CHAPTER ONE
INVESTMENTS: BACKGROUND AND ISSUES
CHAPTER OVERVIEW
In this chapter the student is introduced to the general concept of investing, that is, to forego spending
cash today in the hopes of increasing wealth in the future. Real assets are differentiated from financial
assets, and the major categories of financial assets are defined. The risk/return tradeoff and the reality
that most assets are efficiently (fairly) priced most of the time are introduced. The role of financial
intermediaries is discussed as is the increased globalization of the financial markets.
LEARNING OBJECTIVES
After studying this chapter, students should have an understanding of the overall investment process and
understand some key elements involved in the investment process. Students should understand
differences in financial and real assets and be able to identify the major components of the investment
process. Students should be able to describe a derivative security and understand how they are used in
our markets after studying this chapter.
PRESENTATION OF MATERIAL
1. Real versus Financial Assets
The key elements of the chapter are presented in PPT 1-3. The concept of giving up current consumption
to invest in assets that allow greater consumption in the future is the key notion to start discussion of the
chapter material. The discussion of real and financial assets can be used to discuss key differences in the
assets and their appropriateness as investment vehicles.
PPT 1-3 Financial Versus Real Assets
Summary statistics for balance sheets and net worth for US households are displayed in PPT 1-4 and in
PPT 1-5.
PPT 1-4 Table 1-1 Balance Sheet – US Households, 2006
PPT 1-5 Table 1-2 Domestic Net Worth, 2006
2. A Taxonomy of Financial Assets
Fixed income securities include both long-tern and short-term instruments. The essential element of debt
securities and the other classes of financial assets is the fixed or fixed formula payments that are
associated with these securities. Common stock that features residual payments to the owners can be
contrasted with the relatively certain debt claims. Preferred stock that offers elements of both fixed
income and common stock is riskier than most fixed income securities in many respects but is safer than
most common stock. A derivative security is a security whose performance is based on or tied to another
asset or financial security. The discussion of derivative securities presented in PPT 1-7 should be brief
and used to highlight the discussion of innovation in our markets. It is interesting to describe the key
elements of each derivative and relate the properties to debt and equity securities.
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PPT 1-7 Major Classes of Financial Assets or Securities
3. Financial Markets and the Economy
The crucial role played by the markets in the economy is displayed in PPT 1-9. Markets allow
participants to adjust consumption and to choose levels of risk that are appropriate. Financial markets
also allow for separation of management and ownership.
PPT 1-9 Financial Markets
Current issues related to corporate governance and corporate ethics are displayed in PPT 1-10. This slide
provides good opportunities for class discussion.
PPT 1-10 Corporate Governance and Ethics
4. The Investment Process
Major components of the investment process are described in PPT 1-12. Two of the major elements in
the investment process, asset allocation and security selection can be used to discuss the content and
coverage in the course.
PPT 1-12 The Investor’s Portfolio
5. Markets are Competitive
Previewing the concept of risk-return trade-off is important for the development of portfolio theory and
many other concepts developed in the course. The discussion of active and passive management styles is
in part related to the concept of market efficiency. The discussion of market efficiency ties directly with
the decision to pursue an active management strategy.
The two major elements of active management are security selection and timing. Material in later
chapters can be previewed in terms of emphasis on elements of active management. The essential
element related to passive management is related to holding an efficient portfolio. The elements are not
limited to pure diversification concepts. Efficiency also is related to appropriate risk level, the cash flow
characteristics and the administration costs.
PPT 1-14 Risk-Return Trade-Off
PPT 1-15 Efficient Markets Theory
PPT 1-16 Active versus Passive Management
6. The Players
The major participants in the financial markets are listed in PPT 1-18. Governments, households and
businesses can be issuers and investors in securities. Investment bankers bring issuers and investors
together.
PPT 1-18 The Players
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Summary statistics for commercial banks’ and nonfinance U.S. business’ balance sheets are displayed in
PPT 1-19 and in PPT 1-20.
PPT 1-19 Table 1-3 Balance Sheet of Commercial Banks
PPT 1-20 Table 1-4 Balance Sheet of Nonfinancial U.S. Business
The globalization that has taken place in the last several decades has increased the risk associated with
foreign exchange. The discussion of foreign exchange is related to both domestic and international
investments. Since more of firms’ sales are now international, foreign exchange has implications for
performance of US investments. When diversification is expanded to international stocks, performance
depends not only on performance of the stock but also performance of the currency. Improved
information has played and continues to play an important role in the expansion of international
investing.
PPT 1-22 Globalization
PPT 1-23 Figure 1-1 Global Debt Issue
Several good examples of securitization are presented in the chapter. The historical development of
securitization of different underlying assets can be tied to improved technology and information. The
market initially developed with pass-through securities on home mortgages. The importance of credit
enhancement, the process of some additional party guaranteeing the performance on the securities, was
apparent from the initial development of the market. Initially, performance was partially guaranteed by
the government or an agency of the government. As the market developed to other assets such as charge
card receivables and automobile loans, private firms became involved in the credit enhancement process.
There seems to be no limit to the assets that can be securitized.
PPT 1-24 Securitization
PPT 1-25 Figure 1-2 Asset-backed Securities Outstanding
The securities industry has been very active in the area of financial engineering. The process of financial
engineering involves repackaging the cash flows from a security or an asset to enhance their
marketability to different classes of investors. This activity will continue as long as financial
intermediaries can add value to the total by repackaging the cash flows. One of the more exotic forms of
debt instruments, inverse floaters, experienced large declines in value with the large and unanticipated
rise in interest rates. While these instruments do offer expanded capabilities for investment, they also
demand improved risk management and assessment capabilities. Recently firms have used default swaps
to create synthetic collateralized bond obligations
PPT 1-26 Financial Engineering
PPT 1-27 Figure 1-3 Building a Complex Security
PPT 1-28 Figure 1-4 Unbundling – Mortgage Security
PPT 1-29 Computer Networks
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In the future investors will have even larger capabilities to invest in a broader range of investment
vehicles. Understanding valuation principles for common stock and the portfolio concepts covered in the
text are the basis for valuation of many of the more exotic derivatives.
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