The Investment Environment: Investments (Asia Global Edition)

Chapter 1
The Investment Environment
INVESTMENTS (ASIA GLOBAL EDITION) | BODIE, KANE, MARCUS, JAIN

McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
1-2
Real Assets Versus Financial Assets

• Real Assets
– Determine the productive capacity and
net income of the economy
– Examples: Land, buildings, machines,
knowledge used to produce goods and
services
• Financial Assets
– Claims on real assets
1-3
Financial Assets
• Three types:
1. Fixed income or debt
2. Common stock or equity
3. Derivative securities

1-4
Fixed Income
• Payments fixed or determined by a
formula
• Money market debt: short term, highly

marketable, usually low credit risk
• Capital market debt: long term bonds,

can be safe or risky

1-5
Common Stock and Derivatives

• Common Stock is equity or ownership
in a corporation.
– Payments to stockholders are not fixed,
but depend on the success of the firm
• Derivatives
– Value derives from prices of other
securities, such as stocks and bonds
– Used to transfer risk

1-6
Financial Markets and the Economy
• Information Role: Capital flows to

companies with best prospects 前途
• Consumption 消费 Timing: Use

securities to store wealth and transfer
consumption to the future

1-7
Financial Markets and the

Economy (Ctd.)
• Allocation of Risk: Investors can select
securities consistent 一贯 with their tastes for
risk
• Separation of Ownership and Management 分

离所有权和管理 : With stability comes agency
problems (That means that owners do not need to
be managers and managers do not need to be owners. It is
often the case that someone is both, like the case of Mark
Zuckerberg at Facebook.)
1-8
Financial Markets and the

Economy (Ctd.)
nce and Corporate Ethics公司治理与企业伦理
s the system of rules, practices and processes by which a company is directed and
involves balancing the interests of acompany's many stakeholders, such as shar
nanciers, government and the community.)
udy of proper business policies and practices regarding potentially controversial is
ce, insider trading, bribery, discrimination, corporate social responsibility and fiduc
dals 丑闻
), Olympus (Japan), Longtop Financial Technologies (China)
dogs of the firms
en (Enron)
optimistic research reports 乐观的研究报告
Act 萨班斯 - 奥克斯利法案
INVESTMENTS
les of corporate governance(ASIA GLOBAL EDITION) | BODIE, KANE, MARCUS, JAIN
1-9
The Investment Process
• Asset allocation
– Choice among broad asset classes
• Security selection
– Choice of which securities to hold within
asset class
– Security analysis to value securities and
determine investment attractiveness

1-10
Markets are Competitive
• Risk-Return Trade-Off 交易
• Efficient Markets
– Active Management
• Finding mispriced 错误定价 securities
• Timing the market

1-11
Markets are Competitive (Ctd.)
– Passive Management
• No attempt 尝试 to find undervalued 低估
securities
• No attempt to time the market
• Holding a highly diversified portfolio

1-12
The Players
• Business Firms – net borrowers
• Households – net savers
• Governments – can be both borrowers

and savers

1-13
The Players (Ctd.)

• Financial Intermediaries: Pool and invest
funds
– Investment Companies
– Banks
– Insurance companies
– Credit unions

1-14
Universal Bank Activities

Investment Banking Commercial Banking
• Underwrite 包销, 承诺支付 new • Take deposits and
stock and bond issues make loans
• Sell newly issued securities to
public in the primary market
• Investors trade previously
issued securities among
themselves in the secondary
markets

1-15
Financial Crisis of 2008

• Antecedents 来历 of the Crisis:
– “The Great Moderation 伟大的温和, 适度”: a
time in which the U.S. had a stable economy
with low interest rates and a tame 驯服
business cycle with only mild 温和 recessions
– Historic boom in housing market

1-16
Figure 1.3 The Case-Shiller Index of U.S.

