Essentials of Investments, 10th edition
Chapter 1 – Investments: Background and issues
Investment = commitment of current resources in the expectaton of deriving greater resources in
the future.
1.1 REAL ASSETS VERSUS FINANCIAL ASSETS
Real assets = assets used to produce goods and services. The land, building, equipment, and
knowledge that can be used to produce goods and services.
Financial assets = claims on real assets or the income generated by them. It are claims to the income
generated by real assets.
While real assets generate net income to the economy, fnancial assets simply defne the allocaton
of income or wealth among investors.
1.2 FINANCIAL ASSETS
Three broad types of fnancial assets:
- Debt
- Equity
- Derivatves
Fixed-income / debt securites = pay a specifed cash fow over a specifc period can also be interest
rate).
Money market = fxed-income securites that are short term, highly marketable, and generally of very
low risk.
Capital market = long-term securites such as Treasury bonds, as well as bonds issued by federal
agencies, state and local municipalites, and corporatons.
Equity = an ownership share in a corporaton. Equity holders are not promised any partcular
payment. They receive any dividends the frm may pay and have prorated ownership in the real
assets of the frm.
Derivatve securites = providing payoffs that are determined by the price of other assets such as
bond or stock prices, examples are optons and future contracts.
One use of derivatves, perhaps the primary use, is to hedge risks or transfer them to other partes.
Derivatves also can be used to take highly speculatve positons.
Commodity and derivatve markets allow frms to adjust their exposure to various business risks.
1.3 FINANCIAL MARKETS AND THE ECONOMY
The informatonaa roae of fnanciaa markets
The stock market encourages allocaton of capital to those frms that appear at the tme to have the
best prospects. Many smart, well-trained, and well-paid professionals analyze the prospects of frms
who shares trade on the stock market. However, a few year later those frms can fail.
Consumpton tminn
In high-earnings periods, you can invest your savings in fnancial assets such as stocks and bonds. In
low-earning periods you can sell these assets to provide funds for your consumpton needs.
Aaaocaton of risk
Financial markets and the diverse fnancial instruments traded in those markets allow investors with
the greatest taste for risk to bear that risk, while other, less risk-tolerant individuals can, to a greater
extent, stay on the sidelines. The more optmistc or risk-tolerant investors can buy shares, while the
,more conservatve ones can buy bonds.
When investors are able to select security types with the risk-return characteristcs that best suit
their preferences, each security can be sold for the best possible price.
Separaton of ownership and mananement
All individual investors elect a board of directors that in turn hires and supervises the management of
the frm. This structure means that the owners and managers of the frm are different partes.
Agency problems = conficts of interest between managers and stockholders. Several mechanisms
have evolved to mitgate potental agency problems. First, compensaton plants te the income of
managers to the success of the frm. Second, while boards of directors have sometmes been
portrayed as defenders of top management, they can force out management teams that are
underperforming. Third, outsiders such as security analysts and large insttutonal investors such as
mutual funds or pension funds monitor the frm closely and make the life of poor performers at the
least uncomfortable.
Finally, if the board of directors is lax in monitoring management, unhappy shareholders in principle
can elect a different board.
Corporate novernance and corporate ethics
A frm’s reputaton for integrity is key to building long-term relatonships with its customers and is
therefore one of its most valuable assets.
1.4 THE INVESTMENT PROCESS
Investor’s portolio = his collecton of investment assets.
Asset allocaton = allocaton of an investment portolio across broad asset classes.
Security selecton = choice of specifc securites within each asset class.
‘Top-down’ portolio constructon starts with asset allocaton. Then the decision of the partcular
securites to be held in each asset class will be made.
Security analysis = analysis of the value of securites. The valuaton of partcular securites that might
be included in the portolio.
‘Bottom-up’ strategy, the portolio is constructed from the securites that seem attractvely priced
without as much concern for the resultant asset allocaton.
1.5 MARKETS ARE COMPETITIVE
The risk-return trade-of
Risk-return trade-off = assets with higher expected returns entail greater risk.
Efcient markets
Passive management = buying and holding a diversifed portolio without attemptng to identfy
mispriced securites.
Actve management = attemptng to identfy mispriced securites or to forecast broad market trends.
