on reduces risk o  Instruments and vehicles con9nue to develop (ADRs and WEBs) o  Informa9on and analysis improves Securi9za9on •  Loans of a given type such as mortgages are placed into a ‘pool’ and new securi9es are issued that use the loan payments as collateral. •  The securi9es are marketable and are purchased by many ins9tu9ons. •  “Shadow banking system” •  End result is more investment opportuni9es for purchasers, and spreading loan credit risk among more ins9tu9ons Securi9za9on •  Securi9za9on has grown rapidly due to •  Changes in financial ins9tu9ons and regula9on permiung its growth, par9cularly lower capital requirements on securi9zed loans, •  Improvement in informa9on capabili9es, •  Credit enhancement provided by pool issuers has improved marketability. Figure 1.1 Asset ­backed Securi9es Outstanding Financial Engineering •  Repackaging cash flows of a security to enhance marketability •  Bundling and unbundling of cash flows o Bundling: Combining more than one asset into a composite security, for example securi9es sold backed by a pool of mortgages. o Unbundling Selling separate claims to the cash flows of one security, for example a CMO Figure 1.2 Building a Complex Security Figure 1.3 Mortgage Security Computer Networks •  Online low cost trading •  Informa9on made cheaply and widely available •  Direct trading among investors via electronic communica9on networks •  What have been the effects on Wall Street firms’ profit margins? o  How has Wall Street responded? The Future •  Globaliza9on will con9nue and investors will have far more investment opportuni9es than in the past •  Securi9za9on will con9nue to grow aber the crisis •  Con9nued development of deriva9ves and exo9cs, more regula9on for “over the counter” deriva9ves •  Strong fundamental founda9on of understanding is cri9cal •  Understanding corporate finance requires understanding investments 1.8 Text Outline •  Part One: Introduc9on to Financial Markets, Securi9es and Trading Methods •  Part Two: Modern Porqolio Theory •  Part Three: Debt Securi9es •  Part Four: Equity Security Analysis •  Part Five: Deriva9ve Markets •  Part Six: Ac9ve Investment Management Strategies: Performance Evalua9on, Global inves9ng, Taxes, and the Investment Process ...
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