Chapter

Investments:
1 Background and Issues

Bodie, Kane, and Marcus

Essentials of Investments
12th Edition
 1.1 Real versus Financial Assets
• Real assets

• Assets used to produce goods and services.

• Financial assets

• Claims on real assets or the income generated

by them.

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 Table 1.1 Balance Sheet, U.S. Households, 2019

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 1.1 Financial Assets = Financial Liabilities

• Financial Assets and Liabilities must balance

• Aggregated balance sheets  only real assets

remain
• Domestic Net Worth = Sum of real assets

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 Table 1.2 Domestic Net Worth, 2019

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 1.2 Financial Assets

• Fixed-income (debt) securities

• Pay a specified cash flow over a specific period

• Equity
• An ownership share in a corporation

• Derivative securities
• Securities providing payoffs that depend on the
values of other assets

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 1.3 Financial Markets and the Economy
• Informational Role of Financial Markets
• Capital flow to companies with best prospects

• Market Price = Fair Value?

• Do markets allocate capital to best uses?

• Other mechanisms to allocate capital?

• Advantages/disadvantages of other systems?

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 1.3 Financial Markets and the Economy
• Consumption Timing
• Use securities to store wealth

• Transfer consumption to the future

• Risk Allocation
• Investors select desired risk level

• Bond vs. stock

• Bank CD vs. company bond

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 1.3 Financial Markets and the Economy

• Separation of Ownership and Management

• Separation  Agency Problems

• Mitigating Factors

• Performance-based compensation

• Boards of directors may fire managers

• Threat of takeovers

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 1.3 Financial Markets and the Economy

• Corporate Governance and Corporate Ethics

• Businesses and markets require trust

• No trust  additional costly laws and regulations

• Governance and ethics failures cost the economy

• Erodes public support and confidence

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 1.3 Financial Markets and the Economy
• Corporate Governance and Corporate Ethics
• Accounting scandals

• Enron, WorldCom, Rite-Aid, HealthSouth, Global

Crossing, Qwest

• Misleading research reports

• Citicorp, Merrill Lynch, others

• Auditors: Watchdogs or consultants?

• Arthur Andersen and Enron

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 1.3 Financial Markets and the Economy

• Corporate Governance and Corporate Ethics

• Sarbanes-Oxley Act (SOX):

• Requires more independent directors

• CFO personally verifies the financial statements

• Creates accounting/audit industry oversight board

• Charges board to maintain culture of high ethical

standards

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 1.4 The Investment Process: Asset Allocation

• Asset Allocation
• Allocation of an investment portfolio across
broad asset classes.
• Primary determinant of a portfolio's return
• Percentage of fund in asset classes
• Top Down Investment Strategies

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 1.4 The Investment Process: Security Selection

• Security Selection
• Choice of particular securities within asset class
• Bottom up Investment strategies

• Security Analysis
• Analysis of the value of securities

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 1.5 Markets Are Competitive

• Risk-Return Trade-Off
• Higher expected returns  Higher risk
• Stock portfolios lose money an average of 25%
• Bonds
• Lower average rates of return (under 6%)
• Not lost more than 13% of value in any one year

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 1.5 Markets Are Competitive

• Risk-Return Trade-Off
• How do we measure risk?

• How does diversification affect risk?

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 1.5 Markets Are Competitive
• Efficient Markets

• Passive management

• Buying and holding a diversified portfolio

• No attempt to identify mispriced securities

• Active management

• Identify mispriced securities

• or Forecast broad market trends

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 1.6 The Players
• Business Firms (net borrowers)

• Raise capital now to pay for investments

• Households (net savers)

• Purchase securities issued by firms

• Governments (can be both borrowers and

savers)
• Depends on the relationship between tax
revenue and government expenditures
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 1.6 The Players

• Financial Intermediaries

• Connectors of borrowers and lenders

• Commercial banks
• Investment companies
• Insurance companies
• Pension funds
• Hedge funds

