Chapter One The Investment Environment INVESTMENTS BODIE KANE
Chapter One The Investment Environment INVESTMENTS | BODIE, KANE, MARCUS Copyright © 2014 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of Mc. Graw-Hill Education.
Chapter Overview • 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 1 -2 INVESTMENTS | BODIE, KANE, MARCUS
Real Assets vs. Financial Assets 1 -3 Real Assets Financial Assets • Determine the productive capacity and net income of the economy • Examples: Land, buildings, machines, knowledge used to produce goods and services • Claims on real assets, do not contribute directly to the productive capacity of the economy. • Examples: Stocks, bonds INVESTMENTS | BODIE, KANE, MARCUS
Financial Assets • 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 1 -4 INVESTMENTS | BODIE, KANE, MARCUS
Other Types of Investment • Investment in currency • Investment in real assets through commodity futures • Corporations invest in the commodity futures to hedge the risk 1 -5 INVESTMENTS | BODIE, KANE, MARCUS
Financial Markets and the Economy • 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 1 -6 INVESTMENTS | BODIE, KANE, MARCUS
Financial Markets and the Economy • 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 1 -7 INVESTMENTS | BODIE, KANE, MARCUS
Financial Markets and the Economy • Corporate Governance and Corporate Ethics • Accounting Scandals • Examples – Enron, Rite Aid, Health. South • Auditors: Watchdogs of the firms • Analyst Scandals • Arthur Andersen • Sarbanes-Oxley Act • Tighten the rules of corporate governance 1 -8 INVESTMENTS | BODIE, KANE, MARCUS
The Investment Process • Portfolio: Collection of investment assets. • Asset allocation • Choice among broad asset classes • Security selection • Choice of securities within each asset class 1 -9 INVESTMENTS | BODIE, KANE, MARCUS
The Investment Process • “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 priceattractiveness, which may result in unintended heavy weight of a portfolio in only one or another sector of the economy 1 -10 INVESTMENTS | BODIE, KANE, MARCUS
Markets Are Competitive • 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 1 -11 INVESTMENTS | BODIE, KANE, MARCUS
Markets Are Competitive • 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 1 -12 INVESTMENTS | BODIE, KANE, MARCUS
The Players • Demanders of capital – Firms • Suppliers of capital – Households • Governments – Can be both borrowers or lenders 1 -13 INVESTMENTS | BODIE, KANE, MARCUS
The Players • Financial Intermediaries: Pool and invest funds • Investment Companies • Banks • Insurance companies • Credit unions 1 -14 INVESTMENTS | BODIE, KANE, MARCUS
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 • Investors trade previously issued securities among themselves in the secondary markets 1 -15 INVESTMENTS | BODIE, KANE, MARCUS
Financial Crisis of 2008 • 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 1 -16 INVESTMENTS | BODIE, KANE, MARCUS
1 -17 июл-08 янв-08 июл-07 янв-07 6 июл-06 7 янв-06 июл-05 янв-05 июл-04 янв-04 июл-03 янв-03 июл-02 янв-02 июл-01 янв-01 июл-00 янв-00 июл-99 янв-99 июл-98 янв-98 июл-97 янв-97 июл-96 янв-96 Interest Rates (%) Figure 1. 1 Short-Term LIBOR and Treasury-Bill Rates and the TED Spread 8 3 -month LIBOR 3 -month T-bill TED spread 5 4 3 2 1 0 INVESTMENTS | BODIE, KANE, MARCUS
Figure 1. 3 The Case-Shiller Index of U. S. Housing Prices 250 Index (January 2000 = 100) 200 150 100 50 1 -18 2013 2011 2009 2007 2005 2003 2001 1999 1997 1995 1993 1991 1989 1987 0 INVESTMENTS | BODIE, KANE, MARCUS
Changes in Housing Finance 1 -19 Old Way New 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” • 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” INVESTMENTS | BODIE, KANE, MARCUS
Changes in Housing Finance • 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 nodocumentation 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 1 -20 INVESTMENTS | BODIE, KANE, MARCUS
Figure 1. 4 Cash Flows in a Mortgage Pass. Through Security 1 -21 INVESTMENTS | BODIE, KANE, MARCUS
Mortgage Derivatives • 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 1 -22 INVESTMENTS | BODIE, KANE, MARCUS
Why Was Credit Risk Underestimated? • 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 1 -23 INVESTMENTS | BODIE, KANE, MARCUS
Credit Default Swap (CDS) • 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 1 -24 INVESTMENTS | BODIE, KANE, MARCUS
Rise of Systemic Risk • 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 1 -25 INVESTMENTS | BODIE, KANE, MARCUS
Rise of Systemic Risk • 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 1 -26 INVESTMENTS | BODIE, KANE, MARCUS
Rise of Systemic Risk • 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 1 -27 INVESTMENTS | BODIE, KANE, MARCUS
The Shoe Drops • 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 1 -28 INVESTMENTS | BODIE, KANE, MARCUS
The Shoe Drops • 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 1 -29 INVESTMENTS | BODIE, KANE, MARCUS
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 (eg. : standardize CDS contracts so they can trade in centralized exchanges) • Office of Credit Ratings within the SEC to oversee the credit rating agencies 1 -30 INVESTMENTS | BODIE, KANE, MARCUS
- Slides: 30