1.6 THE PLAYERS
Three major players in the fnancial markets:
1. Firms are net demanders of capital.
2. Households typically are suppliers of capital.
3. Governments can be borrowers or lenders, depending on the relatonship between tax revenue
and government expenditures.
Financiaa intermediaries
Financial intermediaries = insttutons that ‘connect’ borrowers and lenders by acceptng funds from
lenders and loaning funds to borrowers. They issue their own securites to raise funds to purchase
the securites of other corporatons.
,Intermediaries offer advantages. First, by pooling the resources of many small investors, they are
able to lend considerable sums to large borrowers. Second, by lending to many borrowers,
intermediaries achieve signifcant diversifcaton, so they can accept loans that individually might be
too risky. Third, intermediaries build expertse through the volume of business they do and can use
economies of scale and scope to assess and monitor risk.
Investment companies = frms managing funds for investors. An investment company may manage
several mutual funds. Here, the problem is that most household portolios are not large enough to be
spread among a wide variety of securites.
Investment bankers
Investment bankers = frms specializing in the sale of new securites to the public, typically by
underwritng the issue.
The investment banking frm handles the marketng of the security in the primary market, where new
issues of securites are offered to the public. Later, investors can trade previously issued securites
among themselves in the so-called secondary market.
Venture capitaa and private equity
Venture capital VC) = money invested to fnance a new frm.
Private equity = investments in companies that are not traded on a stock exchange.
1.7 THE FINANCIAL CRISIS OF 2008
Antecedents of the crisis
-
Channes in housinn fnance
Securitzaton = pooling loans into standardized securites backed by those loans, which can then be
traded like any other security.
Mortnane Derivatves
-
Credit defauat swaps
-
The rise of systematc risk
Systematc risk = risk of breakdown in the fnancial system, partcularly due to spillover effects from
one market into others.
The shoe drops
-
The dodd-frank reform act
-
1.8 OUTLINE OF THE TEXT
Financial markets:
Money markets
Short-term, marketable, liquid, low-risk debt securites.
Capital markets
Longer-term and riskier securites
1. Longer-term debt markets
2. Equity markets
3. Derivatve markets
, Chapter 2 – Asset classes and fnancial instruments
2.1 THE MONEY MARKET
Money market = include short-term, highly liquid, and relatvely low-risk debt instruments.
- Treasury bills = short-term government securites issued at a discount from face value and returning
the face amount at maturity.
The government raises money by selling bills to the public. Investors buy the bills at a discount from
the stated maturity value. At the bill’s maturity, the holder receives the face value of the bill from the
government. The difference between the purchase price and the ultmate maturity represent the
investor’s earnings.
T-bills are easily converted to cash and sold at low transacton cost and with little price risk.
- Certfcate of deposit CD) = a bank tme deposit.
The bank pays interest and principal to the depositor only at the end of the fxed term of the CD.
- Commercial paper = short-term unsecured debt issued by large corporatons.
- Bankers’ acceptance = an order to a bank by a customer to pay a sum of money at a future date.
- Eurodollars = dollar-denominated deposits at foreign banks or foreign branches of American banks.
- Repurchase agreements repos) = short-term sales of securites with an agreement to repurchase
the securites at a higher price.
- Brokers’ calls =
- Federal funds = funds in the accounts of commercial banks at the Federal Reserve Bank.
- LIBOR = lending rate among banks in the London market.
2.2 THE BOND MARKET
The bond market is composed of longer-term borrowing or debt instruments than those that trade in
the money market.
These instruments are sometmes said to comprise the fxed-income capitaa market.
- Treasury notes or bonds = debt obligatons of the federal government with original maturites of
one year or more.
- Infaton-protected treasury bonds: The principal amount on these bonds is adjusted in proporton
to increases in the Consumer Price Index. Therefore, they provide a constant stream of income in real
infaton-adjusted) dollars, and the real interest rates you earn on these securites are risk-free if you
hold them to maturity.
- Federal agency debt = government agencies who issue their own securites to fnance their
actvites.
- Internatonal bonds = frms who borrow abroad and investors buy bonds from foreign issuers.
- Municipal bonds = tax-exempt bonds issued by state and local governments. Investors pay neither
federal nor state taxes on the interest proceeds.
