Elements of Investments

Chapters in ThisPart:

1 Investments: Background and Issues

2 Asset Classes and Financial Instruments
3 Securities Markets
4 Mutual Funds and Other Investment Companies
Investments:
ackground and Issues
Learning Objectives:

• LO1-1 Define an investment.

• LO1-2 Distinguish between real assets and financial assets.
• LO1-3 Explain the economic functions of financial markets
and how various securities are related to the
governance of the corporation.
• LO1-4 Describe the major steps in the construction of an
investment portfolio.
• LO1-5 Identify different types of financial markets and the
major participants in each of those markets.
• LO1-6 Explain the causes and consequences of the financial
crisis of 2008.
Investment

Refers to the commitment of current resources in the

expectation of greater resources in the future.
deriving.

An investment is the current commitment of money or other

resources in the expectation of reaping future benefits.

For example, an individual might purchase shares of stock

anticipating that the future proceeds from the shares will justify both
the time that her money is tied up as well as the risk of the
investment.
This chapter addresses three topics that will provide a useful
perspective for the material that is to come later.

First, before delving into the topic of “investments,” we

consider the role of financial assets in the economy. We
discuss the relationship between securities and the “real”
assets that actually produce goods and services for
consumers, and we consider why financial assets are
important to the functioning of a developed economy.
 These investment decisions are made in an
environment where higher returns usually can be obtained
only at the price of greater risk and in which it is rare to find
assets that are so time and effort.
While these two investments differ in many ways, they
share one key attribute that is central to all investments:
You sacrifice something of value now, expecting to benefit
from that sacrifice later.
 This text can help you become an informed
practitioner of investments. We will focus on in-
vestments in securities such as stocks, bonds, or options
and futures contracts, but much of what we discuss will
be useful in the analysis of any type of investment.
 We provide an overview of the organization of
security markets as well as the various players that
participate in those markets. Together, these
introductions should give you a feel for who the major
participants are in the securities markets as well as the
setting in which they act.
REAL ASSETS VERSUS FINANCIAL ASSETS

The material wealth of a society is ultimately

determined by the productive capacity of its
economy, that is, the goods and services its
members can create. This capacity is a function of
the real assets of the economy: the land,
buildings, equipment, and knowledge that can be
used to produce goods and services.
 In contrast to such real assets are financial
assets such as stocks and bonds. Such securities
are no more than sheets of paper or, more likely,
computer entries and do not directly contribute to
the productive capacity of the economy.
 While real assets generate net income to the
economy, financial assets simply define the
allocation of income or wealth among investors.
Individuals can choose between consuming their
wealth today or investing for the future. If they
choose to invest, they may place their wealth in
financial assets by purchasing various securities.
 When investors buy these securities from
companies, the firms use the money so raised to
pay for real assets, such as plant, equip- ment,
technology, or inventory. So investors’ returns on
securities ultimately come from the income
produced by the real assets that were financed by
the issuance of those securities
FINANCIAL ASSETS

It is common to distinguish among three broad

types of financial assets: debt, equity, and
derivatives.
Fixed-income (debt) securities

Pay a specified cash flow over a specific period.

Fixed-income or debt securities promise

either a fixed stream of income or a stream of
income that is determined according to a specified
formula.For example, a corporate bond typically
would promise that the bondholder will receive a
fixed amount of interest each year.
Debt securities come in a tremendous variety of maturities
and payment provisions. At one extreme, the money market
refers to fixed-income securities that are short term, highly
marketable, and generally of very low risk. Examples of
money market securities are U.S. Treasury bills or bank
certificates of deposit (CDs).
In contrast, the fixed-income capital market includes long-
term securities such as Treasury bonds, as well as bonds
issued by federal agencies, state and local municipalities,
and corporations.
Equity

An ownership share in a corporation.

Equity holders are not promised any particular

payment. They receive any dividends the firm may
pay and have prorated ownership in the real assets
of the firm. If the firm is successful, the value of
equity will increase; if not, it will decrease.
Derivative securities

• Securities providing payoffs that depend on the values of

other assets.

• Derivative securities such as options and futures

contracts provide payoffs that are determined by the
prices of other assets such as bond or stock prices. For
example, a call option on a share of Intel stock might
turn out to be worthless if Intel’s share price remains
below a threshold or “exercise” price such as $20 a
share, but it can be quite valuable if the stock price rises
above that level.
FINANCIAL MARKETS AND
THE ECONOMY
The Informational Role of Financial Markets

• 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.
Consumption Timing

• Some individuals in an economy are earning more

than they currently wish to spend.

