1.

1 Real Asset Vs Financial Asset

Productive capacity: the goods and services that the members of an economy can create. This
capacity is a function of the real asset.

Real Asset: Assets used to produce goods and services. Examples: Land, Equipment, etc.
There are two types of it: Tangible assets and intangible assets. An example of an intangible
asset is knowledge.

Financial Asset: Claims on real assets or the income generated by them, their value derived
from an underlying asset. Examples: stocks and bonds. Also, they do not directly contribute to
the productive capacity.
Real Asset Financial Asset

Valuation carry an intrinsic value (meaning that they derive their value from the
have an inherited value due to the physical underlying asset
attributes)

Liquidity less liquid because they are expensive, and more liquid than real asset
they don’t have a proper marketplace because each financial asset
has its own market
Tangibility generally, have a physical form but can be more intangible
intangible
Purpose of to generate revenue to generate income for the
holding future
Risk Less risky riskier

1.2 Financial Assets

There are three types of financial assets:

Debt (Fixed income) securities: Pay a specified cash flow over a specific period. Also, it’s
securities issued by the government, financial institutions, and companies. An example of these
securities bonds.
Examples of bonds issued by the government are treasury bills and treasury notes.

There are two types of debt markets:

Money market: short-term securities, highly marketable, and low risk. For example, U.S
treasury bills or bank certificates of deposit (CDs).

Capital market: long-term securities, such as treasury bonds, range from very safe to relatively
risky. How would I know if the security is safe or risky? There are credit rating agencies, that
rate each company’s bond. Any bond rated from BB and below is a junk bond, and any bond
rated higher than BB it is safe.

Equity: Represents ownership share in the corporation. Equity holders are not promised any
particular payment. Equity investments are riskier than debt securities investments. An
example is common stock.

Derivatives: Securities providing payoffs that depend on the values of other assets (they derive
their value from an underlying asset). Such as options, forward, and swaps.

1.3 Financial Markets and The Economy

Stock prices reflect investors’ collective assessment of a firm’s current performance and future
prospects. When the market is more optimistic about the firm, its share price will rise. That
higher price makes it easier for the firm to raise capital. So, stock prices play a major role in the
allocation of capital in market economies.
Does the market price always equal the fair value? No, sometimes the market price could be
overvalued or undervalued.

Consumption Timing
Keep in mind that people go through different earnings periods in their life, there is a high
earnings period and a low earnings period.
A high earnings period refers to a time that you may have a stable income, and you are most
likely to be at a young age.
A low earnings period is when you have probably retired and you are older age, now you need
more income.
During high earnings period, this is where you will invest your money in different financial
instruments, the low-earnings period is the period when you tend to sell these assets to provide
the funds for your consumption needs, so the instruments that you were originally invested in
at a younger age you are going to cash them in low earnings period.

Risk Allocation
It is something that differs on your preference, for instance, if you are a risk-averse investor
you will going to invest in bonds, but if you are a more risk tolerance investor you will most
likely prefer to invest in stocks.

Separation of Ownership and Management

Small businesses mostly are owned and managed by the same individual. But in multi-national
corporations, the owners and managers of the firm are different parties.
The main function of the manager is to maximize shareholder wealth by increasing the
company’s profit.
Agency problem: It happens when the managers engaged in activities that are not in the best
interest of shareholders and pursue their own interests instead.
How to mitigate potential agency problems?

1- Performance-based compensation, tie the income of managers to the success of the firm.
2- Boards of directors may fire managers.
3- Outsiders, monitoring the manager's performance.
4- Threat of takeovers, unhappy shareholders can elect a different board.

Corporate Governance and Corporate Ethics

It is the framework that makes sure that the relationship between the managers and the
investors is good.

Scandals that collectively signaled a crisis in corporate governance and ethics:

1- Different accounting scandals, WorldCom has overstated its profits, also Eron used its
now notorious “special purpose entities” to move debt off its books.
2- Misleading research report put out by stock market analysts.
3- Auditors, Enron’s auditor earned more money consulting for Enron than auditing it;
given its incentive to protect its consulting profits.
Because of these scandals, Congress passed the Sarbanes-Oxley Act, to tighten the rules of
corporate governance and disclosure.
- Requires more independent directors
- CFO personally verifies the financial statements
- Creates accounting/audit industry oversight board
- Charges board to maintain culture of high ethical standards

1.4 The investment process

An investor's portfolio is his collection of investment assets.

Asset Allocation: Choosing between broad asset classes.

Security Selection: Choosing which particular securities to hold within an asset class.

Top Down investment strategy

Starts with asset allocation first then I start choosing securities.
divide money amongst assets then I divide the divided money among securities.

Bottom Up investment strategy

Starts with the security selection first when it comes to the distribution of capital.

Security Analysis: Analysis of the value of securities.

1.5 Markets are Competitive

Risk-Return Trade-off

Assets with higher expected returns have a higher risk.

How do we measure risk? It has to do with the volatility of an asset’s returns but not entirely.
When mixing assets into a diversified portfolio, you need to consider the interplay among
assets and the effect of diversification on the risk of the entire portfolio.

Diversification: many assets are held in the portfolio.

Efficient Markets

In efficient markets, securities should be neither underpriced nor overpriced on average. It

should also reflect all available information to investors.

Your belief in market efficiency will reflect on your choice of investment-management style.
1- Passive Management: Holding highly diversified portfolios without spending effort or
resources to find underpriced securities or security analysis. It does not try to time the
market – Efficient Markets
Or in other words, buying and holding a diversified portfolio and not attempting to
identify mispriced securities.
2- Active Management: Improve performance either by identifying mispriced securities or
by timing the performance of broad asset classes (forecast broad market trends). –
Inefficient Markets. Usually, it is done by portfolio managers because it is needing an
expert.
If markets are efficient, it is better to follow passive strategies.
Both two strategies have their own advantages and disadvantages, there is no one better than
another.

