Chapter One The Investment Environment INVESTMENTS BODIE KANE

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Chapter One The Investment Environment INVESTMENTS | BODIE, KANE, MARCUS © 2018 Mc. Graw-Hill

Chapter One The Investment Environment INVESTMENTS | BODIE, KANE, MARCUS © 2018 Mc. Graw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom. No reproduction or further distribution permitted without the prior written consent of Mc. Graw-Hill Education.

Chapter Overview • Real Assets versus Financial Assets • Risk-return trade-off and efficient pricing

Chapter Overview • Real Assets versus Financial Assets • Risk-return trade-off and efficient pricing • Financial crisis 2008 • Financial system “Real” economy • Systemic risk INVESTMENTS | BODIE, KANE, MARCUS © 2018 Mc. Graw-Hill Education 1 -2

Real Assets vs. Financial Assets Real Assets Financial Assets • Have Productive Capacity •

Real Assets vs. Financial Assets Real Assets Financial Assets • Have Productive Capacity • Claims on real assets • Do not contribute directly to productive capacity • Examples: Land, buildings, • Examples: Stocks, bonds machines, intellectual property INVESTMENTS | BODIE, KANE, MARCUS © 2018 Mc. Graw-Hill Education 1 -3

Financial Assets: Claims on Real Assets Fixed-Income Securities: Equity: Promises a fixed stream of

Financial Assets: Claims on Real Assets Fixed-Income Securities: Equity: Promises a fixed stream of income or a stream of income determined by a specified formula; debt Represents ownership share in a corporation; common Stock Derivatives: Provide payoffs that are determined by the prices of other assets INVESTMENTS | BODIE, KANE, MARCUS © 2018 Mc. Graw-Hill Education 1 -4

Other Types of Investment • Investment in currency • Commodity futures • Corporations invest

Other Types of Investment • Investment in currency • Commodity futures • Corporations invest in the commodity futures to hedge the risk INVESTMENTS | BODIE, KANE, MARCUS © 2018 Mc. Graw-Hill Education 1 -5

Financial Markets and the Economy (1 of 4) • The Informational Role • Stock

Financial Markets and the Economy (1 of 4) • The Informational Role • Stock prices reflect “collective” assessment of a firm current performance and future prospects • Consumption Timing • Store of wealth in financial assets • Buying/selling in different life periods • Allocation of Risk • From high to low (shares/bonds) to different categories of investors INVESTMENTS | BODIE, KANE, MARCUS © 2018 Mc. Graw-Hill Education 1 -6

Financial Markets and the Economy (2 of 4) • Separation of Ownership and Management

Financial Markets and the Economy (2 of 4) • Separation of Ownership and Management • Some businesses are held and managed by the same person • Others are not • agency problems: how can we make sure that managers are acting in the interest of ownership? • compensation plans tie results to remuneration INVESTMENTS | BODIE, KANE, MARCUS © 2018 Mc. Graw-Hill Education 1 -7

Financial Markets and the Economy (3 of 4) • Mechanisms to mitigate Agency Problems:

Financial Markets and the Economy (3 of 4) • Mechanisms to mitigate Agency Problems: • Tie managers' income to the success of the firm • Monitoring from the board of directors • Monitoring by large investors and security analysts • Takeover threat INVESTMENTS | BODIE, KANE, MARCUS © 2018 Mc. Graw-Hill Education 1 -8

Financial Markets and the Economy (4 of 4) • Corporate Governance and Corporate Ethics

Financial Markets and the Economy (4 of 4) • Corporate Governance and Corporate Ethics • Accounting Scandals (to highlight inexistent profit) • Enron, Rite Aid, Health. South • Auditors: Watchdogs (collegio sindacale) • more lucrative consulting than auditing • Analyst Scandals • Arthur Andersen (dead!) • Sarbanes-Oxley Act • Stricter corporate governance rules • More independent directors INVESTMENTS | BODIE, KANE, MARCUS © 2018 Mc. Graw-Hill Education 1 -9

The Investment Process (1 of 2) • Portfolio: Collection of investment assets • Asset

The Investment Process (1 of 2) • Portfolio: Collection of investment assets • Asset allocation • Choice among broad asset classes (stocks; bonds; commodities; real estate; ect. ) • Security selection • Choice of securities within each asset class INVESTMENTS | BODIE, KANE, MARCUS © 2018 Mc. Graw-Hill Education 1 -10

The Investment Process (2 of 2) • “Top-down” approach • Asset allocation followed by

The Investment Process (2 of 2) • “Top-down” approach • Asset allocation followed by security analysis • “Bottom-up” approach • Investment based solely on the price-attractiveness • Not much interest in asset allocation INVESTMENTS | BODIE, KANE, MARCUS © 2018 Mc. Graw-Hill Education 1 -11

Markets Are Competitive (1 of 3) Risk-Return Trade-Off • Higher-risk assets are priced to

