Introduction
An investment is the current commitment of money or other resources in the expectation of reaping
future benefits.
1.1 Real assets versus financial assets
The material wealth of a society is ultimately determined by the productive capacity of its economy, that
is, the goods and services its members can create. This capacity is a function of the real assets of the
economy: the land, buildings, equipment, and knowledge that can be used to produce goods and
services. Financial assets are claims on real assets or the income generated by them. National wealth
consists of structures, equipment, inventories of goods, and land. We will focus almost exclusively on
financial assets, but you shouldn’t lose sight of the fact that the successes or failures of the financial
assets we choose to purchase ultimately depend on the performance of the underlying real assets.
1.2 Financial assets
Three broad types of financial assets: debt, equity, and derivatives. Fixed-income or debt securities
promise either a fixed stream of income or a stream of income that is determined according to a
specified formula. Floating-rate bonds promise payments that depend on current interest rates.
Debt securities come in a tremendous variety of maturities and payment provisions. At one extreme,
money market refers to fixed-income securities that are short-term, highly marketable, and generally of
low risk. The fixed-income capital market includes long-term securities, these range from very safe in
terms of default risk to relatively risky. They are also designed with diverse provisions regarding
payments provided to the investor and protection against the bankruptcy of the issuer.
Common stock, or equity, in a firm represents an ownership share in the corporation. They aren’t
promised any payment. The performance of equity investments is tied directly to the success of the firm
and its real assets. For this reason, equity investments tend to be riskier than investments in debt
securities.
Derivative securities provide payoffs that are determined by the prices of other assets such as bond or
stock prices. They are so named because their value derive from the prices of other assets. One of the
uses is to hedge risks or transfer them to other parties. They can also be used to take highly speculative
positions.
Investors and corporations regularly encounter other financial markets as well(currency trading).
Investors may also invest directly in real assets.
1.3 Financial markets and the economy
Financial assets and the markets in which they trade play several crucial roles in developed economies.
They allow us to make the most of the economy’s real assets.
The informational role of financial markets
Stock prices reflect investors’ collective assessment of a firm’s current performance and future
prospects. Stock prices play a major role in the allocation of capital in market economies, directing
capital to the firms and applications with the greatest perceived potential.
Capital market not always channel resources to the most efficient use. Companies can be hot for a
period of time, attract a lot of investors, but fail after a few years.
,Consumption timing
Some people earn more than they spend. One way to store your money is by investing it in financial
assets.
Allocation of risk
Financial markets and the diverse financial 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. Firms can also profit from it, because investors would choose security types that fit
with their amount of risk, resulting in each security is sold for the best price.
Separation of ownership and management
It is impossible for large organization to be run by a single person. Result is selling stock. The
stockholders elect a board of directors that in turn hires and supervises the management of the firm.
Owners and management of the firm are different parties. This gives the firm a stability that the owner-
managed firm can’t achieve. Investors can sell shares without effect on the management. How can all
disparate owners of the firm agree on objectives of the firm? Financial markets can provide some
guidance. All may agree that the firm’s management should pursue strategies that enhance the value of
their shares. But do managers really attempt to maximize firm value? Potential conflicts of interest are
called agency problems, because managers(agents) may pursue not at the interest of
shareholders(principal). Several mechanisms have evolved to mitigate these problems:
(1)Compensation plans tie the income of managers to the success of the firm. Payout in stock options,
which means that the managers will not do well unless the stock price increases. But they can misuse by
prop up a stock price temporarily, giving them a chance to cash out before the price returns normally.
(2)Boards of directors can force out management teams that are underperforming.
(3)Outsiders monitor the firm closely and make the life of poor performers at least uncomfortable.
(4)Bad performers are subject to the threat of takeover. If the board of directors is lax in monitoring
management, unhappy shareholders can elect a different board by launching a proxy contest in which
they seek to obtain enough proxies(i.e. right to vote the shares of shareholders) to take control of the
firm and vote in another board. Disadvantage is that shareholders should use own funds, while
management can defend itself using corporate coffers.
