BKM PPT Ch01 10e

Chapter One
The Investment Environment
INVESTMENTS | BODIE, KANE,

MARCUS
Chapter Overview
Role of financial assets in the economy: Real
vs. financial assets
Riskreturn 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
MARCUS
Real Assets vs. Financial Assets

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

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
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

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
MARCUS

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
MARCUS

Economy
Corporate Governance and Corporate
Ethics
Accounting Scandals
Examples Enron, Rite Aid, HealthSouth
Auditors: Watchdogs of the firms

Analyst Scandals
Arthur Andersen
Sarbanes-Oxley Act
Tighten the rules of corporate
governance

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

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
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
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
MARCUS
The Players
Demanders of capital Firms
Suppliers of capital Households
Governments Can be both
borrowers or lenders

MARCUS
The Players
Financial Intermediaries: Pool and
invest funds
Investment Companies
Banks
Insurance companies
Credit unions

MARCUS
Universal Bank Activities

Investment Banking
Commercial Banking
Underwrite new
securities issues
Sell newly issued
securities to public
in the primary
market
Investors trade
previously issued
securities among
themselves in the
secondary markets
Take deposits and

make loans

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

MARCUS
Figure 1.1 Short-Term LIBOR and

Treasury-Bill Rates and the TED Spread
8
3-month LIBOR
3-month T-bill
TED spread
7
6
5
Interest Rates (%)

4
3
2
1
0
Jul-96 Jul-97 Jul-98 Jul-99 Jul-00 Jul-01 Jul-02 Jul-03 Jul-04 Jul-05 Jul-06 Jul-07 Jul-08
Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08

MARCUS
Figure 1.3 The Case-Shiller Index of

U.S. Housing Prices
250
200
Index (January 2000 = 100)

150
100
50
0
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
2007
2009
2011

MARCUS
2013
Changes in Housing Finance

Old Way
New Way
Local thrift institution

made mortgage loans
to homeowners
Thrifts major asset: A
portfolio of long-term
mortgage loans
Thrifts 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
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
no-documentation loans and rising allowed
leverage on home loans (loan-to-value
ratio)
Low adjustable-rate mortgages
(ARMs)
INVESTMENTS
| BODIE, KANE,
MARCUS
Figure 1.4 Cash Flows in a Mortgage

Pass-Through Security

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
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

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

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

MARCUS

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
MARCUS

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
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
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
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
MARCUS

BKM PPT Ch01 10e

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

BKM PPT Ch01 10e

Uploaded by

Copyright:

Available Formats

Chapter One

The Investment Environment

INVESTMENTS | BODIE, KANE,

Real Assets vs. Financial Assets

INVESTMENTS | BODIE, KANE,

Common stock or equity

Other Types of Investment

INVESTMENTS | BODIE, KANE,

Financial Markets and the

Financial Markets and the

Mechanisms to mitigate agency problems:

Financial Markets and the

Auditors: Watchdogs of the firms

INVESTMENTS | BODIE, KANE,

The Investment Process

INVESTMENTS | BODIE, KANE,

The Investment Process

Markets Are Competitive

Markets Are Competitive

INVESTMENTS | BODIE, KANE,

INVESTMENTS | BODIE, KANE,

Universal Bank Activities

Take deposits and

INVESTMENTS | BODIE, KANE,

Financial Crisis of 2008

INVESTMENTS | BODIE, KANE,

Figure 1.1 Short-Term LIBOR and

Interest Rates (%)

INVESTMENTS | BODIE, KANE,

Figure 1.3 The Case-Shiller Index of

Index (January 2000 = 100)

INVESTMENTS | BODIE, KANE,

Changes in Housing Finance

Local thrift institution

Changes in Housing Finance

Figure 1.4 Cash Flows in a Mortgage

INVESTMENTS | BODIE, KANE,

Estimated ratings significantly

Why Was Credit Risk

INVESTMENTS | BODIE, KANE,

Credit Default Swap (CDS)

INVESTMENTS | BODIE, KANE,

Rise of Systemic Risk

INVESTMENTS | BODIE, KANE,

Rise of Systemic Risk

Banks were very highly levered,

Rise of Systemic Risk

The Shoe Drops

The Shoe Drops

The Dodd-Frank Reform Act

You might also like