- General obligaton bonds
- Revenue bonds
- Industrial development bond
Chapter 1 – Investments: Background and issues
Investment = commitment of current resources in the expectaton of deriving greater resources in
the future.
1.1 REAL ASSETS VERSUS FINANCIAL ASSETS
Real assets = assets used to produce goods and services. The land, building, equipment, and
knowledge that can be used to produce goods and services.
Financial assets = claims on real assets or the income generated by them. It are claims to the income
generated by real assets.
While real assets generate net income to the economy, fnancial assets simply defne the allocaton
of income or wealth among investors.
1.2 FINANCIAL ASSETS
Three broad types of fnancial assets:
- Debt
- Equity
- Derivatves
Fixed-income / debt securites = pay a specifed cash fow over a specifc period can also be interest
rate).
Money market = fxed-income securites that are short term, highly marketable, and generally of very
low risk.
Capital market = long-term securites such as Treasury bonds, as well as bonds issued by federal
agencies, state and local municipalites, and corporatons.
Equity = an ownership share in a corporaton. Equity holders are not promised any partcular
payment. They receive any dividends the frm may pay and have prorated ownership in the real
assets of the frm.
Derivatve securites = providing payoffs that are determined by the price of other assets such as
bond or stock prices, examples are optons and future contracts.
One use of derivatves, perhaps the primary use, is to hedge risks or transfer them to other partes.
Derivatves also can be used to take highly speculatve positons.
Commodity and derivatve markets allow frms to adjust their exposure to various business risks.
1.3 FINANCIAL MARKETS AND THE ECONOMY
The informatonaa roae of fnanciaa markets
The stock market encourages allocaton of capital to those frms that appear at the tme to have the
best prospects. Many smart, well-trained, and well-paid professionals analyze the prospects of frms
who shares trade on the stock market. However, a few year later those frms can fail.
Consumpton tminn
In high-earnings periods, you can invest your savings in fnancial assets such as stocks and bonds. In
low-earning periods you can sell these assets to provide funds for your consumpton needs.
Aaaocaton of risk
Financial markets and the diverse fnancial instruments traded in those markets allow investors with
the greatest taste for risk to bear that risk, while other, less risk-tolerant individuals can, to a greater
extent, stay on the sidelines. The more optmistc or risk-tolerant investors can buy shares, while the
,more conservatve ones can buy bonds.
When investors are able to select security types with the risk-return characteristcs that best suit
their preferences, each security can be sold for the best possible price.
Separaton of ownership and mananement
All individual investors elect a board of directors that in turn hires and supervises the management of
the frm. This structure means that the owners and managers of the frm are different partes.
Agency problems = conficts of interest between managers and stockholders. Several mechanisms
have evolved to mitgate potental agency problems. First, compensaton plants te the income of
managers to the success of the frm. Second, while boards of directors have sometmes been
portrayed as defenders of top management, they can force out management teams that are
underperforming. Third, outsiders such as security analysts and large insttutonal investors such as
mutual funds or pension funds monitor the frm closely and make the life of poor performers at the
least uncomfortable.
Finally, if the board of directors is lax in monitoring management, unhappy shareholders in principle
can elect a different board.
Corporate novernance and corporate ethics
A frm’s reputaton for integrity is key to building long-term relatonships with its customers and is
therefore one of its most valuable assets.
1.4 THE INVESTMENT PROCESS
Investor’s portolio = his collecton of investment assets.
Asset allocaton = allocaton of an investment portolio across broad asset classes.
Security selecton = choice of specifc securites within each asset class.
‘Top-down’ portolio constructon starts with asset allocaton. Then the decision of the partcular
securites to be held in each asset class will be made.
Security analysis = analysis of the value of securites. The valuaton of partcular securites that might
be included in the portolio.
‘Bottom-up’ strategy, the portolio is constructed from the securites that seem attractvely priced
without as much concern for the resultant asset allocaton.
1.5 MARKETS ARE COMPETITIVE
The risk-return trade-of
Risk-return trade-off = assets with higher expected returns entail greater risk.
Efcient markets
Passive management = buying and holding a diversifed portolio without attemptng to identfy
mispriced securites.
Actve management = attemptng to identfy mispriced securites or to forecast broad market trends.