Corporate governance and corporate ethics
Markets need to be transparent for investors to make informed decisions. Firms can mislead the public
about their prospects. In 2002, in response to the spate of ethics scandals, Congress passed the
Sarbanes-Oxley Act to tighten the rules of corporate governance.
1.4 The investment process
An investor’s portfolio is simply his collection of investment assets. Investment assets can be categorized
into broad asset classes, such as stocks, bonds, real estate, commodities, and so on. Investors make two
types of decisions in constructing their portfolios:
(1)Asset allocation. Which is the choice among these broad asset classes.
(2)Security selection. The choice of which particular securities to hold within each asset class.
Top down portfolio construction starts with asset allocation, before turning to the decision of the
particular securities to be held in each asset class.
,Security analysis involves the valuation of particular securities that might be included in the portfolio.
Valuation is far more difficult for stocks than for bonds because a stock’s performance usually is far more
sensitive to the condition of the issuing firm.
Bottom-up strategy means that the portfolio is constructed from the securities that seem attractively
priced without as much concern for the resultant asset allocation. It can result in unintended bets on one
or another sector of the economy.
1.5 Financial markets are competitive
The competition means that we should expect to find few, if any, “free lunches”, securities that are so
underpriced that they represent obvious bargains. There are several implications of this:
The risk-return trade-off
Actual or realized return will almost always deviate from the expected return anticipated at the start of
the investment period. If all else could be equal, investors would prefer investments with the highest
expected return. However, the no-free lunch rule tells us that all else can’t be held equal. If you want
higher expected returns, you will have to pay a price in terms of accepting higher investment risk. If
higher expected return can be achieved without bearing extra risk, there will be a rush to buy the high-
return assets, with the result that their prices will be driven up. The price will continue to rise until its
expected return is no more than commensurate with risk.
Diversification means that many assets are held in the portfolio so that the exposure to any particular
asset is limited.
Efficient markets
We should rarely expect to find bargains in the security market. The hypothesis that exists about
financial markets is that they process all available information about securities quickly and efficiently,
that is, the security price usually reflects all the information available to investors concerning the value
of the security. One implication of this hypothesis concerns the choice between active and passive
investment-management strategies. Passive management calls for holding highly diversified portfolios
without spending effort or other resources attempting to improve investment performance through
security analysis. Active management is the attempt to improve performance either by identifying
mispriced securities or by timing the performance of broad asset classes. If markets reflect all relevant
information, it is better to follow passive strategies. A motivation for active management is the term
near-efficiency, because even in high competitive markets efficiency is not completely achieved.
1.6 The players
Three major players in the financial markets:
(1)Firms are net demanders of capital. They raise capital to pay for investments, and they generate
income by those real assets, which will provide returns to investors who purchase their securities.
(2)Households typically are suppliers of capital. They purchase the securities issued by firms that need to
raise funds.
(3)Governments can be borrowers or lenders, depending on the relationship between tax revenue and
government expenditures.
About half of all stock is held by large financial institutions, which stand between the security issuer(the
firm) and the ultimate owner of the security(individual investor). They are called financial intermediaries.
,Corporations don’t directly market their securities to the public. They hire agents to represent them to
the investing public, called investment bankers.
Financial intermediaries
Are institutions that “connect” borrowers and lenders by accepting funds from lenders and loaning funds
to borrowers. They bring together the suppliers of capital(investors) with the demanders of
capital(primarily corporations). They raise their own securities to raise funds to purchase the securities of
other corporations. Financial intermediaries are distinguished from other businesses in that both their
assets and their liabilities are overwhelmingly financial. The primary social function of them is to channel
household savings to the business sector. They offer advantages in their role:
(1)By pooling resources of many small investors, they are able to lend considerable sums to large
borrowers.
(2)By lending to many borrowers, intermediaries achieve significant diversification, so they can accept
loans that individually might be too risky.
(3)Intermediaries build expertise through the volume of business they do and can use economies of scale
and scope to assess and monitor risk.
Investment companies manage funds for investors. They may manage several mutual funds. It is very
expensive for households in terms of brokerage fees and research costs to purchase one or two shares of
many different forms. Mutual funds have the advantage of large scale trading an portfolio management.