Markets Are Competitive (1 of 3) Risk-Return Trade-Off • Higher-risk assets are priced to offer higher expected returns than lower-risk assets • Risk and expected return are positively correlated INVESTMENTS | BODIE, KANE, MARCUS © 2018 Mc. Graw-Hill Education 1 -12

Markets Are Competitive (2 of 3) Efficient Markets • Efficient markets: prices quickly adjust

Markets Are Competitive (2 of 3) Efficient Markets • Efficient markets: prices quickly adjust to all relevant information • There should be neither underpriced nor overpriced securities INVESTMENTS | BODIE, KANE, MARCUS © 2018 Mc. Graw-Hill Education 1 -13

Markets Are Competitive (3 of 3) • Passive Management • Holding a highly diversified

Markets Are Competitive (3 of 3) • 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 INVESTMENTS | BODIE, KANE, MARCUS © 2018 Mc. Graw-Hill Education 1 -14

The Players Price of Capital (1 of 2) Who Supplies Capital? Households What Demands

The Players Price of Capital (1 of 2) Who Supplies Capital? Households What Demands Capital? Firms Quantity of Capital Role of Government? Can be either borrowers or lenders INVESTMENTS | BODIE, KANE, MARCUS © 2018 Mc. Graw-Hill Education 1 -15

The Players (2 of 2) • Financial Intermediaries: Pool and invest funds • •

The Players (2 of 2) • Financial Intermediaries: Pool and invest funds • • Investment Companies Banks Insurance companies Credit unions (different than banks: the bottom line is that banks are for-profit institutions, while credit unions are non-profit. Credit unions typically brag better customer service and lower fees, but have higher interest rates. On the contrary, banks generally have lower interest rates and higher fees) INVESTMENTS | BODIE, KANE, MARCUS © 2018 Mc. Graw-Hill Education 1 -16

The Players (2 of 2) • Investment companies arise out of economies of scale.

The Players (2 of 2) • Investment companies arise out of economies of scale. • portfolios are not large enough to be spread across a wide variety of securities • design portfolios specifically for large investors with particular goals • in terms of brokerage fees and research costs, purchasing one or two shares of many different firms is very expensive • Mutual funds have the advantage of large-scale trading and portfolio management, • participating investors are assigned a prorated share • are sold in the retail market, and their investment philosophies are differentiated INVESTMENTS | BODIE, KANE, MARCUS © 2018 Mc. Graw-Hill Education 1 -17

The Players (2 of 2) • Like mutual funds, hedge funds also pool and

The Players (2 of 2) • Like mutual funds, hedge funds also pool and invest the money of many clients • they are open only to institutional investors such as pension funds, endowment funds, or wealthy individuals • they are more likely to pursue complex and higher -risk strategies • they typically keep a portion of trading profits as part of their fees, whereas mutual funds charge a fixed percentage of assets under management. INVESTMENTS | BODIE, KANE, MARCUS © 2018 Mc. Graw-Hill Education 1 -18

Universal Bank Activities Investment Banking Commercial Banking • Underwrite new securities • Take deposits

Universal Bank Activities Investment Banking Commercial Banking • Underwrite new securities • Take deposits and make issues loans • Sell newly issued securities to public in the primary market INVESTMENTS | BODIE, KANE, MARCUS © 2018 Mc. Graw-Hill Education 1 -19

Financial Crisis of 2008 (1 of 3) • Antecedents of the Crisis: • Strong

Financial Crisis of 2008 (1 of 3) • Antecedents of the Crisis: • Strong ties with macroeconomics • “The Great Moderation” • https: //en. wikipedia. org/wiki/Great_Moderation • Historic boom in housing market INVESTMENTS | BODIE, KANE, MARCUS © 2018 Mc. Graw-Hill Education 1 -20

Financial Crisis of 2008 (2 of 3) “The Great Moderation (mild business cycles) in

Financial Crisis of 2008 (2 of 3) “The Great Moderation (mild business cycles) in particular)” INVESTMENTS | BODIE, KANE, MARCUS © 2018 Mc. Graw-Hill Education 1 -21

Short-Term LIBOR and Treasury-Bill Rates and the TED Spread TED = Treasury–Eurodollar spread INVESTMENTS

Short-Term LIBOR and Treasury-Bill Rates and the TED Spread TED = Treasury–Eurodollar spread INVESTMENTS | BODIE, KANE, MARCUS © 2018 Mc. Graw-Hill Education 1 -22

Financial Crisis of 2008 (3 of 3) Historic boom in housing market https: //fred.

