Investments: Background and Issues

Chapter 1 Investments: Background and Issues

1.1 Real versus Financial Assets

  • Real Assets:

    • Definition: Assets used to produce goods and services.

    • Characteristics: Tangible in nature, can include real estate and equipment.

  • Financial Assets:

    • Definition: Claims on real assets or the income generated by them.

    • Characteristics: Intangible, represent ownership or creditor claims, such as stocks and bonds.

1.2 Key Financial Data of U.S. Households (2019)

  • Balance Sheet Overview (Table 1.1):

    • Total Assets: $124,694 Billion

    • Total Liabilities: $16,051 Billion

    • Net Worth: $108,643 Billion (87.1% of Total)

  • Breakdown of Assets (% of Total):

    • Real Assets: $35,799 Billion (28.7%)

    • Real estate: $29,551 Billion (23.7%)

    • Consumer durables: $5,590 Billion (4.5%)

    • Financial Assets: $88,895 Billion (71.3%)

    • Deposits and money market shares: $13,250 Billion

    • Corporate equity: $17,494 Billion

    • Pension reserves: $26,493 Billion

    • Total liabilities: $16,051 Billion

1.3 Financial Assets Must Equal Financial Liabilities

  • Key Principle: Financial assets and liabilities must balance allowed only in aggregated balance sheets.

  • Domestic Net Worth Calculation: Sum of real assets equals net worth.

1.4 Structure of Financial Assets

  • Types of Financial Assets:

    • Fixed-income (debt) securities:

    • Definition: Pay a specified cash flow over a specific period.

    • Characteristics: Typically lower risk, predictable returns.

    • Equity:

    • Definition: An ownership share in a corporation.

    • Characteristics: Higher risk, potential for higher returns.

    • Derivative securities:

    • Definition: Securities providing payoffs that depend on the values of other assets.

    • Characteristics: Used for hedging, speculation, or arbitrage.

1.5 Financial Markets and the Economy

1.5.1 Consumption Timing

  • Purpose of Securities:

    • Store wealth and transfer consumption to the future.

1.5.2 Informational Role of Financial Markets

  • Key Functions:

    • Capital flows to companies with the best prospects.

    • Market price mechanisms—are they fair values?

    • Examination of other mechanisms for capital allocation.

1.5.3 Risk-Return Trade-Off

  • Investor Choices:

    • Investors select desired risk level (e.g., bonds vs. stocks).

    • Examples: Bank certificates of deposit (CD) vs. company bonds.

1.5.4 Separation of Ownership and Management

  • Agency Problems: Emergence of agency problems due to separation of decision-makers from owners.

    • Mitigating Factors: Performance-based compensation, boards' authority to fire managers, and takeover threats.

1.5.5 Corporate Governance and Ethical Considerations

  • Trust in Markets: Trust is fundamental for business operations and market functionality.

    • Lack of trust results in costly regulations.

    • Governance failures can erode public support.

1.5.6 Historical Cases of Governance Failures

  • Accounting Scandals:

    • Included Enron, WorldCom, Rite-Aid, among others.

    • Impact of misleading research reports from firms like Citicorp and Merrill Lynch.

    • Role of auditors, questioning whether they act more as watchdogs or consultants.

    • Example: Arthur Andersen and Enron case.

1.5.7 Legislative Reforms

  • Sarbanes-Oxley Act (SOX):

    • Mandates: More independent directors, personal verification of financial statements by CFOs, and creation of oversight boards.

    • Purpose: To maintain high ethical standards within corporate practices.

1.6 The Investment Process: Asset Allocation

  • Asset Allocation:

    • Definition: Allocation of an investment portfolio across broad asset classes.

    • Importance: It is the primary determinant of a portfolio's return.

    • Strategic approaches: Top Down Investment Strategies.

1.7 The Investment Process: Security Selection

  • Security Selection:

    • Definition: Choice of particular securities within an asset class.

    • Strategic approaches: Bottom-Up Investment Strategies.

    • Security Analysis: Analyzing the value of securities to make informed investment decisions.

1.8 Competitive Nature of Financial Markets

1.8.1 Risk-Return Trade-Off

  • Higher expected returns correlate with higher risk.

    • Statistically, stock portfolios can lose money an average of 25%.

    • Bonds typically yield lower returns but present less risk—an average return under 6% and maximum loss not exceeding 13% in one year.

1.8.2 Measuring Risk

  • Queries regarding the measurement of risk and the role of diversification in mitigating risk.

