Investments: Background and Issues – Chapter 1 Notes

Investment objective: Reduce current consumption today for greater consumption later (intertemporal trade-off).
Real assets: Used to produce goods and services (e.g., property, human capital).
Financial assets: Claims on real assets or real-asset income.

Fixed-income (debt) securities:
- Money market instruments (short term): bank certificates of deposit, T-bills, commercial paper.
- Bonds (long term): government, municipal, corporate.
- Preferred stock.
Common stock (equity): Ownership stake in the entity, residual cash flow rights.
Derivative securities (options & futures): Contract value derives from an underlying market condition.

Informational role of financial markets: Market prices reflect expected future risky cash flows; can misallocate capital due to optimism.
Consumption Timing: Store wealth in financial assets to smooth consumption.
Risk Allocation: Investors choose desired risk level; principle of risk–return trade-off.
Separation of Ownership and Management: Principals (owners) and agents (managers) are separate. Mitigated by performance-based compensation, boards, threat of takeovers.
Corporate Governance and Corporate Ethics: Trust is essential. Failures are costly. Sarbanes-Oxley Act (2002) for stricter governance.

Asset Allocation: Primary determinant of portfolio return; percentage of funds in different asset classes.
Security Selection: Choosing specific securities within an asset class.
Security Analysis: Analysis of security value.
Top-Down investment strategies: Start with asset allocation.
Bottom-Up strategies: Start with attractive security selection.

Risk–Return Trade-Off: Higher expected returns come with higher risk (e.g., stocks vs. bonds).
- Average annual return (historical): stocks about 12 ext{%}; bonds under 6 ext{%}.
Diversification: Reduces risk.
Efficient Markets Hypothesis (EMH): Securities are neither underpriced nor overpriced on average; prices reflect all available information.

Active management: Assumes inefficient markets; seeks undervalued securities and market timing.
Passive management: Assumes efficient markets; avoids timing/selection; maintains a diversified portfolio (e.g., indexing).

Core groups: Business firms (net borrowers), Households (net savers), Governments.
Financial intermediaries: Connect borrowers and lenders (Commercial banks, Investment companies, Insurance companies, Pension funds, Hedge funds).
Investment Bankers: Specialize in primary market transactions (newly issued securities); typically underwrite issues.
Primary market: Newly issued securities offered to the public.
Secondary market: Preexisting securities traded among investors.
Venture Capital: Equity investment in young, high-potential firms (startups).
Private equity: Investments in non-exchange-traded firms, often for performance improvement and later sale.

Securitization: Bundles mortgage loans into tradable pools, creating liquidity.
Subprime loans: High loan-to-value ratios, lax underwriting, higher default risk.
Regulatory response: Dodd-Frank Wall Street Reform and Consumer Protection Act (2010): stricter rules for banks, increased transparency.
Volcker Rule (Section 619 of Dodd-Frank): Limited banks’ ability to trade for their own account.