Chapter 1 Investments Background and Issues Mc GrawHillIrwin
Chapter 1 Investments: Background and Issues Mc. Graw-Hill/Irwin Copyright © 2010 by The Mc. Graw-Hill Companies, Inc. All rights reserved.
1. 1 Real Versus Financial Assets 1 -2
Real Versus Financial Assets • Essential nature of investment • Reduce current consumption in hopes of greater future consumption • Real Assets • Used to produce goods and services: Property, plant & equipment, human capital, etc. • Financial Assets • Claims on real assets or claims on asset income 1 -3
Table 1. 1. Balance Sheet – U. S. Households, 2008 1 -4
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. 1 -5
Table 1. 2 Domestic Net Worth, 2008 1 -6
1. 2 A Taxonomy of Financial Assets 1 -7
Major Classes of Financial Assets or Securities • Debt o Money market instruments • Bank certificates of deposit, T-bills, commercial paper, etc. o Bonds o Preferred stock • Common stock o Ownership stake in the entity, residual cash flow • Derivative securities o A contract whose value is derived from some underlying market condition. 1 -8
1. 3 Financial Markets and the Economy 1 -9
Financial Markets • Informational Role of Financial Markets o Do market prices equal the fair value estimate of a security’s expected future risky cash flows? o Can we rely on markets to allocate capital to the best uses? • What other mechanism could we use to allocate capital? • What would be the advantages and disadvantages of another system? 1 -10
Consumption Timing o People tend to smooth consumption over time. o If one has more than enough cash to meet their basic needs in the current time period one might shift consumption through time by investing the surplus. 1 -11
Allocation 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? 1 -12
Separation of Ownership and Management • Large size of firms requires separation 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 Mitigating factors: • Performance based compensation • Boards of Directors may fire managers • Threat of takeovers 1 -13
Example 1. 1 • In February 2008, Microsoft 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 Microsoft’s offer. • He lost, and Yahoo stock fell from $29 to $21. • Did Yahoo managers act in the best interests of their shareholders? 1 -14
Corporate Governance and Corporate Ethics • Business and market require trust to operate efficiently o Without trust additional laws and regulations are required o All laws and regulations 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 1 -15
Corporate Governance and Corporate Ethics • Accounting Scandals o Enron, World. Com, Rite-Aid, Health. South, Global Crossing, Qwest, • Misleading Research Reports o Citicorp, Merrill Lynch, others • Auditors: Watchdogs or Consultants? o Arthur Andersen and Enron 1 -16
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 accounting/audit industry o Charged the board with maintaining a culture of high ethical standards 1 -17
1. 4 The Investment Process o Asset allocation Choosing the percentage of funds in asset classes 60% Stocks 30% Bonds 6% Alternative Assets 4% Money market securities o Security selection & analysis Choosing specific securities w/in an asset class o The asset allocation decision is the primary determinant of a portfolio’s return 1 -18
1. 5 Markets Are Competitive o Risk-return trade-off: o Assets with higher expected returns have higher risk. Average Annual Return Stocks About 12% Minimum (1931) Maximum (1933) -46% 55% A stock portfolio can be expected to lose money about 1 out of every 4 years. o 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. 1 -19
Risk-Return Trade- Off o How do we measure risk? o How does diversification affect risk? o Discussed in Part 2 of the text 1 -20
Efficient Markets o Market efficiency: o Securities should be neither underpriced nor overpriced on average o Security prices should reflect all information available to investors o Whether we believe markets are efficient affects our choice of appropriate investment management style. 1 -21
Active vs. Passive Management Active Management (inefficient markets) Finding undervalued securities Security Selection Asset Allocation Timing the market Passive Management (efficient markets) No attempt to find undervalued securities • Indexing No attempt to time • Constructing an Holding a diversified portfolio: “efficient” portfolio 1 -22
1. 6 The Players 1 -23
The Players • Business Firms – net borrowers • Households – net savers • Governments – can be both borrowers and savers • Financial Intermediaries “Connectors of borrowers and lenders” o Commercial Banks • Traditional line of business: Make loans funded by deposits o o Investment companies Insurance companies Pension funds Hedge funds 1 -24
The Players Cont. • Investment Bankers o Firms that specialize in primary market transactions o Primary market: • A market where newly issued securities are offered to the public. • The investment banker typically ‘underwrites’ the issue. o Secondary market • A market where pre-existing securities are traded among investors. 1 -25
Investment Bankers • Investment Bankers o Commercial and investment banks’ functions and organizations were separated by law from 1933 to 1999. o Post 1999 large investment banks, collectively known as “Wall Street, ” operated independently from commercial banks, although many of the large commercial banks increased their investment banking activities, 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. 1 -26
• 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 regulations. • What are the implications for innovation and capital issuance resulting from these changes? 1 -27
Table 1. 3 Balance Sheet of Commercial Banks, 2008 1 -28
Table 1. 4 Balance Sheet of Nonfinancial U. S. Business, 2008 1 -29
- Slides: 29