Summary chapter one: the investment environment

 Investment: is the current commitment of money or other resources in the

expectation of reaping future benefits.

Real assets versus financial assets:

 Real assets:
 The material wealth of a society is ultimately determined by the productive
capacity of its economy, that is, the goods and services its members can create.
 This capacity is a function of the real assets of the economy: the land, buildings,
machines, and knowledge that can be used to produce goods and services.

 Financial assets:
 Such as stocks and bonds are the means by which individuals in well-
developed economies hold their claims on real assets.

 Notes:

o While real assets generate net income to the economy, financial assets define the allocation of
income or wealth among investors.
o Real assets determine the wealth of an economy, while financial assets merely represent claims
on real assets.
o If they choose to invest, they may place their wealth in financial assets by purchasing various
securities.
o When investors buy these securities from companies, the firms use the money so raised to pay for
real assets, such as plant, equipment, technology, or inventory.
o So investors' returns on securities ultimately come from the income produced by the real assets
that were financed by the issuance of those securities.
 Taxonomy of financial assets:

1) Debt securities or fixed-income: ( bonds)

 Debt securities promise either a fixed stream of income or a stream of income

that is determined according to a specified formula.
 A corporate bond typically would promise that the bondholder will receive a
fixed amount of interest each year.
 A floating-rate bonds promise payments that depend on current interest rates.
 The payment on these securities are either fixed or determined by formula, unless
the borrower is declared bankrupt.
 For this reason, the investment performance of debt securities typically is the
least is closely tied to the financial condition of the issuer.

2) Equity securities: (common stocks & preferred stocks)

 A firm represents an ownership share in the corporation.

 Equity holders are not promised any particular payment, but they receive any
dividends the firm may pay.
 If the firm is successful, the value of equity will increase. If not, it will decrease.
 Therefore, the performance of equity investments is tied directly to the success of
the firm and its real assets.
 For this reason, equity investments tend to be riskier than investments n debt
securities.

3) Derivative securities: ( options, futures, and swap contracts )

 Provide payoffs that are determined by the prices of other assets such as bond or
stock prices.
 Derivative securities are so named because their values derive from the prices of
the other assets.
 A call option: is the right to buy a share or stock at a given exercise price on or
before the option's expiration date.
 Derivatives have become an integral part of the investment environment.
 The primary use of derivatives is to hedge risks or transfers them to other
parties, and also can be used to take highly speculative positions.
 The role of Financial markets

a) The informational role of financial markets:

 In a capitalist system, financial markets play a central role in the allocation of
capital resources.
 If a corporation seems to have good prospects for future profitability, investors will
bid up its stock price.
 Investors in the stock market ultimately decide which companies will live and which
will die.
 The company’s management will find it easy to issue new shares or borrow funds to
finance research and development, build now production facilities, and expand its
operations.

b) Consumption timing:
 "store or invest" your wealth in financial assets: the way is to shift the purchasing
power from high-earnings periods to low-earnings periods of life
 In high-earnings periods, you can invest your saving in financial assets.
 In low-earnings periods, you can sell these assets to provide funds for your
consumption needs.
 Thus, financial markets allow individuals to separate decisions concerning current
consumption and current earnings.

c) Allocation of risk:
 Financial markets and the diverse financial instruments traded in those markets
allow investors with the greatest taste for risk to bear that risk, while other, less
risk-tolerant individuals can, to a greater extent, stay on the sidelines.

d) Separation of ownership and management:

 Corporations of huge size simply cannot exist as owner-operated firms. For these
corporations, the owners and managers of the firm are different parties.
 This structure gives the firm a stability that the owner-managed firm cannot
achieve.
 If some stockholders decide they no longer wish to hold shares in the firms, they can
sell their shares to other investors, with no impact on the management of the firm.
 Thus, financial assets and the ability to buy and sell those assets in the financial
markets allow for easy separation of ownership and management.
  Agency problem: potential conflicts of interest because managers, who are
hired as agents of the shareholders, may try to achieve their own interests instead.
 Managers attempt to maximize firm value and avoid risky projects to protect
their own jobs.

o Several mechanisms have evolved to mitigate potential agency problems:

First: compensation plans tie the income of managers to the success of the firm.

 A major part of the total compensation of top executives is often in the form of stock
options, which means that the managers will not do well unless the stock price increases,
benefiting shareholders.

Second: while board of directors are sometimes portrayed as defenders of top

management, they can force out management teams that are underperforming.

Third: outsiders such as security analysts and large institutional investors monitor the
firm closely.

Fourth: bad performers are subject to the threat of takeover.

e) Corporate governance and corporate ethics:

 Securities markets can play an important role in facilitating the deployment of

capital resources to their most productive uses. But for markets to effectively serve
this purpose there must be an acceptable level of transparency that allows investors
to make well-informed decisions.
 If firms can mislead the public about their prospects, then much can go wrong.

The investment process

 Saving: means not spending all of your current income on consumption.