Investment companies also can design portfolios specifically for large investors with particular goals.
Hedge funds also pool and invest the money of many clients, but they are only open to institutional
investors. They are more likely to pursue complex and higher-risk strategies. They typically keep a
portion of trading profits as part of their fees, while mutual funds charge a fixed percentage of assets
under management. Also they could play the role of information provider, because investors with small
portfolios find it not economical to personally gather information.
Investment bankers
Are firms that specialize in the sale of new securities to the public, typically by underwriting the issue.
They advise an issuing corporation on the prices it can charge for the securities, appropriate interest
rates, and so forth. The investment banking firm handles the marketing of the security in the primary
market, where new issues of securities are offered to the public. Banks are here underwriters. Later,
investors can trade previously issued securities among themselves in the secondary market.
Venture capital and private equity
Start-up companies rely on bank loans and investors who are willing to invest in them in return for an
ownership stake. The equity investment in these companies is called venture capital(VC). Sources of
venture capital are dedicated venture capital funds, wealthy individuals known as angel investors, and
institutions. Private equity are investments in companies that are not traded on a stock exchange.
, 1.7 The financial crisis of 2008
Antecedents of the crisis
Between 2002-2002 the collapse of the high-tech bubble appeared. The Federal Reserve responded to
an emerging recessions by aggressively reducing interest rates. Treasury bill rates dropped drastically,
and the LIBOR rate, which is the interest rate at which major money-center banks lend to each other, fall
in tandem. These actions appeared to be successful, and the recession was short-lived and mild. The
combination of reduced interest rates and a stable economy fed a historic boom in the housing market.
But confidence in the power of macroeconomic policy to reduce risk, the impressive recovery of the
economy from the high-tech implosion, and particularly the housing price boom may have sown the
seeds for the debacle that played out in 2008. On one hand, the reducing interest rates had resulted in
low yields on a wide variety of investments, and investors were hungry for higher-yielding alternatives.
On the other hand, low volatility and growing complacency about risk encouraged greater tolerance for
risk in the search for these higher-yielding investments. The U.S. housing and mortgage finance markets
were at the center of a gathering storm.
Changes in housing finance
In 1970s most mortgage loans would come from a local lender such as a neighborhood savings bank or
credit union. A homeowner would borrow funds over a long period(commonly 30 years). This landscape
began to change in the 1970s when Fannie Mae and Freddie Mac began buying large quantities of
mortgage loans from originators and bundling them into pools that could be traded like any other
financial asset. These pools, which were essentially claims on the underlying mortgages, were soon
dubbed "mortgage-backed securities”, and the process was called securitization. Read example page 19.
While conforming loans were pooled almost entirely through Freddie Mac and Fannie Mae, once the
securitization model took hold, it created an opening for a new product: securitization by private firms of
nonconforming “subprime” loans with higher default risk. One important difference between the
government-agency pass-throughs and these so-called private-label pass-throughs was that the investor
in the private-label pool would bear the risk that homeowners might default on their loans. Thus,
originating mortgage brokers had little incentive to perform due diligence on the loan as long as the
loans could be sold to an investor. These investors had no direct contact with the borrowers and could
not perform detailed underwriting concerning loan quality. Instead, they relied on borrowers’ credit
scores which steadily came to replace conventional underwriting. The majority of subprime borrowers
purchased houses by borrowing the entire purchase price. When housing prices began falling, these
highly leveraged loans were quickly “underwater,” meaning that the house was worth less than the loan
balance, and many homeowners decided to “walk away” or abandon their home – and their loans.
Adjustable rate mortgages(ARMs) became quickly the standard in the subprime market. These loans
offered borrowers low initial or “teaser” interest rates, but these rates eventually would reset to current
market interest yields. As soon as the loan rate was reset, their monthly payments rose.
Despite the increase in house prices, a widespread belief existed that continually rising home prices
would bail out poorly performing loans. But in 2004, the ability of refinancing to save a loan began to
diminish: (1)Higher interest rates put payment pressure on homeowners who had taken out adjustable
rate mortgages, (2)Housing prices peaked by 2006, so homeowners’ ability to refinance a loan using
built-up equity in the house declined.