Housing Prices

1-17
Changes in Housing Finance 住房融资

Old Way New Way
• Local thrift institution 本地节 • Securitization: Fannie Mae
俭机构 made mortgage loans and Freddie Mac bought
to homeowners mortgage loans and bundled
• Thrift’s major asset 节俭的主 them into large pools
要资产: a portfolio of long- • Mortgage-backed securities
term mortgage loans 抵押贷款支持证券 are tradable
• Thrift’s main liability 税 : claims against the underlying

deposits mortgage pool
• “Originate to hold” 起源持有 • “Originate to distribute”

1-18
Figure 1.4 Cash Flows in a Mortgage

Pass-Through Security

1-19
Changes in Housing Finance

(Ctd.)
• At first, Fannie Mae and Freddie Mac securitized
conforming 符合 mortgages, which were lower risk and
properly documented.
• Later, private firms began securitizing nonconforming
“subprime 次贷” loans with higher default risk.
– Little due diligence 尽职调查
– Placed higher default risk on investors
– Greater use of ARMs(Adjustable Rate Mortgage) and
“piggyback 捎带” loans

1-20
Mortgage Derivatives
• Collateralized debt obligations 抵押债务
(CDOs)
– Mortgage pool divided into slices or tranches
两档 to concentrate default risk
– Senior tranches: Lower risk, highest rating
– Junior tranches: High risk, low or junk rating

1-21
Mortgage Derivatives
• Problem: Ratings were wrong! Risk was
much higher than anticipated 预期, even
for the senior tranches

1-22
Why was Credit Risk Underestimated 低估?
• No one expected the entire housing

market to collapse all at once
• Geographic diversification did not
reduce risk as much as anticipated
• Agency problems with rating agencies
• Credit Default Swaps 信用违约互换
(CDS) did not reduce risk as
anticipated
1-23
Credit Default Swap (CDS)

• A CDS is an insurance contract against
the default of the borrower
• Investors bought sub-prime 次贷 loans

and used CDS to insure their safety

1-24
Credit Default Swap (CDS)

• Some big swap issuers did not have
enough capital to back their CDS when the
market collapsed.
• Consequence: CDO insurance failed

1-25
Rise of Systemic Risk

• Systemic Risk: a potential breakdown of the financial
system in which problems in one market spill over 溢
出来 and disrupt 破坏 others.
– One default 默认 may set off a chain of further
defaults
– Waves of selling may occur in a downward spiral
as asset prices drop
– Potential contagion 传染性 from institution to
institution, and from market to market
1-26
Rise of Systemic Risk (Ctd.)
• Banks had a mismatch between the maturity

and liquidity of their assets and liabilities.
– Liabilities were short and liquid
– Assets were long and illiquid
– Constant need to refinance the asset portfolio
• Banks were very highly levered 杠杆, giving
them almost no margin of safety无边际安全

1-27
Rise of Systemic Risk (Ctd.)
• Investors relied too much on “credit

enhancement” through structured products
like CDS
• CDS traded mostly “over the counter”, so
less transparent, no posted margin
requirements没有过帐保证金要求
• Opaque linkages 不透明的连接 between
financial instruments and institutions
1-28
The Shoe Drops

• 2000-2006: Sharp increase in housing
prices caused many investors to believe
that continually rising home prices would
bail out 保释 poorly performing loans
• 2004: Interest rates began rising
• 2006: Home prices peaked

1-29
The Shoe Drops

• 2007: Housing defaults and losses on
mortgage-backed securities surged
• 2007: Bear Stearns announces trouble at

its subprime mortgage–related hedge
funds

1-30
The Shoe Drops

• 2008: Troubled firms include Bear
Stearns, Fannie Mae, Freddie Mac, Merrill
Lynch, Lehman Brothers, and AIG
– Money market breaks down
– Credit markets freeze up
– Federal bailout to stabilize financial system

1-31
Systemic Risk and the Real Economy
• Add liquidity to reduce insolvency 破产 risk and

break a vicious 恶毒 circle of valuation
risk/counterparty risk/liquidity risk
• Increase transparency of structured products
like CDS contracts
• Change incentives to discourage excessive
risk-taking and to reduce agency problems at
rating agencies

