Professional Documents
Culture Documents
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Essential nature of investment
± Reduced current consumption
± Planned later consumption
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Financial Versus Real Assets
Real Assets
± Assets used to produce goods and services
± E.g. land, buildings, equipment, and
knowledge
Financial Assets
± Claims to income generated by real assets
± E.g. stocks and bonds
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Table 1.1. Balance Sheet ± U.S.
Households, 2006
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Are the following assets real
or financial?
A. Patents
B. Lease obligations
C. Customer goodwill
D. A college education
E. A $5 bill
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ºajor Classes of Financial
Assets or Securities
Debt
± ºoney market instruments
Bank certificates of deposit
± Capital market instruments
Bonds
Equity
± Common stock
± Preferred stock
Derivative securities
± E.g. Option, futures
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Financial ºarkets
1. Informational Role of Financials
ºarkets
±HSBC rebound from $33 to $85 in
(1.6 times) after the right issue
±Google climb to $400 per share in
2005, P/E ratio 70,market cap $120
billion
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Financial ºarkets
2. Consumption Timing
±Shifting purchasing power from high-
earnings periods to low-earnings
periods
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Financial ºarkets
4. Separation of Ownership and
ºanagement
± Agency Issues: conflicts of interest
between managers and stockholders
± Solutions:
Compensation link to performance
Control by board of directors
ºonitor by outsiders
Threat of takeover
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Corporate Governance and Ethics
Accounting Scandals
± Examples ± Enron and WorldCom
ºisleading research reports
Auditors watchdogs or consultants
± Example ± Arthur Andersen and Enron
Sarbanes-Oxley Act
± Tighten the rules of corporate
governance
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The Investor¶s Portfolio
Asset allocation
± Choice among broad asset classes
± E.g. stocks, bonds, real estate, commodities
Security selection
± Choice of which securities to hold within asset
class
± E.g. HSBC, China ºobile
Portfolio construction
± Top-down strategies
± Bottom-up strategies
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ÎÎÎÎÎÎÎÎÎÎ portfolio construction
starts with selecting attractively
priced securities.
a. Top-down
b. Bottom-up
c. Upside-down
d. Side-to-side
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Risk--Return Trade
Risk Trade--Off
Questions unanswered
How should one measure risk
What role does diversification play
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Efficient ºarkets Theory
Should be neither underpriced nor
overpriced securities
Security price should reflect all
information available to investors
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Active Versus Passive
ºanagement
Active ºanagement
Finding undervalued securities
Timing the market
Passive ºanagement
No attempt to find undervalued securities
No attempt to time
Holding an efficient portfolio
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The Players
Business Firms ± net borrowers
Households ± net savers
Governments ± can be both
borrowers and savers
± Issuing of Treasury bills, notes or bonds
to borrow funds when budget deficits
± Retire some outstanding debt when
budget surplus
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The Players
Financial Intermediaries
± Institutions that ³ connect´ borrowers
and lenders by accepting funds from
lenders and loaning funds to borrowers
Banks
Investment companies
Insurance companies
Credit unions
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Computer networks have made it
much cheaper and easier for small
investors to trade for their own
accounts and perform their own
security analysis.
What will be the likely effect on
financial intermediation?
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The Players
Investment Bankers
± Firms specializing in the sale of new
securities to the public, typically by
underwriting the issue
± E.g. Goldman Sachs, ºerrill Lynch,
Citigroup
± Investment banking firm handles the
marketing of security in primary market
and investors can trade these securities
in the secondary market
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Recent Trends
Globalization
Securitization
Financial Engineering
Information and computer networks
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Globalization
Diversification to improve
performance
Instruments and vehicles continue to
develop (WEBs)
Information and analysis improves
Concerns: ºanaging foreign
exchange
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Globalization
Investors can participant via
± Trading of NASDAQ stocks e.g.
Starbucks, Intel, Dell, ºicrosoft
± Purchase foreign securities e.g.
Citibank
± Buy mutual funds invest internationally
± Buy derivative securities with payoffs
depending on prices in foreign security
market
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Securitization
Securitization: pooling loans into
standardized securities backed by
those loans, which can then be
traded like any other security
Pass-thorough securities e.g.
mortgage, students loans, credit card
loans, and debt of firms
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Securitization
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Figure 1.2 Asset-backed Securities
Outstanding
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Financial Engineering
Repackaging Services of Financial
Intermediaries
Bundling and unbundling of cash flows
Slicing and dicing of cash flows
Examples: strips, CºOs, dual purpose
funds, principal/interest splits
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Building a Complex Security
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Unbundling ± ºortgage Security
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Computer Networks
Online trading
Information made cheaply and
widely available
Direct trading among investors
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U.S. Treasury bonds pay interest
every six months and repay the
principle at maturity. The U.S.
Treasury routinely sells individual
interest payments on these bonds to
investors. This is an example of
ÎÎÎÎÎÎÎÎÎÎÎÎ.
a. Unbundling
b. Bundling
c. Securitization
d. Security selection
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References
Bodie, Kane, and ºarcus, P
, 7th Edition, ºcGraw-
Hill, pp 2-23
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