An investment is the current commitment of money or other resources in the expectation of reaping
future benefits.
1.1 Real assets versus financial assets
The material wealth of a society is ultimately determined by the productive capacity of its economy, that
is, the goods and services its members can create. This capacity is a function of the real assets of the
economy: the land, buildings, equipment, and knowledge that can be used to produce goods and
services. Financial assets are claims on real assets or the income generated by them. National wealth
consists of structures, equipment, inventories of goods, and land. We will focus almost exclusively on
financial assets, but you shouldn’t lose sight of the fact that the successes or failures of the financial
assets we choose to purchase ultimately depend on the performance of the underlying real assets.
1.2 Financial assets
Three broad types of financial assets: debt, equity, and derivatives. Fixed-income or debt securities
promise either a fixed stream of income or a stream of income that is determined according to a
specified formula. Floating-rate bonds promise payments that depend on current interest rates.
Debt securities come in a tremendous variety of maturities and payment provisions. At one extreme,
money market refers to fixed-income securities that are short-term, highly marketable, and generally of
low risk. The fixed-income capital market includes long-term securities, these range from very safe in
terms of default risk to relatively risky. They are also designed with diverse provisions regarding
payments provided to the investor and protection against the bankruptcy of the issuer.
Common stock, or equity, in a firm represents an ownership share in the corporation. They aren’t
promised any payment. The performance of equity investments is tied directly to the success of the firm
and its real assets. For this reason, equity investments tend to be riskier than investments in debt
securities.
Derivative securities provide payoffs that are determined by the prices of other assets such as bond or
stock prices. They are so named because their value derive from the prices of other assets. One of the
uses is to hedge risks or transfer them to other parties. They can also be used to take highly speculative
positions.
Investors and corporations regularly encounter other financial markets as well(currency trading).
Investors may also invest directly in real assets.
1.3 Financial markets and the economy
Financial assets and the markets in which they trade play several crucial roles in developed economies.
They allow us to make the most of the economy’s real assets.
The informational role of financial markets
Stock prices reflect investors’ collective assessment of a firm’s current performance and future
prospects. Stock prices play a major role in the allocation of capital in market economies, directing
capital to the firms and applications with the greatest perceived potential.
Capital market not always channel resources to the most efficient use. Companies can be hot for a
period of time, attract a lot of investors, but fail after a few years.
,Consumption timing
Some people earn more than they spend. One way to store your money is by investing it in financial
assets.
Allocation of risk
Financial markets and the diverse financial 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. Firms can also profit from it, because investors would choose security types that fit
with their amount of risk, resulting in each security is sold for the best price.
Separation of ownership and management
It is impossible for large organization to be run by a single person. Result is selling stock. The
stockholders elect a board of directors that in turn hires and supervises the management of the firm.
Owners and management of the firm are different parties. This gives the firm a stability that the owner-
managed firm can’t achieve. Investors can sell shares without effect on the management. How can all
disparate owners of the firm agree on objectives of the firm? Financial markets can provide some
guidance. All may agree that the firm’s management should pursue strategies that enhance the value of
their shares. But do managers really attempt to maximize firm value? Potential conflicts of interest are
called agency problems, because managers(agents) may pursue not at the interest of
shareholders(principal). Several mechanisms have evolved to mitigate these problems:
(1)Compensation plans tie the income of managers to the success of the firm. Payout in stock options,
which means that the managers will not do well unless the stock price increases. But they can misuse by
prop up a stock price temporarily, giving them a chance to cash out before the price returns normally.
(2)Boards of directors can force out management teams that are underperforming.
(3)Outsiders monitor the firm closely and make the life of poor performers at least uncomfortable.
(4)Bad performers are subject to the threat of takeover. If the board of directors is lax in monitoring
management, unhappy shareholders can elect a different board by launching a proxy contest in which
they seek to obtain enough proxies(i.e. right to vote the shares of shareholders) to take control of the
firm and vote in another board. Disadvantage is that shareholders should use own funds, while
management can defend itself using corporate coffers.