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Chapter 1

The Investment Environment

INVESTMENTS (ASIA GLOBAL EDITION) | BODIE, KANE, MARCUS, JAIN

Real Assets Versus Financial Assets

INVESTMENTS (ASIA GLOBAL EDITION) | BODIE, KANE, MARCUS, JAIN

• Money market debt: short term, highly

• Capital market debt: long term bonds,

INVESTMENTS (ASIA GLOBAL EDITION) | BODIE, KANE, MARCUS, JAIN

Common Stock and Derivatives

INVESTMENTS (ASIA GLOBAL EDITION) | BODIE, KANE, MARCUS, JAIN

Financial Markets and the Economy

• Information Role: Capital flows to

• Consumption 消费 Timing: Use

INVESTMENTS (ASIA GLOBAL EDITION) | BODIE, KANE, MARCUS, JAIN

Financial Markets and the

• Separation of Ownership and Management 分

Financial Markets and the

The Investment Process

INVESTMENTS (ASIA GLOBAL EDITION) | BODIE, KANE, MARCUS, JAIN

Markets are Competitive

INVESTMENTS (ASIA GLOBAL EDITION) | BODIE, KANE, MARCUS, JAIN

Markets are Competitive (Ctd.)

INVESTMENTS (ASIA GLOBAL EDITION) | BODIE, KANE, MARCUS, JAIN

• Business Firms – net borrowers

• Households – net savers

• Governments – can be both borrowers

INVESTMENTS (ASIA GLOBAL EDITION) | BODIE, KANE, MARCUS, JAIN

The Players (Ctd.)

INVESTMENTS (ASIA GLOBAL EDITION) | BODIE, KANE, MARCUS, JAIN

Universal Bank Activities

INVESTMENTS (ASIA GLOBAL EDITION) | BODIE, KANE, MARCUS, JAIN

Financial Crisis of 2008

– Historic boom in housing market

INVESTMENTS (ASIA GLOBAL EDITION) | BODIE, KANE, MARCUS, JAIN

Figure 1.3 The Case-Shiller Index of U.S.

INVESTMENTS (ASIA GLOBAL EDITION) | BODIE, KANE, MARCUS, JAIN

Changes in Housing Finance 住房融资

• Thrift’s main liability 税 : claims against the underlying

INVESTMENTS (ASIA GLOBAL EDITION) | BODIE, KANE, MARCUS, JAIN

Figure 1.4 Cash Flows in a Mortgage

INVESTMENTS (ASIA GLOBAL EDITION) | BODIE, KANE, MARCUS, JAIN

Changes in Housing Finance

INVESTMENTS (ASIA GLOBAL EDITION) | BODIE, KANE, MARCUS, JAIN

– Senior tranches: Lower risk, highest rating

– Junior tranches: High risk, low or junk rating

INVESTMENTS (ASIA GLOBAL EDITION) | BODIE, KANE, MARCUS, JAIN

INVESTMENTS (ASIA GLOBAL EDITION) | BODIE, KANE, MARCUS, JAIN

Why was Credit Risk Underestimated 低估?

• No one expected the entire housing

Credit Default Swap (CDS)

• Investors bought sub-prime 次贷 loans

INVESTMENTS (ASIA GLOBAL EDITION) | BODIE, KANE, MARCUS, JAIN

Credit Default Swap (CDS)

• Consequence: CDO insurance failed

INVESTMENTS (ASIA GLOBAL EDITION) | BODIE, KANE, MARCUS, JAIN

Rise of Systemic Risk

Rise of Systemic Risk (Ctd.)

• Banks had a mismatch between the maturity

INVESTMENTS (ASIA GLOBAL EDITION) | BODIE, KANE, MARCUS, JAIN

Rise of Systemic Risk (Ctd.)

• Investors relied too much on “credit

The Shoe Drops

• 2004: Interest rates began rising