1.8.3 Efficient Markets Hypothesis

  • Investment Management Strategies:

    • Passive Management: Involves buying and holding diversified portfolios without attempting to identify mispriced securities.

    • Active Management: Involves identifying mispriced securities or forecasting broad market trends to exploit market inefficiencies.

1.9 Market Players

1.9.1 Business Firms, Households, Governments

  • Business Firms: Typically net borrowers raising capital for investments.

  • Households: Function as net savers purchasing securities.

  • Governments: Can act as both borrowers and savers based on tax revenue and expenditures.

1.9.2 Financial Intermediaries

  • Roles of Intermediaries: Connect borrowers and lenders, including:

    • Commercial banks

    • Investment companies

    • Insurance companies

    • Pension funds

    • Hedge funds

1.9.3 Investment Bankers

  • Functions in Primary Market Transactions:

    • Facilitate the sale of newly issued securities to public.

    • Underwrite issues.

  • Secondary Market Functions:

    • Involves trading preexisting securities among investors.

1.9.4 Regulation Changes in Investment Banking

  • Separation of Functions (1933 - 1999): Investment banking and commercial banking separated legally.

  • Post-1999 Developments: Banks began increasing investment banking activities leading to reduced profit margins.

  • Crisis of 2008: Following the mortgage market collapse, many major investment banks went bankrupt or were reorganized.

1.9.5 Current Investment Banking Landscape

  • Investment banks may take on roles of commercial banks, accessing deposit funding and government assistance.

  • Stricter regulations apply to major banks now.

1.10 Financial Statements of Banks

1.10.1 Commercial Banks (2019)

  • Balance Sheet Overview (Table 1.3):

    • Total Assets: $18,090.1 Billion

    • Total liabilities detail different sources of funds like deposits and borrowed funds.

1.10.2 Nonfinancial U.S. Business (2019)

  • Balance Sheet Overview (Table 1.4):

    • Total Assets: $45,643 Billion

    • Detailed breakdown of assets and liabilities, highlighting importance in assessing financial health.

1.11 Venture Capital and Private Equity

  • Definitions:

    • Venture Capital: Equity investment aimed at financing new firms.

    • Private Equity: Investments in privately-held companies.

  • Fintech Innovations:

    • Example application includes cryptocurrencies and blockchain technology.

1.12 The Financial Crisis of 2008 to 2009

1.12.1 Changes in Housing Finance

  • Old Method:

    • Traditional institutions made mortgage loans to homeowners maintaining long-term portfolios.

  • New Method:

    • Securitization Process: Involves bundling loans into mortgage-backed securities.

    • Introduction of “Originate to Distribute”, changing how mortgages were funded and transferred.

1.12.2 Securitization and Its Effects

  • Details about Securitization: Pooling of loans into standard securities which can be traded, increasing market liquidity.

1.12.3 Issues Leading to Crisis

  • Rise of Nonconforming Loans:

    • Increased use of subprime loans with low/no documentation and high loan-to-value ratios.

1.12.4 Mortgage Derivatives and Risks

  • CDOs: Consolidated the default risk of loans into specific investor classes and structured payments into tranches.

  • Influence of Ratings Agencies: These were pressured to provide high ratings, contributing to market instability.

1.12.5 Credit Default Swaps (CDS)

  • Definition: Insurance contracts against borrower defaults; led to unsustainable risk levels.

  • Specific Example: AIG sold $400 billion in CDS contracts, exemplifying excessive risk exposure.

1.12.6 Systemic Risk Concerns

  • Definition: The potential for a breakdown in the financial system affecting multiple markets simultaneously.

    • Issues include high leverage among banks and illiquid assets.

1.12.7 Financial Crisis Events

  • Key Dates:

    • September 7, 2008: Fannie Mae and Freddie Mac were placed into conservatorship.

    • Lehman Brothers and Merrill Lynch faced bankruptcy risks.

    • September 17, 2008: Government assistance of $85 billion was provided to AIG.

1.12.8 Dodd-Frank Reform Act

  • Purpose: Imposed strict rules for capital, liquidity, risk management, and mandated transparency.

  • Volcker Rule: Specific regulations part of Dodd-Frank aimed at limiting banks' risk-taking.

1.13 Text Outline

  • Overview of the structure of the text includes various parts focusing on financial markets, securities, trading methods, modern portfolio theory, debt securities, equity security analysis, derivative markets, and active investment management strategies.