Corporate governance and corporate ethics
Markets need to be transparent for investors to make informed decisions. Firms can mislead the public
about their prospects. In 2002, in response to the spate of ethics scandals, Congress passed the
Sarbanes-Oxley Act to tighten the rules of corporate governance.
1.4 The investment process
An investor’s portfolio is simply his collection of investment assets. Investment assets can be categorized
into broad asset classes, such as stocks, bonds, real estate, commodities, and so on. Investors make two
types of decisions in constructing their portfolios:
(1)Asset allocation. Which is the choice among these broad asset classes.
(2)Security selection. The choice of which particular securities to hold within each asset class.
Top down portfolio construction starts with asset allocation, before turning to the decision of the
particular securities to be held in each asset class.
,Security analysis involves the valuation of particular securities that might be included in the portfolio.
Valuation is far more difficult for stocks than for bonds because a stock’s performance usually is far more
sensitive to the condition of the issuing firm.
Bottom-up strategy means that the portfolio is constructed from the securities that seem attractively
priced without as much concern for the resultant asset allocation. It can result in unintended bets on one
or another sector of the economy.
1.5 Financial markets are competitive
The competition means that we should expect to find few, if any, “free lunches”, securities that are so
underpriced that they represent obvious bargains. There are several implications of this:
The risk-return trade-off
Actual or realized return will almost always deviate from the expected return anticipated at the start of
the investment period. If all else could be equal, investors would prefer investments with the highest
expected return. However, the no-free lunch rule tells us that all else can’t be held equal. If you want
higher expected returns, you will have to pay a price in terms of accepting higher investment risk. If
higher expected return can be achieved without bearing extra risk, there will be a rush to buy the high-
return assets, with the result that their prices will be driven up. The price will continue to rise until its
expected return is no more than commensurate with risk.
Diversification means that many assets are held in the portfolio so that the exposure to any particular
asset is limited.
Efficient markets
We should rarely expect to find bargains in the security market. The hypothesis that exists about
financial markets is that they process all available information about securities quickly and efficiently,
that is, the security price usually reflects all the information available to investors concerning the value
of the security. One implication of this hypothesis concerns the choice between active and passive
investment-management strategies. Passive management calls for holding highly diversified portfolios
without spending effort or other resources attempting to improve investment performance through
security analysis. Active management is the attempt to improve performance either by identifying
mispriced securities or by timing the performance of broad asset classes. If markets reflect all relevant
information, it is better to follow passive strategies. A motivation for active management is the term
near-efficiency, because even in high competitive markets efficiency is not completely achieved.
1.6 The players
Three major players in the financial markets:
(1)Firms are net demanders of capital. They raise capital to pay for investments, and they generate
income by those real assets, which will provide returns to investors who purchase their securities.
(2)Households typically are suppliers of capital. They purchase the securities issued by firms that need to
raise funds.
(3)Governments can be borrowers or lenders, depending on the relationship between tax revenue and
government expenditures.
About half of all stock is held by large financial institutions, which stand between the security issuer(the
firm) and the ultimate owner of the security(individual investor). They are called financial intermediaries.
,Corporations don’t directly market their securities to the public. They hire agents to represent them to
the investing public, called investment bankers.
Financial intermediaries
Are institutions that “connect” borrowers and lenders by accepting funds from lenders and loaning funds
to borrowers. They bring together the suppliers of capital(investors) with the demanders of
capital(primarily corporations). They raise their own securities to raise funds to purchase the securities of
other corporations. Financial intermediaries are distinguished from other businesses in that both their
assets and their liabilities are overwhelmingly financial. The primary social function of them is to channel
household savings to the business sector. They offer advantages in their role:
(1)By pooling resources of many small investors, they are able to lend considerable sums to large
borrowers.
(2)By lending to many borrowers, intermediaries achieve significant diversification, so they can accept
loans that individually might be too risky.
(3)Intermediaries build expertise through the volume of business they do and can use economies of scale
and scope to assess and monitor risk.
Investment companies manage funds for investors. They may manage several mutual funds. It is very
expensive for households in terms of brokerage fees and research costs to purchase one or two shares of
many different forms. Mutual funds have the advantage of large scale trading an portfolio management.
Investment companies also can design portfolios specifically for large investors with particular goals.
