Investments:

Background and Issues

Bodie, Kane, and Marcus

Essentials of Investments,
1
9th Edition

McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapters Overview
The first part of the text builds the foundational groundwork for the investment
process with easy to access chapters on asset classes, financial instruments,
securities markets, trading mechanisms and investment vehicles such as
mutual funds.

Chapter 1: Investments: Background and Issues – Basic overview of the

investment landscape. Includes sections on securitization, the rise of fintech,
the roots of the financial crisis, and the fallout from the crisis.

Chapter 2: Asset Classes and Financial Instruments – Presents the major

asset classes and the financial instruments within each class.

Chapter 3: How Securities Trade: Introduces the types of markets, basic

security trading (limit orders and market orders), as well as buying on margin
and short sales. Extensive coverage of the rise of electronic markets,
algorithmic and high-speed trading, and changes in market structure.

1-2
Chapters Overview
This part contains the core of modern portfolio theory, including its foundations
in economics and mathematics.

Chapter 5: Risk, Return, and the Historical Record – Provides students with
basic performance methodology, including holding period return and dollar-
weighted returns as well as some more advanced topics like Value At Risk.

Chapter 6: Efficient Diversification – Calculates mean, variance and

covariances and demonstrates their role in calculating the optimal risky
portfolio. It also introduces us to the index model.

Chapter 7: Capital Asset Pricing and Arbitrage Pricing Theory – Presents the
Capital Asset Pricing Model, its critiques, and other competing models on
security behavior.

1-3
1.1 What is an investment? By Investopedia

An investment is an asset or item acquired to generate income

or gain appreciation. Appreciation is the increase in the value of

an asset over time. It requires the outlay of a resource today, like

time, effort, and money for a greater payoff in the future,

generating a profit.

1-4
1.1 Real versus Financial Assets
• Nature of Investment
• Reduce current consumption for greater future
consumption
• Real Assets
• Used to produce goods and services: Property,
plants and equipment, human capital, etc.
• Financial Assets
• Claims on real assets or claims on real-asset
income
1-5
Table 1.1 Balance Sheet, U.S. Households, 2011

Liabilities and Net

Assets $ Billion % Total Worth $ Billion % Total

Real assets
Real estate 18,117 25.2% Mortgages 10,215 14.2%
Consumer durables 4,665 6.5% Consumer credit 2,404 3.3%

Other 303 0.4% Bank and other loans 384 0.5%

Total real assets 23,085 32.1% Security credit 316 0.4%
Other 556 0.8%
Total liabilities 13,875 19.3%
Financial assets
Deposits 8,038 11.2%
Life insurance reserves 1,298 1.8%
Pension reserves 13,419 18.7%
Corporate equity 8,792 12.2%
Equity in noncorp.
business 6,585 9.2%

1-6
Mutual fund shares 5,050 7.0%
1.1 Real versus Financial Assets
• All financial assets (owner of the claim) are
offset by a financial liability (issuer of the
claim)
• When all balance sheets are aggregated,
only real assets remain.
• Net wealth of economy: Sum of real assets

1-7
Table 1.2 Domestic Net Worth, 2011

Assets $ Billion
Commercial real estate 14,248
Residential real estate 18,117
Equipment and
software 4,413

Inventories 1,974
Consumer durables 4,665

TOTAL 43,417
Note: Column sums may differ from total because of rounding error.

SOURCE: Flow of Funds Accounts of the United States, Board of Governors

of the Federal Reserve System, June 2011.

1-8
1.2 Financial Assets
• Major Classes of Financial Assets or Securities
• Fixed-income (debt) securities
• Money market instruments
• Bank certificates of deposit, T-bills, commercial paper, etc.

• Bonds
• Preferred stock

• Common stock (equity)

• Ownership stake in entity, residual cash flow

• Derivative securities
• Contract, value derived from underlying market condition

1-9
1.3 Financial Markets and the Economy
• Informational Role of Financial Markets
• Do market prices equal the fair value estimate
of a security's expected future risky cash flows?
• Can we rely on markets to allocate capital to the
best uses?
• Other mechanisms to allocate capital?

• Advantages/disadvantages of other systems?

