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Topic 1

The Investment environment /


Asset Classes & Financial instruments

BUS329 Investment Analysis


Chapter One
The Investment Environment
Chapter Overview
Role of financial assets in the economy: Real vs. financial
assets
Riskreturn trade-off and the efficient pricing
Financial crisis 2008
Connections between the financial system
and the real side of the economy
Lessons learned for evaluating systemic
risk
Investment

What is investment?
Investment is to commit money or other resources to get
benefit in the future
In this unit we shall be concerned with investing money
in financial asset
Real Assets vs. Financial Assets
Real Assets Financial Assets

Determine the Claims on real assets,


productive capacity and do not contribute
net income of the directly to the
economy productive capacity of
Examples: Land, the economy.
buildings, machines, Examples: Stocks,
knowledge used to bonds
produce goods and
services
Financial Assets

Fixed income or debt


Promise either a fixed stream of income or a stream of
income determined by a specified formula
Common stock or equity
Represent an ownership share in the corporation
Derivative securities
Provide payoffs that are determined by the prices of other
assets
Derivatives and risk

Multinational corporations invest in currency futures and


options to hedge currency risks
Corporations invest in the commodity futures to hedge
the risk
Financial Markets and the
Economy
The Informational Role
Capital flows to companies with best prospects
Consumption Timing
Use securities to store wealth and transfer
consumption to the future
Allocation of Risk
Investors can select securities consistent with their
tastes for risk, which benefits the firms that need to
raise capital as security can be sold for the best
possible price
Financial Markets and the
Economy

Separation of Ownership and Management


Agency problems arise when managers start
pursuing their own interests instead of maximizing
firm's value
Mechanisms to mitigate agency problems:
Tie managers' income to the success of the firm
(stock options)
Monitoring from the large outside investors and
security analysts
Takeover threat
Financial Markets and the
Economy

Corporate Governance and Corporate Ethics


Accounting Scandals
Examples Enron, Rite Aid, HealthSouth
Auditors: Watchdogs of the firms
Analyst Scandals
Arthur Andersen
Sarbanes-Oxley Act
Tighten the rules of corporate governance
The Investment Process

Portfolio: Collection of investment assets.


Asset allocation
Choice among broad asset classes
Security selection
Choice of securities within each asset class
The Investment Process

Top-down approach
Asset allocation followed by security analysis to evaluate
which particular securities to be included in the portfolio
Bottom-up approach
Investment based solely on the price-attractiveness, which
may result in unintended heavy weight of a portfolio in only
one or another sector of the economy
Markets Are Competitive

Risk-Return Trade-Off
Higher-risk assets are priced to offer higher expected
returns than lower-risk assets
Efficient Markets
In fully efficient markets when prices quickly adjust to all
relevant information, there should be neither underpriced
nor overpriced securities
Markets Are Competitive
Passive Management
Holding a highly diversified portfolio
No attempt to find undervalued securities
No attempt to time the market
Active Management
Finding mispriced securities
Timing the market
The Players

Demanders of capital Firms


Suppliers of capital Households
Governments Can be both borrowers or lenders
The Players

Financial Intermediaries: Pool and invest funds


Investment Companies
Banks
Insurance companies
Credit unions
The Financial Crisis of 2008

Antecedents of the Crisis:


The Great Moderation: A time in which the
U.S. had a stable economy with low interest
rates and a tame business cycle with only mild
recessions
Historic boom in housing market
Short-Term LIBOR and Treasury-Bill Rates and the
TED Spread
8

3-month LIBOR
7
3-month T-bill
TED spread
6

5
Interest Rates (%)

0
Jul-96 Jul-97 Jul-98 Jul-99 Jul-00 Jul-01 Jul-02 Jul-03 Jul-04 Jul-05 Jul-06 Jul-07 Jul-08
Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08
The Case-Shiller Index of U.S. Housing
Prices
250

200

Index (January 2000 = 100)

150

100

50

0
1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013
The Financial Crisis of 2008