Hedge funds also pool and invest the money of many clients, but they are only open to institutional
investors. They are more likely to pursue complex and higher-risk strategies. They typically keep a
portion of trading profits as part of their fees, while mutual funds charge a fixed percentage of assets
under management. Also they could play the role of information provider, because investors with small
portfolios find it not economical to personally gather information.
Investment bankers
Are firms that specialize in the sale of new securities to the public, typically by underwriting the issue.
They advise an issuing corporation on the prices it can charge for the securities, appropriate interest
rates, and so forth. The investment banking firm handles the marketing of the security in the primary
market, where new issues of securities are offered to the public. Banks are here underwriters. Later,
investors can trade previously issued securities among themselves in the secondary market.
Venture capital and private equity
Start-up companies rely on bank loans and investors who are willing to invest in them in return for an
ownership stake. The equity investment in these companies is called venture capital(VC). Sources of
venture capital are dedicated venture capital funds, wealthy individuals known as angel investors, and
institutions. Private equity are investments in companies that are not traded on a stock exchange.
, 1.7 The financial crisis of 2008
Antecedents of the crisis
Between 2002-2002 the collapse of the high-tech bubble appeared. The Federal Reserve responded to
an emerging recessions by aggressively reducing interest rates. Treasury bill rates dropped drastically,
and the LIBOR rate, which is the interest rate at which major money-center banks lend to each other, fall
in tandem. These actions appeared to be successful, and the recession was short-lived and mild. The
combination of reduced interest rates and a stable economy fed a historic boom in the housing market.
But confidence in the power of macroeconomic policy to reduce risk, the impressive recovery of the
economy from the high-tech implosion, and particularly the housing price boom may have sown the
seeds for the debacle that played out in 2008. On one hand, the reducing interest rates had resulted in
low yields on a wide variety of investments, and investors were hungry for higher-yielding alternatives.
On the other hand, low volatility and growing complacency about risk encouraged greater tolerance for
risk in the search for these higher-yielding investments. The U.S. housing and mortgage finance markets
were at the center of a gathering storm.
Changes in housing finance
In 1970s most mortgage loans would come from a local lender such as a neighborhood savings bank or
credit union. A homeowner would borrow funds over a long period(commonly 30 years). This landscape
began to change in the 1970s when Fannie Mae and Freddie Mac began buying large quantities of
mortgage loans from originators and bundling them into pools that could be traded like any other
financial asset. These pools, which were essentially claims on the underlying mortgages, were soon
dubbed "mortgage-backed securities”, and the process was called securitization. Read example page 19.
While conforming loans were pooled almost entirely through Freddie Mac and Fannie Mae, once the
securitization model took hold, it created an opening for a new product: securitization by private firms of
nonconforming “subprime” loans with higher default risk. One important difference between the
government-agency pass-throughs and these so-called private-label pass-throughs was that the investor
in the private-label pool would bear the risk that homeowners might default on their loans. Thus,
originating mortgage brokers had little incentive to perform due diligence on the loan as long as the
loans could be sold to an investor. These investors had no direct contact with the borrowers and could
not perform detailed underwriting concerning loan quality. Instead, they relied on borrowers’ credit
scores which steadily came to replace conventional underwriting. The majority of subprime borrowers
purchased houses by borrowing the entire purchase price. When housing prices began falling, these
highly leveraged loans were quickly “underwater,” meaning that the house was worth less than the loan
balance, and many homeowners decided to “walk away” or abandon their home – and their loans.
Adjustable rate mortgages(ARMs) became quickly the standard in the subprime market. These loans
offered borrowers low initial or “teaser” interest rates, but these rates eventually would reset to current
market interest yields. As soon as the loan rate was reset, their monthly payments rose.
Despite the increase in house prices, a widespread belief existed that continually rising home prices
would bail out poorly performing loans. But in 2004, the ability of refinancing to save a loan began to
diminish: (1)Higher interest rates put payment pressure on homeowners who had taken out adjustable
rate mortgages, (2)Housing prices peaked by 2006, so homeowners’ ability to refinance a loan using
built-up equity in the house declined.