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 1.6 The Players

• Investment Bankers
• Specialize in primary market transactions

• Primary market

• Newly issued securities offered to public

• Investment banker “underwrites” issue

• Secondary market

• Preexisting securities traded among investors

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 1.6 The Players
• Investment Bankers
• Separate from commercial banks' functions by
law (1933-1999)
• Post-1999: Large commercial banks increased
investment-banking activities, pressuring
investment banks’ profit margins
• September 2008: Mortgage-market collapse
• Major investment banks bankrupt;
purchased/reorganized

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 1.6 The Players

• Investment Bankers
• Investment banks may become commercial
banks
• Obtain deposit funding

• Have access to government assistance

• Major banks now under stricter regulations

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 Table 1.3 Balance Sheet of Commercial Banks, 2019

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Table 1.4 Balance Sheet of Nonfinancial U.S. Business, 2019

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 1.6 The Players
• Venture Capital and Private Equity
• Venture capital

• Equity Investment to finance new firm

• Private equity

• Investments in privately-held companies

• Fintech and Financial Innovation

• Application of technology to financial markets

• Ex: cryptocurrencies and blockchain technology

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 1.7 The Financial Crisis of 2008-2009
Changes in Housing Finance
Old Way New Way
• Local thrift institution made • Securitization: Fannie Mae
mortgage loans to and Freddie Mac bought
homeowners mortgage loans, bundled
• Thrift’s possessed a them into large pools
portfolio of long-term • Mortgage-backed securities
mortgage loans are tradable claims against
• Thrift’s main liability: the underlying mortgage
Deposits pool
• “Originate to hold” • “Originate to distribute”

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 Figure 1.1 LIBOR, T-Bill Rates and the TED Spread

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 Figure 1.2 Cumulative Returns
Cumulative returns on a $1 investment in the S&P 500 index

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 Figure 1.3 Case-Shiller Index of U.S. Housing Prices

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 1.7 Changes in Housing Finance

• Securitization
• Pooling loans into standardized securities back
by loans
• Can be traded like any other security

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 1.7 Changes in Housing Finance (Continued)

• Inclusion of nonconforming “subprime”

loans
• Low/No-documentation loans
• Rising loan-to-value ratio
• Adjustable-Rate Mortgages

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 1.7 The Financial Crisis of 2008-2009
• Mortgage Derivatives

• CDOs: Consolidated default risk of loans

onto one class of investor, divided payment
into tranches
• Ratings agencies paid by issuers; pressured
to give high ratings

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 1.7 The Financial Crisis of 2008-2009
• Credit Default Swaps

• Insurance contract against the default of

borrowers
• Issuers ramped up risk to unsupportable
levels
• AIG sold $400 billion in CDS contracts

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 1.7 The Financial Crisis of 2008-2009
• Systemic Risk

• Risk of breakdown in financial system —

spillover effects from one market into others
• Banks highly leveraged; assets less liquid

• Formal exchange trading replaced by over-

the-counter markets — no margin for
insolvency protection

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 1.7 The Financial Crisis of 2008-2009
• The Shoe Drops

• September 7: Fannie Mae and Freddie Mac

put into conservatorship
• Lehman Brothers and Merrill Lynch verged
on bankruptcy
• September 17: Government lends $85 billion
to AIG
• Money market panic freezes short-term
financing market

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 1.7 The Financial Crisis of 2008-2009
• Dodd-Frank Reform Act

• Stricter rules for bank capital, liquidity, risk

management
• Mandated increased transparency

• Clarified regulatory system

• Volcker Rule: limit a bank’s ability to trade for

its own account and to own or invest in a
hedge fund or private equity fund.

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 1.8 Text Outline
• Part One: Introduction to Financial Markets,
Securities, and Trading Methods
• Part Two: Modern Portfolio Theory

• Part Three: Debt Securities

• Part Four: Equity Security Analysis

• Part Five: Derivative Markets

• Part Six: Active Investment Management

Strategies

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