1.6 The Players

Three major players in the financial markets:

1- Business Firms (net demanders of capital) (net borrowers). They raise capital now by
issuing different securities to pay for investments in plants and equipment. Income
generated by these real assets provides returns to investors who purchase shares.
2- Households (suppliers of capital) (net savers). They purchase securities issued by firms
that need to raise funds.
3- Governments (can be either borrowers or lenders) depend on the relationship between tax
revenue and government expenditures. In other words, it depends if the government
suffers a deficit it will borrow from the public by issuing treasury securities, and if it has
a surplus it will purchase from the public.
Corporations and governments usually don’t sell their securities directly to investors. But they
usually do so by selling funds to financial institutions.

Financial Intermediaries

They are the connectors between borrowers and lenders.

Companies do not necessarily sell all their securities to individual investors, sometimes they sell
them to large financial institutions. In fact, about 50% of stocks are held by large financial
institutions, such as:
1- Commercial Banks
2- Investment Companies
3- Insurance Companies
4- Credit Unions
All of these large institutions are called financial intermediaries.
Why do we need financial intermediaries? they help create an efficient market, and they also
lower the cost of doing business.

Companies do not directly market their securities to the public, they hire agencies (investor
bankers) to represent them to the public, so these investor bankers are responsible for issuing
IPOs in the primary market.
How do they operate? They issue their own security to raise funds in order to buy securities of
other companies. They move funds from parties with excess capital to the parties who need
funds. Make a profit from the difference between what they earn from their assets and what
they paid for their liabilities.

Investment Bankers (underwriters): They are financial advisors for large companies, help
business raise capital, and they specialize in primary market transactions.

Primary market: newly issued securities offered to the public.

Secondary market: preexisting securities traded among investors

Venture Capital and Private Equity

They do not raise their capital publicly by issuing stocks or bonds, because they are private.

Venture Capital: Small firms, do not have IPO, and depend on bank loans or investments that
wealthy individuals make (angel investors). Or in other words, it is an equity investment to
finance a new firm. This venture capital is a type of private equity investment.

Angle investors: Wealthy individuals who invest in start-up firms, will receive ownership taking
the business, and take an active role in the management of these firms.

Private Equity: Investment in firms that don’t trade on public stock exchanges.
Fintech and Financial Innovation

Fintech: is the application of technology to financial markets, and it has changed many aspects
of the financial landscape.

Peer-to-peer lending: it is a technology that can be used to link lenders and borrowers directly.

1.7 The Financial Crisis of 2008-2009

The crisis started in the U.S. and started in the housing sector because there were a lot of
unsustainable debts related to this sector.

High-tech bubble 2000-2002: in 1990 internet had become very popular and people became
interested to invest in internet-related companies, people were over-optimistic about them,
and the stock prices of these companies increased, in 2000-2002 people started to realize that
the market value of these companies is way overvalued. This was the worst crisis after the great
depression.

Causes of Financial Crisis 2008

A homeowner would borrow funds for a home purchase and repay it over a long period. A
typical thrift institution would have as its major asset a portfolio of these long-term home
loans, while its major liability would be the accounts of its depositors. This landscape began to
change in the 1970s when FNMA and FHLMC began buying large quantities of mortgage loans
from originators (banks) and bundling them into pools that could be traded like any other
financial asset. These pools were called securitization.

Securitization: Buying mortgage loans from originators (banks) and bundling them into
mortgage-backed securities.
Add to that problem, financial institutions were selling mortgage derivatives (CDOs) to
investors. Rating agencies are engaged with the companies by giving them high credit rates, so
people bought them.
Another risky investment that was offered by the financial institutions was credit default swaps.

Credit Default Swaps: Insurance contract against the default of borrowers.

Systemic Risk: risk of a breakdown in the financial system.

To prevent these events to happen in the future U.S. government has passed an act Dodd-Frank
Reform, which called for stricter rules for bank capital, and liquidity. So, there are rules related
to this act such as:
• Mandated increased transparency
• Clarified regulatory system
• Volcker Rule
Key Terms

- Active management: The attempt to improve performance either by identifying mispriced

securities or by timing the performance of broad asset classes.

- Agency problems: Conflicts of interest between managers and stockholders.

- Asset allocation: Allocation of an investment portfolio across broad asset classes.

- Derivative securities: Securities that provide payoffs that are determined by the prices of
other assets.

- Equity: An ownership share in a corporation; also known as common stock.

- Financial assets: Claims on real assets or the income generated by them.

- Financial intermediaries: Bring together the suppliers of capital (investors) with the
demanders of capital (mainly corporations and the federal government).

- Fixed-income (debt) securities: Pay a specified cashflow over a specific period of time.

- Investment: Commitment of current resources in the expectation of deriving greater

resources in the future.

- Investment companies: Firms that manage funds for investors (i.e., mutual funds).

- Investment bankers: Firms specializing in the sale of new securities to the public (i.e.,
underwriting).

- Passive management: Buying and holding a diversified portfolio without attempting to

identify mispriced securities.

- Primary market: A market in which new issues of securities are offered to the public.

- Private equity: Investment in companies that are not publicly traded on a stock exchange.

- Real assets: Assets used to produce goods and services (i.e., building, land, equipment,
knowledge).

- Risk-return trade-off: Assets with higher expected returns entail greater risk.

- Secondary market: Previously issued securities are traded among investors.