Chapter 1 Essentials of Investments

FINC 325

Real Assets

Assets used to produce goods and services

• physical things

Examples of real assets

• buildings

• land

• equipment

• production materials

• Real estate

• consumer durables

• “other”

Financial Assets

Claims on real assets or the income generated by them

• non-physical

Examples of financial assets

• stocks

• bonds

• deposits and money market shares

• life insurance reserves

• pension reserves

• corporate equity

• equity in noncorporate business

• mutual fund shares

• debt securities

• “other”

Is cash a real or financial asset?

Technically can be both as it is a claim on wealth

• most likely would be under financial as you cannot physically make things with cash, but it does produce physical assets

Financial Liabilities

• must balance out with financial assets

• only real assets remain on the BS

• Mortgages

• consumer credit

• bank and other loans

• “other”

What does domestic net worth equal

sum of real assets

Fixed-income (debt) securities

pay a specified cash flow over a specific period

What is the main type of debt security?

bonds (

• has interest rates annually/biannually

• principal at the end

What is the risk that comes with debt securities (bonds)

Borrowers can still default (on interest payments)

• callable bonds: can be taken back

• less attractive due to factors

Equity

An ownership share in a corporation

What is the main type(s) of equity?

stocks

• shares of ownership

• preferred stock, common stock, retained earnings, Additional paid in capital (APIC), treasury stock

Derivative securities

securities providing payoffs that depend on the values of other assets

• contracts based on some other contracts

What are the types of derivative securities?

• futures

• options

consumption timing

the choice to use securities to store wealth or transfer consumption of wealth to the future

risk allocation

when investors select desired risk levels of investments (stocks V bonds, CD’s V company bond)

efficient market

market price = fair value?

meaning information is reflected in the investments price

stock market bubble

when stocks are overvalued and correction is needed so the stock market crashes causing people not to want to pay

free market characteristics

• complete competition

• reacts quickly to trades/ actions

• more volatility

When is it better to have a more controlled market?

when big events like a pandemic happened because this type of market will have slower reaction and fall less initially

• may be more stable

• disadvantage: cannot leave when you want

mitigating factors of agency problems with ownership and management

• having performance-based compensation: makes management board and owners (stockholders) have similar goals

• board of directors (stockholders) can fire managers

• threatening a takeover (changing management)

Sarbanes-Oxley Act (SOX)

the main act that made ethical standards requiring independent directors, CFO verification of financials, having an audit industry oversight board, and charge boards to maintain ethical standards

• auditors are on the side of investors

• they need to make sure companies are truthful (financial statements)]

• reduce conflict of interest

Asset allocation

allocation of an investment portfolio across broad asset classes

• is the primary determinant of a portfolios return

• is a percentage of funds in asset classes

• top down strategy: choose broader asset classes then security selection (exact type of stock)

security selection

the choice of particular securities within asset class

• is the bottom up investment strategies

security analysis

analysis of the value of securities

• analyzing initial companies

what type of management do you want with efficient markets?

passive management

• buying and holding a diversified portfolio

• no attemp to identify mispriced securities

• going with the market

active management

identifying mispriced securities and trying to get ahead of the market by forecasting broad market trends

business firms

raising capital to pay for investments

• are net borrowers

households

purchase securities issued by firms

• net savers

• individuals

Governments

Depends on the relationship between tax revenue and government expenditures

• can be both borrowers and savers

financial intermediaries

connectors of borrowers and lenders

commercial banks

places like U.S bank, Wells Fargo that allow customers to have checking’s, savings, and other accounts

• for-profit financial institutions that accept deposits, offer checking/savings accounts, and provide loans to individuals and businesses. They drive economic growth by intermediating funds, primarily making money through net interest income

• is a financial intermediary

investment companies

financial institutions—such as corporations, partnerships, or trusts—that pool money from investors to invest in securities like stocks, bonds, and real estate.

• hedge funds

• mutual funds

• other ways for many people to invest

• is a financial intermediary

insurance companies

• provides insurance with premiums and invests based on the money we give them

• is a financial intermediary

pension funds

retirement funds

• investment pools set up by employers, unions, or governments to provide retirement income, typically offering a steady stream of payments based on salary and service

• is a financial intermediary

Hedge funds

• investments that are risky, innovative, and require a large amount of funds

private investment pools for wealthy/institutional investors, using complex, less-regulated strategies

investment bankers

the people behind the IPO’s of a company

• they specialize in primary market transactions

• used to be independent until the 2008 crash (major investment banks went bankrupt or merged)

• separation of commercial banks and investment bankers laws (1933-1999)

• post 1999 large commercial banks increased investment banking activities

• investment banks may become commercial banks (deposit funding, access to gov’t assistance- major banks have stricter regulations)`

primary market

• newly issued securities offered to public

• investment bankers underwrites issue of new stock

• where new securities (stocks, bonds) are created and sold for the first time directly by companies or governments to investors, raising capital for the issuer, with common examples being an Initial Public Offering (IPO)

Secondary Market

when preexisting securities are traded among investors

• here investors buy and sell existing securities, like stocks and bonds, from each other, rather than from the original issuer, with major examples being the New York Stock Exchange (NYSE) and Nasdaq stock exchanges

Venture Capital

a form of private equity financing where investors (VC firms) provide capital to high-growth, early-stage startups with significant long-term potential in exchange for equity.

