CHAPTER 1

Investments - Background and Issues

McGraw-Hill/Irwin

Copyright 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

What is Investment?
A Definition?
The use of financial capital in an effort to create more money. Commitment of cash flow now for cash flow in the future.

The Essence of Investments

Allowing the tradeoff between current consumption and consumption in the future Is this important? Is it useful? Why should we care?

1-2

The Difference Between Saving and Investing

Even though the words "saving" and "investing" are often used interchangeably, there are differences between the two. Saving provides funds for emergencies and for making specific purchases in the relatively near future (usually three years or less).
Safety of the principal and liquidity of the funds (ease of converting to cash) are important aspects of savings funds. Because of these characteristics, savings dollars generally yield a low rate of return and do not maintain purchasing power.

Investing, on the other hand, focuses on increasing net worth and achieving long-term financial goals. Investing involves risk (of loss of principal) and is to be considered only after you have adequate savings.
1-3

Savings vs. Investment Funds

Savings Funds Safe Easily accessible
Low return Used for short-term

goals

Investment Funds Involve risk Volatile in short time periods Offer potential appreciation Used for mid- & long-term goals

1-4

1.1 REAL ASSETS VERSUS FINANCIAL ASSETS

1-5

Financial Versus Real Assets

Real Assets
Assets used to produce goods and services

Financial Assets
Claims on real assets

1-6

Major Classes of Financial Assets

Financial Assets or Securities: A legal representation of the right to receive prospective future benefits under stated conditions.

Equity Securities - represents an ownership stake Debt/Fixed Income securities - promises a fixed stream of income Derivative securities - payoffs depend on values of other assets.
1-7

Financial Markets
Informational Role of Financials Markets
The Google effect

Consumption Timing Allocation of Risk Separation of Ownership and Management

Agency Issues

1-8

Corporate Governance and Ethics

Accounting Scandals
Examples Enron and WorldCom

Misleading research reports Auditors watchdogs or consultants

Example Arthur Andersen and Enron

1-9

The Investors Portfolio

Asset allocation
Choice among broad asset classes

Security selection
Choice of which securities to hold within asset class

1-10

Risk-Return Trade-Off
How should one measure risk Assets with higher expected returns have greater risk What role does diversification play

1-11

Efficient Markets Theory

Should be neither underpriced nor overpriced securities Security price should reflect all information available to investors

1-12

Active Versus Passive Management

Active Management Finding undervalued securities Timing the market
Passive Management No attempt to find undervalued securities No attempt to time Holding an efficient portfolio
1-13

The Players
Business Firms net borrowers Households net savers Governments can be both borrowers and savers Financial Intermediaries
Banks Investment companies Insurance companies Credit unions

Investment Bankers

1-14

Globalization
Managing foreign exchange Diversification to improve performance Instruments and vehicles continue to develop (WEBs) Information and analysis improves

1-15

Securitization

Offers opportunities for investors and originators Changes in financial institutions and regulation Improvement in information capabilities Credit enhancement and its role

1-16

Financial Engineering
Repackaging Services of Financial Intermediaries Bundling and unbundling of cash flows Slicing and dicing of cash flows Examples: strips, CMOs, dual purpose funds, principal/interest splits

1-17

Computer Networks
Online trading Information made cheaply and widely available Direct trading among investors

1-18