 Investing: is choosing what assets to hold.
 Notes:
o You may choose to invest in safe assets, risky assets, or a combination of both.
o In common usage, however, the term saving is often taken to mean investing in safe assets such
as an insured bank account.
Investor's portfolio
 An investor's portfolio is simply his collection of investment assets.
 Once the portfolio is established, it is updated or "rebalanced" by selling existing
securities and using the proceeds to buy new securities, by investing additional
funds to increase the overall size of the portfolio, or by selling securities to decrease
the size of the portfolio.
 Investors make two types of decisions in constructing their portfolios:

1) The asset allocation decision: is the choice among these broad asset classes
(such as stocks, bonds, real estate, commodities, and so on ).
2)The security selection decision: Is the choice of which particular securities to
hold within each asset class.

 Note:

 There are two ways of managing the portfolio:

 1st: top-down portfolio management:
o Start with asset allocation to establish the portfolio with a level of risk appropriate
to you.
o You can select according to your policy and not analyze the entire asset in the
market.

 2nd: bottom-up portfolio management:

o Start from the selection of securities that seem attractively priced (underpriced) to
select from them.

 Disadvantages of the bottom-up management:

1) Under bottom-up no determine for risk and return.
2) The portfolio may end up with a very heavy representation of firms in one
industry or exposure to one source of uncertainty (non diversification portfolio).
3) You must identify the whole market and determine the undervalued security
which may not be compatible with your policy.

Markets are competitive

 The risk-return trade off:
 Investors invest for anticipated future returns, but those returns rarely can be
predicted precisely.
 There will almost always be risk associated with investments.
 Actual or realized returns will almost always deviate from the expected return
anticipated at the start of the investment period.
 Thus, we conclude that there should be a risk-return trade-off in the securities
markets, with higher-risk assets priced to offer higher expected returns than lower-
risk assets.

 Efficient markets:
 According to the no-free-lunch proposition, financial markets process all relevant
information about securities quickly and efficiently, that is, that the security price
usually reflects all the information available to investors concerning the value of the
security.
 If these were so, there would be neither underpriced nor overpriced securities.

 Note:

 Active management:
o It is attempt to improve performance either by identifying mispriced securities or
forecasting the market trend.

 Passive management:
o Calls for holding highly diversified portfolios without spending attempting to
improve the investment performance through securities analysis.

 If the market is efficient and prices reflect all relevant information it's better to follow
passive strategies than active strategies.

The players
1) Firm are net borrowers:
o They raise capital now to pay for investments in plant and equipment. The
income generated by those real assets provides the returns to investors who
purchase the securities issued by the firm.

2) Households typically are net savers:

o They purchase the securities issued by firms that need to raise funds.

3) Governments can be borrowers or lenders:

o Depending on the relationship between tax revenue and government
expenditures.

 Corporations and governments do not sell all or even most of their securities
directly to individuals.
 These financial institutions stand between the security issuer-the firm- and the
ultimate owner of the security-the individual investor- for this reason, they are
called financial intermediaries.

Financial intermediaries
 The primary social function of such intermediaries is to channel household saving
to the business sector.

 The advantages of financial intermediaries:

 Pooling the resources of many small investors, they are able to lend
considerable sums to large borrowers.
 By lending many borrowers, intermediaries achieve significant diversification,
so they can accept loans that individually might be too risky.
 Intermediaries build expertise through the volume of business they do and can
use economies of scale and scope to assess and monitor risk.

Types of Financial intermediaries

 Investment companies:

 Here, the problem is that the most household portfolios are not large enough to
be spread among wide variety of securities. It is very expensive in terms of
brokerage fees and research costs to purchase one or two shares of many
different firms.

 Investments companies Pool and manage the money of many investors, also
arise out of economies of scale.

 Investment companies also can design portfolios specifically for large investors
with particular goals. In contrast, mutual funds are sold in the retail market,
and their investment philosophies are differentiated mainly by strategies that
are likely to attract a large number of clients.

 Investment bankers:

 Investment bankers advise the issuing corporation on the prices it can charge
for the securities issued, appropriate interest rates, and so forth. Ultimately, the
investment banking firms handles the marketing of the security in the primary
market, where new issues of securities are offered to the public. Later, investors
can trade previously issued securities among themselves in the so-called
secondary market.

 Investment bankers can provide more than just expertise to security issuers.
Because investment bankers are constantly in the market, assisting one firm or
another in issuing securities, it is in their own interest to protect and maintain
their reputation for honesty.

Recent trends
 Four important trends have changed the contemporary investment environment:
1) Globalization.
2) Securitization.
3) Financial engineering.
4) Information and computer networks.

1) Globalization :
 Investors commonly can participate in foreign investment opportunities in
several ways:
1) Purchase foreign securities which are domestically traded securities that
represent claims to shares of foreign stocks.
2) Purchase foreign securities that are offered in dollars.
3) Buy mutual funds that invest internationally.
4) Buy derivative securities with payoffs that depend on prices in foreign
security markets.

2) Securitization :
 The securitization of mortgages means mortgages can be traded just like other
securities
 Other loans that have been securitized into pass-through arrangements include
car loans, student loans, home equity loans, credit card loans, and debts of firms.

3) Financial engineering:
 It is the use of mathematical models and computer based trading technology to
synthesize new financial products.
 We have 2 ways under financial engineering to redesign new securities:
o Bundling securities:
 Which means combining more than one security into composite security.
o Unbundling securities:
 Which means breaking up one security to different types of securities and
sell to different investors this means (separation process).

End of summary chapter (1) ……