1-10
1.3 Financial Markets and the Economy
• Consumption Timing
• Consumption smoothes over time

• When current basic needs are met, shift

consumption through time by investing surplus

1-11
1.3 Financial Markets and the Economy
• Risk Allocation
• Investors can choose desired risk level

• Bond vs. stock of company

• Bank CD vs. company bond

• Risk-and-return trade-off

1-12
1.3 Financial Markets and the Economy
• Separation of Ownership and Management

• Large size of firms requires separate

principals and agents
• Mitigating Factors

• Performance-based compensation

• Boards of directors may fire managers

• Threat of takeovers

1-13
1.3 Financial Markets and the Economy
• Example 1.1
• In February 2008, Microsoft offered to buy Yahoo at
$31 per share when Yahoo was trading at $19.18
• Yahoo rejected the offer, holding out for $37 a
share
• Proxy fight to seize control of Yahoo's board and
force Yahoo to accept offer
• Proxy failed; Yahoo stock fell from $29 to $21
• Did Yahoo managers act in the best interests of
their shareholders?

1-14
1.3 Financial Markets and the Economy
• Corporate Governance and Corporate Ethics
• Businesses and markets require trust to operate
efficiently
• Without trust additional laws and regulations are
required
• Laws and regulations are costly

• Governance and ethics failures cost the economy

billions, if not trillions
• Eroding public support and confidence

1-15
1.3 Financial Markets and the Economy
• Corporate Governance and Corporate Ethics
• Accounting scandals

• Enron, WorldCom, Rite-Aid, HealthSouth, Global

Crossing, Qwest

• Misleading research reports

• Citicorp, Merrill Lynch, others

• Auditors: Watchdogs or consultants?

• Arthur Andersen and Enron

1-16
1.3 Financial Markets and the Economy
• Corporate Governance and Corporate Ethics
• Sarbanes-Oxley Act:

• Requires more independent directors on company

boards
• Requires CFO to personally verify the financial
statements
• Created new oversight board for the accounting/audit
industry
• Charged board with maintaining a culture of high
ethical standards

1-17
1.4 The Investment Process
• Asset Allocation
• Primary determinant of a portfolio's return
• Percentage of fund in asset classes
• Stocks 60%
• Bonds 30%
• Alternative assets 6%
• Money market securities 4%

• Security selection and analysis

• Choosing specific securities within asset class

1-18
1.5 Markets Are Competitive
• Risk-Return Trade-Off
• Assets with higher expected returns have higher
risk
Average Annual Return Minimum (1931) Maximum (1933)
Stocks About 12% −46% 55%

• Stock portfolio loses money 1 of 4 years on

average
• Bonds
• Have lower average rates of return (under 6%)
• Have not lost more than 13% of their value in any one
year
1-19
1.5 Markets Are Competitive
• Risk-Return Trade-Off
• How do we measure risk?

• How does diversification affect risk?

1-20
1.5 Markets Are Competitive
• Efficient Markets

• Securities should be neither underpriced nor

overpriced on average
• Security prices should reflect all information
available to investors
• Choice of appropriate investment-
management style based on belief in market
efficiency

1-21
1.5 Markets Are Competitive
• Active versus Passive Management
• Active management (inefficient markets)
• Finding undervalued securities (security selection)
• Market timing (asset allocation)

• Passive management (efficient markets)

• No attempt to find undervalued securities
• No attempt to time
• Holding a diversified portfolio
• Indexing; constructing “efficient” portfolio

1-22
1.6 The Players
• Business Firms (net borrowers)

• Households (net savers)

• Governments (can be both borrowers and savers)

• Financial Intermediaries (connectors of borrowers

and lenders)
• Commercial banks
• Investment companies
• Insurance companies
• Pension funds
• Hedge funds
1-23
1.6 The Players
• Investment Bankers
• Firms that specialize in primary market
transactions
• Primary market

• Newly issued securities offered to public

• Investment banker typically “underwrites” issue

• Secondary market

• Preexisting securities traded among investors

1-24
1.6 The Players
• Investment Bankers
• Commercial and investment banks' functions and
organizations separated by law 1933-1999
• Post-1999: Large investment banks independent from
commercial banks
• Large commercial banks increased investment-
banking activities, pressuring investment banks’
profit margins
• September 2008: Mortgage-market collapse
• Major investment banks bankrupt;
purchased/reorganized

1-25
1.6 The Players
• Investment Bankers
• Investment banks may become commercial
banks
• Obtain deposit funding