1.6 THE PLAYERS
Three major players in the fnancial markets:
1. Firms are net demanders of capital.
2. Households typically are suppliers of capital.
3. Governments can be borrowers or lenders, depending on the relatonship between tax revenue
and government expenditures.
Financiaa intermediaries
Financial intermediaries = insttutons that ‘connect’ borrowers and lenders by acceptng funds from
lenders and loaning funds to borrowers. They issue their own securites to raise funds to purchase
the securites of other corporatons.
,Intermediaries offer advantages. First, by pooling the resources of many small investors, they are
able to lend considerable sums to large borrowers. Second, by lending to many borrowers,
intermediaries achieve signifcant diversifcaton, so they can accept loans that individually might be
too risky. Third, intermediaries build expertse through the volume of business they do and can use
economies of scale and scope to assess and monitor risk.
Investment companies = frms managing funds for investors. An investment company may manage
several mutual funds. Here, the problem is that most household portolios are not large enough to be
spread among a wide variety of securites.
Investment bankers
Investment bankers = frms specializing in the sale of new securites to the public, typically by
underwritng the issue.
The investment banking frm handles the marketng of the security in the primary market, where new
issues of securites are offered to the public. Later, investors can trade previously issued securites
among themselves in the so-called secondary market.
Venture capitaa and private equity
Venture capital VC) = money invested to fnance a new frm.
Private equity = investments in companies that are not traded on a stock exchange.
1.7 THE FINANCIAL CRISIS OF 2008
Antecedents of the crisis
-
Channes in housinn fnance
Securitzaton = pooling loans into standardized securites backed by those loans, which can then be
traded like any other security.
Mortnane Derivatves
-
Credit defauat swaps
-
The rise of systematc risk
Systematc risk = risk of breakdown in the fnancial system, partcularly due to spillover effects from
one market into others.
The shoe drops
-
The dodd-frank reform act
-
1.8 OUTLINE OF THE TEXT
Financial markets:
Money markets
Short-term, marketable, liquid, low-risk debt securites.
Capital markets
Longer-term and riskier securites
1. Longer-term debt markets
2. Equity markets
3. Derivatve markets
, Chapter 2 – Asset classes and fnancial instruments
2.1 THE MONEY MARKET
Money market = include short-term, highly liquid, and relatvely low-risk debt instruments.
- Treasury bills = short-term government securites issued at a discount from face value and returning
the face amount at maturity.
The government raises money by selling bills to the public. Investors buy the bills at a discount from
the stated maturity value. At the bill’s maturity, the holder receives the face value of the bill from the
government. The difference between the purchase price and the ultmate maturity represent the
investor’s earnings.
T-bills are easily converted to cash and sold at low transacton cost and with little price risk.
- Certfcate of deposit CD) = a bank tme deposit.
The bank pays interest and principal to the depositor only at the end of the fxed term of the CD.
- Commercial paper = short-term unsecured debt issued by large corporatons.
- Bankers’ acceptance = an order to a bank by a customer to pay a sum of money at a future date.
- Eurodollars = dollar-denominated deposits at foreign banks or foreign branches of American banks.
- Repurchase agreements repos) = short-term sales of securites with an agreement to repurchase
the securites at a higher price.
- Brokers’ calls =
- Federal funds = funds in the accounts of commercial banks at the Federal Reserve Bank.
- LIBOR = lending rate among banks in the London market.
2.2 THE BOND MARKET
The bond market is composed of longer-term borrowing or debt instruments than those that trade in
the money market.
These instruments are sometmes said to comprise the fxed-income capitaa market.
- Treasury notes or bonds = debt obligatons of the federal government with original maturites of
one year or more.
- Infaton-protected treasury bonds: The principal amount on these bonds is adjusted in proporton
to increases in the Consumer Price Index. Therefore, they provide a constant stream of income in real
infaton-adjusted) dollars, and the real interest rates you earn on these securites are risk-free if you
hold them to maturity.
- Federal agency debt = government agencies who issue their own securites to fnance their
actvites.
- Internatonal bonds = frms who borrow abroad and investors buy bonds from foreign issuers.
- Municipal bonds = tax-exempt bonds issued by state and local governments. Investors pay neither
federal nor state taxes on the interest proceeds.
- General obligaton bonds
- Revenue bonds
- Industrial development bond