• equity investments to finance a new firm

• mainly work with private companies

Private Equity

an investment strategy involving capital invested in private companies or taking public companies private, aiming to grow the business for a profitable sale, often involving active management and a long-term, illiquid commitment from investors like pension funds and wealthy individuals.

• big investment firms that mainly work with private companies

• they use leverage and make big deals

• not as regulated

• investments in privately-held companies

Angel investors

a wealthy individual who provides capital to early-stage startups, often in exchange for equity or convertible debt, bridging the funding gap before venture capital, and frequently offering mentorship and industry expertise alongside their personal funds to high-risk, high-potential ventures. 

Fintech and financial innovation

• the application of technology to financial markets

• ex: crypto and blockchain tech

old way of house financing

•Local thrift institution made mortgage loans to homeowners

•Thrift’s possessed a portfolio of long-term mortgage loans

•Thrift’s main liability: Deposits

•“Originate to hold”

New way of house financing

Securitization: Fannie Mae and Freddie Mac bought mortgage loans, bundled them into large pools

Mortgage-backed securities are tradable claims against the underlying mortgage pool

“Originate to distribute”

Securitization

when mortgage lenders were incentivized to give out more mortgages regardless of the risk levels of clients

• the financial process of pooling illiquid assets, like mortgages, auto loans, or credit card debt, and repackaging them into tradable securities (like bonds) that are sold to investors, creating cash flow from the bundled assets' principal and interest payments, which transforms hard-to-sell loans into liquid investments

• allows lenders to offload risk and raise capital while providing investors with new income streams. 

• caused the housing market to crash

• allowed for outside lenders and real estate marketers to enter

• created asymmetry in the loans given out

adjustable rate mortgages

mortgage rates that increase or decrease following the financial market

• is risky and unpredictable

• how a lot of securitized loans were given out with this type of interest rates

Consolidated Default Risk of Loans (CDO’s)

• is a mortgage derivative

• worsened the 2008 housing market crash

• the grouping of mortgages to sell be put onto one class of investor, dividing payments into tranches (portions)

• rating agencies paid by issuers were pressured to give high ratings

Credit Default Swaps (CDS)

• insurance contracts against the default of borrowers

• issuers ramped up risk to unsupportable levels

• worsened the 2008 housing market crash

• financial derivative acting like insurance, where a buyer makes periodic payments to a seller in exchange for protection against a borrower's default on a debt (like a bond or loan). The seller pays the buyer a lump sum if a "credit event" (default, bankruptcy) occurs, allowing investors to hedge risk or speculate on creditworthiness

• basically would give out too many mortgages even if they would default, but they couldn’t compensate all the people who defaulted

Systemic risk

risk of breakdown in financial system; only a part of a system is affected, but leeches into other areas

• spillover effects from one market into another

• banks are highly leveraged meaning assets are less liquid

• formal exchange trading replaced by other the counter markets - no margin for insolvency protection

systematic risk

A risk that affects everyone all at once

• also known as market risk or undiversifiable risk, is the inherent risk affecting the entire market or broad segments due to macroeconomic factors like inflation, recessions, interest rate changes, or geopolitical events, impacting all investments, and is unremovable through diversification

The Shoe Drops (Financial Crisis 2008 continued)

•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

the government intervenes and takes over a lot of companies and money markets making it safe and liquid

Dodd-Frank Reform Act

•The response to the 2008 crash by reforming

• Stricter rules for bank capital, liquidity, risk management

• Mandated increased transparency

• Clarified regulatory system

• Volcker Rule: restricts U.S. banks from engaging in proprietary trading (trading for their own profit with their own money) and from owning or sponsoring hedge funds or private equity funds, aiming to prevent risky speculation using taxpayer-insured deposits, though exemptions exist for activities like market making and underwriting, with later modifications simplifying compliance and excluding smaller community banks. 

The London Interbank Offered Rate (LIBOR)

a widely used benchmark interest rate for global financial contracts, essentially representing the cost of banks borrowing from one another. Due to scandals and lack of supporting transactions

• bank that lends and owes money

Treasury Bills (T-bill)

short-term, low-risk, taxable securities with maturities from 4 to 52 weeks, purchased at a discount and redeemed at face value

• risk is virtually 0

• risk free rate and minimum of investment return

TED spread

The difference between the LIBOR risk and the T-Bill risk premium

• market perceived risk levels

• signals a crisis or risk by jumping up a lot right before the crisis