Chapter 1 The Investment Environment

essential nature of investment (transfer money forward)

reduced current consumption, planned later consumption

real assets

tangible assets used to produce goods and services, PP&E is an example, draw value from substances or properties

TVM money can be

transferred forward or backward

loan is transferring money

backward

definition of investment

if one has more than enough cash to meet their basic needs in the current time one might shift consumption through time by investing the surplus

financial assets

claims on real assets, such as common stock, preferred stock, bonds, and derivatives, they are liquid assets that get their value from a contractual right or ownership claim

is cash a real or financial asset?

a financial asset, They may seem intangible with only the stated value on a piece of paper, such as a dollar bill or a listing on a computer screen. What that paper or listing represents, though, is a claim of ownership of an entity, like a public company, or contractual rights to payments—say, the interest income from a bond, cash has value because it can be exchanged for goods and services

real assets are physical, drawing value from

substances or properties like precious metals, land, real estate, and commodities like soybeans, wheat, and oil

type of financial assets common stock

class A voting rights, class B no voting rights and pays dividends

types of financial assets

preferred stock or other equity, such as REITs, ETFs, stock mutual funds

financial assets fixed income or debt short-term

money market instruments, bank certificates of deposit (CD), T-bills, etc.

financial assets fixed income or debt long-term

capital market instruments, bonds, notes, etc.

financial assets derivative securities

options, futures, forward, swaps, etc.

weak-form market efficiency

efficient market (price reflects historical public information), least efficient market, price only reflects news after awhile

semi-strong form market efficiency

efficient market (price reflects both historical and contemporaneous public information), price going up is reflected right away for example, this is the form that describes the U.S. market. Insider trading is proof we are still in this form, still insider information

strong-form market efficiency

efficient market (price reflects all information: public and private), considered unrealistic because price reflects public and private, this form is just a hypothesis

passive management

portfolio manager believes market is fully semi-strong efficient

passive management

securities are fairly priced, so no undervalued or overvalued securities

passive management

no attempt to find undervalued securities

passive management

no attempt to time the market

passive management

holding a highly diversified portfolio

passive management

across types, countries, sectors, styles

active management

finding mispriced securities (alpha strategy, means want to have higher than market performance)

active management

timing the market

active management

holding a less diversified portfolio

active management

focus on one or more specific assets

active management

short securities - not mutual funds, hedge funds do

active management

active manage ETF funds

active management

buy undervalued security

active management

believe less efficient or inefficient market

ultimate lenders in the financial system

households, they typically earn more income than they spend on immediate needs, so they save and invest their surplus funds. By depositing money in banks, buying bonds, or investing in stocks, they are essentially lending/supplying funds to the financial system.

borrowers in the financial system

businesses and governments, they need more capital than they have on hand to finance:

• Businesses → fund operations, expansion, and investments

• Governments → finance public spending and budget deficits

They borrow by issuing stocks, bonds, and other securities, which are purchased by households (the ultimate lenders) — completing the flow of funds through the financial system

1st step in investment process

security availability, identify securities available to you: safe asset classes: T-bills,
CDs, etc. risky asset classes: stocks, corporate commercial
papers, corporate bonds, etc., higher SD means more risky security

2nd step in investment process

asset allocation (risk preference), balance between safe securities and the optimal risky portfolio, 70/30 split for younger people, senior less in risky assets, more cash

3rd step in investment process

security selection (form an optimal risky portfolio), choice of which securities to hold within each risky asset class to construct the optimal risky portfolio, use formula to calculate

4th step in investment process

post performance analysis, ex post analysis on past performance, such as Sharpe ratio,
Jensen’s alpha, etc., what you use depends on market, should be able to beat the market, step shows whether strategy works or not

5th step in investment process

risk management, rebalance portfolio based on new information. May use financial
derivatives to hedge potential risks