The global financial crisis (GFC) or global


economic crisis begins in July 2007
loss of confidence by US investors in the value of sub-
prime mortgages
liquidity crisis
US Federal Bank injects a large amount of capital into
financial markets
September 2008: Lehman Brothers failure.
the crisis hit stock markets around the globe crashed and
became highly volatile.
Consumer confidence hit rock bottom.
Chapter Two
Asset Classes and Financial Instruments
Chapter Overview

Asset allocation Asset classes


Money markets vs. capital markets
Types of money market instruments
Capital market securities:
Bonds
Equity
Derivatives
The Money Market

Subsector of the fixed-income market: Securities are


short-term, liquid, low risk, and often have large
denominations
Money market mutual funds allow individuals to access
the money market
Money Market Securities

Treasury bills: Short-term debt of U.S.


government
Treasury Notes: Short-term debt of
Commonwealth government
Bid and asked price
Bank discount method

Certificates of deposit: Time deposit with a bank


Commercial paper: Short-term, unsecured debt
of a company
Money Market Securities

Bank-accepted bills: A time draft drawn on and accepted


by commercial bank.
Eurodollars: Dollar-denominated time deposits in banks
outside the U.S.
Repos and reverse repos: Short-term loan backed by
government securities.
Fed funds: Very short-term loans between banks
The Bond Market
Treasury Bonds
Inflation-Protected Treasury Bonds
Federal Agency Debt
International Bonds
Municipal Bonds
Corporate Bonds
Mortgages and Mortgage-Backed Securities
Bond Market Securities

Treasury Bonds
Maturities
Notes Maturities up to 10 years
Bonds Maturities from 10 to 30 years
Par Value - $1,000
Interest paid semiannually
Quotes Percentage of par
Bond Market Securities

Inflation-Protected Treasury Bonds


TIPS: Provide inflation protection
Federal Agency Debt
Debt of mortgage-related agencies such as Fannie Mae and
Freddie Mac
International Bonds
Bond Market Securities

Municipal Bonds
General obligation bonds
Revenue bonds
Municipal Bond Yields

To choose between taxable and tax-exempt bonds,


compare after-tax returns on each bond.
Let t equal the investors marginal tax bracket
Let r equal the before-tax return on the taxable bond
and rm denote the municipal bond rate.
If r(1 - t ) > rm, then the taxable bond gives a higher
return; otherwise, the municipal bond is preferred.
Table 2.2 Tax-Exempt Yield Table

The equivalent taxable yield is simply the tax-free


rate, rm, divided by (1 - t).
Bond Market Securities

Corporate Bonds
Issued by private firms
Semi-annual interest payments
Subject to larger default risk than government
securities
Options in corporate bonds
Callable
Convertible
Mortgage-backed securities
Equity Securities
Common stock: Ownership
Residual claim
Limited liability
Preferred stock: Perpetuity
Fixed dividends
Priority over common
Tax treatment
American Depository Receipts
Certificates traded in U.S. markets that represent ownership
in shares of a foreign company
Stock Market Indexes

S&P/ASX 200
S&P/ASX Banks
S&P/ASX Industrials
S&P/ASX Resources
Dow Jones Industrial Average
NASDAQ
Price-weighted average
Market-value weighted average
Stock Market Indexes

Investors can base their portfolios on an index


Buy an index mutual fund
Buy exchange traded funds (ETFs)
Derivatives Markets

A derivative is a security that gets its value from


the values of another asset, such as currency,
commodity, bond, stock, or market index.
Derivatives Markets
Options
Call: Right to buy underlying asset at the strike or exercise
price
Value of calls decreases as strike price increases
Put: Right to sell underlying asset at the strike or exercise
price
Value of puts increase with strike price
Value of both calls and puts increases with time until
expiration
Derivatives Markets

Futures Contracts
An agreement made today regarding the delivery of an asset
(or in some cases, its cash value) at a specified delivery or
maturity date for an agreed-upon price, called the futures
price, to be paid at contract maturity
Comparison

Option Futures Contract


Right, but not Obliged to make or take
obligation, to buy or delivery; long position
sell; option is exercised must buy at the futures
only when it is profitable price, short position must
Options must be sell at futures price
purchased Futures contracts are
The premium is the entered into without cost
price of the option itself.