Investments:
Background and Issues
Bodie, Kane, and Marcus
Essentials of Investments,
1
9th Edition
McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
1.1 Real versus Financial Assets
• Nature of Investment
• Reduce current consumption for greater future
consumption
• Real Assets
• Used to produce goods and services: Property,
plants and equipment, human capital, etc.
• Financial Assets
• Claims on real assets or claims on real-asset
income
1-2
1.2 Financial Assets
• Major Classes of Financial Assets or Securities
• Fixed-income (debt) securities
• Money market instruments
• Bank certificates of deposit, T-bills, commercial paper, etc.
• Bonds
• Preferred stock
• Common stock (equity)
• Ownership stake in entity, residual cash flow
• Derivative securities
• Contract, value derived from underlying market condition
1-3
1.3 Financial Markets and the Economy
• Informational Role of Financial Markets
• Do market prices equal the fair value estimate
of a security's expected future risky cash flows?
• Can we rely on markets to allocate capital to the
best uses?
• Other mechanisms to allocate capital?
• Advantages/disadvantages of other systems?
1-4
1.3 Financial Markets and the Economy
• Consumption Timing
• Consumption smoothes over time
• When current basic needs are met, shift
consumption through time by investing surplus
1-5
1.3 Financial Markets and the Economy
• Risk Allocation
• Investors can choose desired risk level
• Bond vs. stock of company
• Bank CD vs. company bond
• Risk-and-return trade-off
1-6
1.3 Financial Markets and the Economy
• Separation of Ownership and Management
• Large size of firms requires separate
principals and agents
• Mitigating Factors
• Performance-based compensation
• Boards of directors may fire managers
• Threat of takeovers
1-7
1.3 Financial Markets and the Economy
• Corporate Governance and Corporate Ethics
• Businesses and markets require trust to operate
efficiently
• Without trust additional laws and regulations are
required
• Laws and regulations are costly
• Governance and ethics failures cost the economy
billions, if not trillions
• Eroding public support and confidence
1-8
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
1-9
1.3 Financial Markets and the Economy
• Corporate Governance and Corporate Ethics
• Sarbanes-Oxley Act:
• Requires more independent directors on company
boards
• Requires CFO to personally verify the financial
statements
• Created new oversight board for the accounting/audit
industry
• Charged board with maintaining a culture of high
ethical standards
1-10
1.4 The Investment Process
• Asset Allocation
• Primary determinant of a portfolio's return
• Percentage of fund in asset classes
• Stocks 60%
• Bonds 30%
• Alternative assets 6%
• Money market securities 4%
• Security selection and analysis
• Choosing specific securities within asset class
1-11
1.5 Markets Are Competitive
• Risk-Return Trade-Off
• Assets with higher expected returns have higher
risk
Average Annual Return Minimum (1931) Maximum (1933)
Stocks About 12% −46% 55%
• Stock portfolio loses money 1 of 4 years on
average
• Bonds
• Have lower average rates of return (under 6%)
• Have not lost more than 13% of their value in any one
year
1-12
1.5 Markets Are Competitive
• Risk-Return Trade-Off
• How do we measure risk?
• How does diversification affect risk?
1-13
1.5 Markets Are Competitive
• Efficient Markets
• Securities should be neither underpriced nor
overpriced on average
• Security prices should reflect all information
available to investors
• Choice of appropriate investment-
management style based on belief in market
efficiency
1-14
1.5 Markets Are Competitive
• Active versus Passive Management
• Active management (inefficient markets)
• Finding undervalued securities (security selection)
• Market timing (asset allocation)
• Passive management (efficient markets)
• No attempt to find undervalued securities
• No attempt to time
• Holding a diversified portfolio
• Indexing; constructing “efficient” portfolio
1-15
1.6 The Players
• Business Firms (net borrowers)
• Households (net savers)
• Governments (can be both borrowers and savers)
• Financial Intermediaries (connectors of borrowers
and lenders)
• Commercial banks
• Investment companies
• Insurance companies
• Pension funds
• Hedge funds
1-16
1.6 The Players
• Investment Bankers
• Firms that specialize in primary market
transactions
• Primary market
• Newly issued securities offered to public
• Investment banker typically “underwrites” issue
• Secondary market
• Preexisting securities traded among investors
1-17
1.6 The Players
• Investment Bankers
• Commercial and investment banks' functions and
organizations separated by law 1933-1999
• Post-1999: Large investment banks independent from
commercial banks
• Large commercial banks increased investment-
banking activities, pressuring investment banks’
profit margins
• September 2008: Mortgage-market collapse
• Major investment banks bankrupt;
purchased/reorganized
1-18
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 commercial
bank regulations
1-19
1.6 The Players
• Venture Capital and Private Equity
• Venture capital
• Investment to finance new firm
• Private equity
• Investments in companies not traded on
stock exchange
1-20
