Chapter 1 investments: background and issues What is an investment?

? An investment is the current commitment of money or other resource in the expectation of reaping future benefit Investment decisions made in an environment with higher returns can be only obtained at the price of greater risk, rare to see mispriced assets that are obvious bargains o Real assets vs. financial assets Real assets assets used to produce goods and services Financial assets claims on real assets or the income generated by them Real assets generate net income to the economy, financial assets simply define the allocation of income among investors Financial assets of households are liabilities of the issuer of the securities in an aggregate balance sheet these claims cancel out and leave only real assets as indication of wealth of economy A taxonomy of financial assets Fixed income securities promise either a fixed stream of income or a stream of income determined according to a specified formula, performance closely tied to financial condition of issuer Equity represents an ownership share in the corporation, not promised particular payment Derivative securities provide payoffs that are determined by the prices of other asset, primarily used to hedge risk or transfer them to other parties Financial markets and the economy o Consumption timing Shifting consumption over course of lifetime, thereby allocating your consumption to periods that provide greatest satisfaction o Allocation of risk Capital markets allow risk that is inherent in all investments to be borne by investors most willing to bear the risk Allocation of risk benefits the firm that need to raise capital to finance their investments When investors and able to choose investments whose risk return-return are best suited to them, each security can be sold for best possible price o Separation of ownership and management Owners and managers of a firm are different parties firm has more stability Agency problems managers who are hired as agents of stockholders may pursue own interests instead Investment process Asset allocation allocation of an investment portfolio across broad asset classes Security selection - choice of specific securities within each asset class Top down portfolio construction start with asset allocation

Chapter 1 investments: background and issues Security analysis valuation of particular securities that might be included in portfolio Bottom up strategy portfolio is constructed from securities deemed most attractive without concern for asset allocation Markets are competitive o The risk return trade off Higher returns, must accept higher risk Diversification many asset held in a portfolio so exposure to any particular asset is limited o Efficient markets Security price usually reflects all the information available to investors concerning value of security new information becomes available, price will change (no mispriced securities) Passive management buying and holding a diversified portfolio without attempting to identify mispriced securities Active management attempting to identify mispriced securities or to forecast broad market trends Not relevant if efficient market hypothesis is true The players Firms net borrowers, raise capital not to pay for investment in plant and equipment Households net savers, purchase securities Governments - can be borrowers or lender depending on relationship between tax revenue and expenditures o Financial intermediaries Because of small financial size of mot households, direct investments are difficult Financial intermediaries have evolved to bring lenders and borrower together Investment companies pool and manage money of many investors o Investment bankers Advise issuing corporation on the prices it can charge for the securities issued , will handle the marketing of the security issue to the public Markets and market structure o Direct search markets Least organized market, buyers and seller must seek each other out directly o Brokered markets New issues of securities are offered to the public Primary market o Dealer markets Markets in which traders specializing in particular assets buy and sell for their own accounts

Chapter 1 investments: background and issues Secondary markets o Auction markets All traders meet at one place to buy or sell Recent trends o Globalization Purchase foreign securities using American Depository Receipts (ADRs), which are domestically traded securities that represent claims to shares of foreign stock Purchase foreign securities that are offered in dollars Buy mutual funds that invest internationally Buy derivative securities with payoffs that depend on prices in foreign security markets. o Securitization Securitization pooling loans into standardized securities back by these loans, which can be traded like any other security Pass through securities pool of loans sold a package, owners receive interest and principle of borrowers o Financial engineering Creation of new securities by unbundling (breaking up and allocating cash flows from one security to create new securities) or by bundling (combining more than one security into a composite security