Investments Chapter 1 condensed

Investment

The current commitment of money or other resources in the expectation of reaping future profits.

Real Assets

Assets used to produce goods and services.

Financial Assets

Claims on real assets or the income generated by them; examples include stocks, bonds, and derivatives.

Real vs. Financial Assets

Real assets produce goods and services; financial assets are claims on real assets or their income.

Financial Assets = Financial Liabilities

Financial assets and liabilities balance; when all balance sheets are aggregated, only real assets remain.

Domestic Net Worth

The sum of real assets.

Securities

Investment contracts sold by corporations and governments to raise capital.

Fixed-Income (Debt) Securities

Securities that pay a specified cash flow over a specific period.

Equity

An ownership share in a corporation.

Derivative Securities

Securities whose payoffs depend on the values of other assets.

Informational Role of Financial Markets

Financial markets help direct capital toward companies with the best prospects.

Consumption Timing

Securities allow investors to store wealth and transfer consumption into the future.

Risk Allocation

Financial markets allow investors to choose their desired level of risk, such as bonds versus stocks.

Agency Problems

Problems caused by the separation of ownership and management when managers' interests may differ from owners' interests.

Ways to Reduce Agency Problems

Performance-based compensation, boards that can fire managers, and the threat of takeovers.

Stakeholder Capitalism

Firms recognize ethical and societal considerations beyond their private pursuit of profit.

ESG Investing

Considering environmental, social, and governance characteristics when making investment decisions.

Sarbanes-Oxley Act (SOX)

Corporate-governance reform requiring more independent directors, CFO verification of financial statements, audit oversight, and high ethical standards.

Asset Allocation

Allocation of an investment portfolio across broad asset classes; a primary determinant of portfolio return.

Asset Allocation Strategy

Top-down investment strategy that determines the percentage of a fund invested in different asset classes.

Security Selection

Choosing particular securities within an asset class; a bottom-up investment strategy.

Security Analysis

The valuation of specific securities.

Asset Allocation vs. Security Selection

Asset allocation chooses how much to invest across broad asset classes; security selection chooses individual securities within those classes.

Risk-Return Trade-Off

Higher expected returns are associated with higher risk.

Efficient Markets

Markets in which prices reflect available information.

Passive Management

Buying and holding a diversified portfolio without attempting to identify mispriced securities.

Index Funds

Funds associated with passive management that seek to track a market index.

Active Management

Attempting to identify mispriced securities or forecast broad market trends through market timing.

Passive vs. Active Management

Passive management buys and holds a diversified portfolio; active management attempts to find mispriced securities or forecast market trends.

Business Firms

Net borrowers that raise capital now to pay for investments.

Households

Net savers that purchase securities issued by firms.

Financial Intermediaries

Institutions connecting borrowers and savers, such as commercial banks, investment companies, insurance companies, pension funds, and hedge funds.

Investment Banks

Financial institutions specializing in primary-market transactions.

Primary Market

The market where newly issued securities are offered to the public; the issuing company receives cash less fees.

Secondary Market

The market where preexisting securities are traded among investors; the issuing company does not receive cash.

Primary vs. Secondary Market

Primary = new securities and money goes to the issuing company. Secondary = existing securities traded between investors and the company receives no cash.

Private Equity

Investments in privately held companies.

Venture Capital

Private equity used to finance new firms.

Fintech

The application of technology to financial markets.

Securitization

Buying/pooling mortgage loans and bundling them into standardized mortgage-backed securities that can be traded.

Originate to Hold

Old mortgage model in which a local thrift originates a mortgage and keeps it in its portfolio.

Originate to Distribute

New mortgage model in which mortgages are originated, sold, pooled, and distributed to investors through securities.

Mortgage-Backed Securities (MBS)

Tradable claims against an underlying pool of mortgages.

Major Changes Leading to the 2008–09 Crisis

Securitization, subprime loans, low/no-documentation loans, rising loan-to-value ratios, and adjustable-rate mortgages.

CDOs and CDSs

CDOs bundle mortgage loans and separate payments into tranches; CDSs are insurance contracts against borrower default.

Systemic Risk

The risk of a breakdown in the financial system where problems in one market spill over into others.

Dodd-Frank Reform Act

Post-crisis reform imposing stricter bank capital, liquidity, and risk-management rules, greater transparency, and regulatory changes; the Volcker Rule restricts proprietary trading by depository institutions.