Financial Crisis of 2008 (3 of 3) Historic boom in housing market https: //fred. stlouisfed. org/series/CSUSHPINSA INVESTMENTS | BODIE, KANE, MARCUS © 2018 Mc. Graw-Hill Education 1 -23

Changes in Housing Finance (1 of 2) Old Way New Way • Local thrift

Changes in Housing Finance (1 of 2) Old Way New Way • Local thrift institution made • mortgage loans to homeowners • Thrift’s possessed a portfolio • of long-term mortgage loans • Thrift’s main liability: Deposits • • “Originate to hold” Securitization: Fannie Mae and Freddie Mac bought mortgage loans and bundled them into large pools (https: //st. ilsole 24 ore. com/art/Sole. O n. Line 4/Finanza%20 e%20 Mercati/200 8/09/fannie-freddie-scheda. shtml) Mortgage-backed securities are tradable claims against the underlying mortgage pool • “Originate to distribute” INVESTMENTS | BODIE, KANE, MARCUS © 2018 Mc. Graw-Hill Education 1 -24

Changes in Housing Finance (2 of 2) • Securitization: • Inclusion of nonconforming “subprime”

Changes in Housing Finance (2 of 2) • Securitization: • Inclusion of nonconforming “subprime” loans • Low/No-documentation loans • Rising loan-to-value ratio • Adjustable-Rate Mortgages INVESTMENTS | BODIE, KANE, MARCUS © 2018 Mc. Graw-Hill Education 1 -25

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

Mortgage Derivatives • Collateralized debt obligations (CDOs) • Mortgage pool divided into tranches to concentrate default risk: • Senior tranches: • Junior tranches: • Ratings significantly underestimated risk • A strong trend toward low-documentation and then no-documentation loans, entailing little verification of a borrower’s ability to carry a loan, soon emerged INVESTMENTS | BODIE, KANE, MARCUS © 2018 Mc. Graw-Hill Education 1 -26

Why Was Credit Risk Underestimated? • Default probabilities were misestimated • Geographic diversification did

Why Was Credit Risk Underestimated? • Default probabilities were misestimated • Geographic diversification did not reduce risk sufficiently • Why had the rating agencies so dramatically underestimated credit risk in these subprime securities? First, default probabilities had been estimated using historical data from an unrepresentative period characterized by a housing boom and an uncommonly prosperous and recessionfree macroeconomy • Agency problems with rating agencies. The ratings agencies were paid to provide ratings by the issuers of the securities—not the purchasers INVESTMENTS | BODIE, KANE, MARCUS © 2018 Mc. Graw-Hill Education 1 -27

Credit Default Swap (CDS) • A CDS is an insurance contract against borrower default

Credit Default Swap (CDS) • A CDS is an insurance contract against borrower default • Investors bought sub-prime loans and CDSs • Some big swap issuers did not have enough capital to back their CDSs • This lack of capital resulted in the failure of CDO insurance INVESTMENTS | BODIE, KANE, MARCUS © 2018 Mc. Graw-Hill Education 1 -28

Rise of Systemic Risk (1 of 3) • Systemic Risk: Further Defaults • One

Rise of Systemic Risk (1 of 3) • Systemic Risk: Further Defaults • One default triggers Further Defaults • Waves of selling downward spiral as asset prices drop • Potential contagion INVESTMENTS | BODIE, KANE, MARCUS © 2018 Mc. Graw-Hill Education 1 -29

Rise of Systemic Risk (2 of 3) • Banks mismatched maturity/liquidity of their assets

Rise of Systemic Risk (2 of 3) • Banks mismatched maturity/liquidity of their assets and liabilities: • Liabilities were short and liquid • Assets were long and illiquid • Constant need to refinance • Banks: highly leveraged no margin of safety INVESTMENTS | BODIE, KANE, MARCUS © 2018 Mc. Graw-Hill Education 1 -30

Rise of Systemic Risk (3 of 3) • Investors relied too much on credit

Rise of Systemic Risk (3 of 3) • Investors relied too much on credit enhancement through structured products • CDS traded mostly over-the-counter • (I mercati OTC sono quindi il complesso delle operazioni di compravendita di titoli che non figurano nei listini di borsa, la cui funzionalità è organizzata da alcuni attori, e le cui caratteristiche dei contratti che vengono negoziati non sono standardizzate. ) • No posted margin requirements • Little transparency • Opaque linkages between instruments and institutions INVESTMENTS | BODIE, KANE, MARCUS © 2018 Mc. Graw-Hill Education 1 -31

The Shoe Drops (1 of 2) • 2004: Interest rates began rising • 2006:

The Shoe Drops (1 of 2) • 2004: Interest rates began rising • 2006: Home prices peaked • 2007: Housing defaults and losses on mortgage-backed securities surged INVESTMENTS | BODIE, KANE, MARCUS © 2018 Mc. Graw-Hill Education 1 -32

The Shoe Drops (2 of 2) • 2008: Troubled firms include Bear Stearns, Fannie

The Shoe Drops (2 of 2) • 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 INVESTMENTS | BODIE, KANE, MARCUS © 2018 Mc. Graw-Hill Education 1 -33

The Dodd-Frank Reform Act • Mechanisms to mitigate systemic risk • Stricter rules for

The Dodd-Frank Reform Act • Mechanisms to mitigate systemic risk • Stricter rules for bank capital, liquidity, and risk management practices • Increased transparency, especially in derivatives markets • Office of Credit Ratings within the SEC to oversee the credit rating agencies INVESTMENTS | BODIE, KANE, MARCUS © 2018 Mc. Graw-Hill Education 1 -34