CH 1 Investment Analysis

Chapter 1: The Investment Environment

Overview of Investments

• Learning Changes Everything: Understanding investments is crucial as they impact both the financial environment and the real economy.

• Investment Decision Criterion: I will invest if the expected return (E(R)) is greater than the cost.

Key Topics Covered

• Real assets vs. Financial assets.

• Risk-return trade-off and efficient pricing of financial assets.

• Role of financial institutions and key players.

• Insights from the financial crisis of 2008-2009.

• Systemic risk lessons.

Real Assets vs. Financial Assets

Real Assets

• Definition: Assets used to produce goods and services.

• Types: Can be tangible (e.g., buildings) or intangible (e.g., intellectual property).

• Characteristics: Have innate productive capacity.

• Examples: Land, machines.

Financial Assets

• Definition: Claims on income generated by real assets or claims on government income.

• Characteristics: Do not contribute directly to the economy's productive capacity.

• Examples: Stocks, bonds, derivatives.

• Value: Derives from ownership claims.

Types of Financial Assets

Categories of Financial Securities

• Fixed-income Securities: e.g., corporate bonds that promise fixed or formulaic income streams.

• Equity: Represents ownership in a firm (e.g., stocks).

• Derivative Securities: Payoffs linked to other financial variables (e.g., stock prices, interest rates).

Financial Markets Overview

Types of Financial Markets

• Currency (FX): Daily trading volume exceeds $6 trillion globally.

• Commodities: Includes goods like corn and natural gas; traded on exchanges like NY Mercantile Exchange and CBOT.

U.S. Households Balance Sheet (Table 1.1)

• Assets: Total $154,161 billion

  • Real estate: $37,558 billion

  • Financial assets: $109,562 billion

• Liabilities: Total $17,244 billion

  • Mortgages: $11,331 billion

• Net Worth: $136,917 billion

Domestic Net Worth (Table 1.2)

• Total Assets: $86,282 billion

  • Residential real estate: $45,816.3 billion

  • Commercial real estate: $20,842.9 billion

• Importance of monitoring changes in net worth for economic insights.

Financial Markets and the Economy

Informational Role of Financial Markets

• Transparency: Markets indicate desired resources.

• Consumption Timing: Timing has value.

• Risk Allocation: Markets allow for risk distribution.

• Agency Problems: Conflicts between managers and owners.

Mechanisms to Mitigate Agency Problems

• Compensation Plans: Align manager income with firm success.

• Monitoring: By boards, large investors, and analysts.

• Threat of Takeovers: Discourages poor performance.

Corporate Governance and Ethics

Historical Context

• Key accounting and auditing scandals (Enron, HealthSouth).

• Sarbanes-Oxley Act: 2002 legislation focused on governance reforms.

The Investment Process

Portfolio Management

• Definition: Collection of investment assets.

• Asset Allocation: Distribution among broad categories (stocks, bonds, etc.).

• Security Selection: Choosing specific securities within categories.

Analysis Approaches

• Top-Down Approach: Starts with macroeconomic factors, then narrows down to specific securities.

• Bottom-Up Approach: Focuses on individual securities regardless of asset allocation.

Competitive Markets

Characteristics of Financial Markets

• Highly competitive with inherent risks.

• Risk-Return Trade-off: Higher-risk assets typically yield higher returns.

• Efficiency: Market prices reflect available information; theoretical existence of no mispriced securities (Efficient Market Hypothesis).

Investment Players and Intermediaries

Key Participants in Financial Markets

1. Firms: Seek capital for investment.

2. Households: Provide capital through securities.

3. Governments: Can be borrowers or lenders.

Financial Intermediaries

• Examples: Investment companies, banks, insurance companies, credit unions

Investment Banks

• Specialize in bringing new securities to market.

• Differentiate between primary (new issues) and secondary (existing securities) markets.

Innovation in Finance

Fintech and Financial Innovation

• Fintech: Technology impacting financial markets.

• Peer-to-Peer Lending: Direct connections between lenders and borrowers.

• Robo-Advisors: Automated investment advice.

• Cryptocurrency: Digital currencies using blockchain technology.

The Financial Crisis of 2008

Crisis Origins

• Fed's response to the high-tech bubble resulted in lowered interest rates, creating a housing boom.

• Increased risk tolerance led to securitization of mortgages.

Changes in Housing Finance

• Old System: Local lenders providing mortgage loans.

• New System: Securitization, leading to intermediaries like Fannie Mae and Freddie Mac dominating the market.

Key Metrics and Calculations

• Mortgage Derivatives - CDOs: Consolidated risk by dividing payments into tranches.

• Misestimation of credit risk due to underestimating default probabilities.

Systemic Risk

• Analysis of fragility in the financial system, leading to a series of crises and government interventions (e.g., bailouts).

Regulatory Responses

Dodd-Frank Act

• Passed in 2010 to create stricter regulations in response to the financial crisis.

• Introduced stress tests and oversight for credit rating agencies for improved systemic risk management.

This compilation serves as a comprehensive resource for understanding the fundamentals and complexities of investment environments, financial markets, and systemic risks.