Chapter One The Investment Environment INVESTMENTS BODIE KANE

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 • 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 • 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 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 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 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 • 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: • 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 • 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 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 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 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 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 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 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 • • 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. • 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 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 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 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

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

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

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” 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 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 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 • 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 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 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 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: 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 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 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