• Have access to government assistance

• Major banks now under stricter commercial

bank regulations

1-26
Table 1.3 Balance Sheet of Commercial Banks, 2011

Assets $ Billion % Total Liabilities and Net Worth $ Billion % Total

Real assets Liabilities

Equipment and premises 110.4 0.9% Deposits 8,674.6 71.4%
Other real estate 46.6 0.4% Debt and other borrowed funds 1,291.8 10.6%
Federal funds and repurchase
Total real assets 157.0 1.3% agreements 499.1 4.1%
Other 308.4 2.5%

Total liabilities 10,773.9 88.6%

Financial assets
Cash 1,066.3 8.8%
Investment securities 2,406.1 19.8%
Loans and leases 6,279.1 51.6%
Other financial assets 1,153.9 9.5%
Total financial assets 10,905.4 89.7%

Other assets
Intangible assets 373.9 3.1%
Other 721.0 5.9%
Total other assets 1,094.9 9.0% Net worth 1,383.4 11.4%

TOTAL 12,157.3 100.0% 12,157.3 100.0%

Note: Column sums may differ from total because of rounding error.
SOURCE: Federal Deposit Insurance Corporation, [Link], July 2011.
1-27
Table 1.4 Balance Sheet of Nonfinancial U.S. Business, 2011

Liabilities and Net

Assets $ Billion % Total Worth $ Billion % Total
Real assets Liabilities
Equipment and software 4,109 14.6% Bonds and mortgages 5,321 18.9%
Real estate 7,676 27.2% Bank loans 538 1.9%
Inventories 1,876 6.7% Other loans 1,227 4.4%
Total real assets 13,661 48.5% Trade debt 1,863 6.6%
Other 4,559 16.2%
Financial assets Total liabilities 13,509 47.9%
Deposits and cash 1,009 3.6%
Marketable securities 899 3.2%
Trade and consumer credit 2,388 8.5%
Other 10,239 36.3%
Total financial assets 14,535 51.5%
TOTAL 28,196 100.0% Net worth 14,687 52.1%
28,196 100.0%
Note: Column sums may differ from total because of rounding error.
SOURCE: Flow of Funds Accounts of the United States, Board of Governors of the Federal Reserve System, June 2011.

1-28
1.6 The Players
• Venture Capital and Private Equity
• Venture capital

• Investment to finance new firm

• Private equity

• Investments in companies not traded on

stock exchange

1-29
1.7 The Financial Crisis of 2008
• Changes in Housing Finance

• Low interest rates and a stable economy

created housing market boom, driving
investors to find higher-yield investments
• 1970s: Fannie Mae and Freddie Mac bundle
mortgage loans into tradable pools
(securitization)
• Subprime loans: Loans above 80% of home
value, no underwriting criteria, higher default
risk
1-30
1.7 The Financial Crisis of 2008
• Mortgage Derivatives

• CDOs: Consolidated default risk of loans

onto one class of investor, divided payment
into tranches
• Ratings agencies paid by issuers; pressured
to give high ratings

1-31
1.7 The Financial Crisis of 2008
• Credit Default Swaps

• Insurance contract against the default of

borrowers
• Issuers ramped up risk to unsupportable
levels
• AIG sold $400 billion in CDS contracts

1-32
1.7 The Financial Crisis of 2008
• Systemic Risk

• Risk of breakdown in financial system —

spillover effects from one market into others
• Banks highly leveraged; assets less liquid

• Formal exchange trading replaced by over-

the-counter markets — no margin for
insolvency protection

1-33
1.7 The Financial Crisis of 2008
• The Shoe Drops

• September 7, 2008: 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
1-34
1.7 The Financial Crisis of 2008
• Dodd-Frank Reform Act

• Called for stricter rules for bank capital,

liquidity, risk management
• Mandated increased transparency

• Clarified regulatory system

• Volcker Rule: Limited banks’ ability to trade

for own account

1-35
Figure 1.1 Short-Term LIBOR and Treasury-Bill Rates and the
TED Spread

1-36
Figure 1.2 Cumulative Returns
Cumulative returns on a $1 investment in the
S&P 500 index

1-37
Figure 1.3 Case-Shiller Index of U.S. Housing Prices

1-38
1.8 Text Outline
• Part One: Introduction to Financial Markets,
Securities, and Trading Methods
• Part Two: Modern Portfolio Theory

• Part Three: Debt Securities

• Part Four: Equity Security Analysis

• Part Five: Derivative Markets

• Part Six: Active Investment Management

Strategies: Performance Evaluation, Global
Investing, Taxes, and the Investment Process
1-39