• In high-earnings periods, you can invest your

savings in financial assets such as stocks and
bonds. In low-earnings periods, you can sell these
assets to provide funds for your consumption
needs.
Allocation of Risk

• Virtually all real assets involve some risk.

• Financial markets and the diverse financial

instruments traded in those markets allow
investors with the greatest taste for risk to bear
that risk, while other, less risk-tolerant
individuals can, to a greater extent, stay on the
sidelines.
Separation of Ownership
and Management
• Many businesses are owned and managed by the
same individual. This simple organization is well
suited to small businesses and, in fact, was the
most common form of business organization
before the Industrial Revolution.
Agency problems

• Conflicts of interest between managers and

stockholders.

• These potential conflicts of interest are called

agency problems because managers, who are
hired as agents of the shareholders, may pursue
their own interests instead.
Corporate Governance
and Corporate Ethics
We’ve argued that securities markets can play an
important role in facilitating the deployment of
capital resources to their most productive uses. But
market signals will help to allocate capital
efficiently only if investors are acting on accurate
information. We say that markets need to be
transparent for investors to make informed
decisions.
THE INVESTMENT PROCESS

• An investor’s portfolio is simply his collection of

investment assets. Once the portfolio is estab-
lished, it is updated or “rebalanced” by selling
existing securities and using the proceeds to buy
new securities, by investing additional funds to
increase the overall size of the portfolio, or by
selling securities to decrease the size of the
portfolio.
Asset allocation

• Allocation of an investment portfolio across broad asset classes.

Security selection
• Choice of specific securities within each asset class

• The asset allocation decision is the choice among these broad

asset classes, while the security selection decision is the choice of
which particular securities to hold within each asset class.
• Security analysis involves the valuation of
particular securities that might be included in the
portfolio. For example, an investor might ask
whether Merck or Pfizer is more attractively
priced.
MARKETS ARE COMPETITIVE

• Financial markets are highly competitive.

Thousands of well-backed analysts constantly
scour securities markets searching for the best
buys. This competition means that we should
expect to find few, if any, “free lunches,”
securities that are so underpriced that they
represent obvious bargains.
The Risk-Return Trade-Off

• Investors invest for anticipated future returns,

but those returns rarely can be predicted
precisely. There will almost always be risk
associated with investments. Actual or realized
returns will almost always deviate from the
expected return anticipated at the start of the
investment period.
Risk-return trade-off

• Assets with higher expected returns entail greater

risk.

• We conclude that there should be a risk-return

trade-off in the securities markets, with higher-
risk assets priced to offer higher expected returns
than lower-risk assets.
• Diversification means that many assets are held in
the portfolio so that the exposure to any
particular asset is limited. The effect of
diversification on portfolio risk, the implications
for the proper measurement of risk, and the risk-
return relationship are the topics of Part Two.
These topics are the subject of what has come to
be known as modern portfolio theory.
fficient Markets
Passive management

• Passive management calls for holding highly

diversified portfolios without spending effort or
other resources attempting to improve
investment performance through
security analysis.
Active management

• Active management is the attempt to improve

performance either by identifying mispriced
securities or by timing the performance of
broad asset classes—for example, increasing
one’s commitment to stocks when one is
bullish on the stock market.
THE PLAYERS

From a bird’s-eye view, there would appear to be

three major players in the financial markets.

1. Firms are net demanders of capital

2. Households typically are suppliers of capital.
3. Governments can be borrowers or lenders
Financial Intermediaries

• Households want desirable investments for their

savings, yet the small (financial) size of most
households makes direct investment difficult.
Financial intermediaries

• Institutions that “connect” borrowers and lenders

by accepting funds from lenders and loaning
funds to borrowers.

• For these reasons, financial intermediaries have

evolved to bring together the suppliers of capital
(investors) with the demanders of capital
(primarily corporations).
nvestment companies

• Firms managing funds for investors. An investment

company may manage several mutual funds.

• which pool and manage the money of many

investors, also arise out of economies of scale.
Here, the problem is that most household
portfolios are not large enough to be spread
among a wide variety of securities
On the MARKET FRONT
Investment Bankers

• Firms specializing in the sale of new securities to

the public, typically by underwriting the issue.

• Investment bankers that specialize in such

activities can offer their services at a cost below
that of maintaining an in- house security issuance
division.
rimary market

• A market in which new issues of securities are

offered to the public.

• where new issues of securities are offered to the

public. In this role, the banks are called
underwriters. Later, investors can trade
previously issued securities among themselves in
the so-called secondary market.
Venture Capital and Private Equity

• Money invested to finance a new firm.

• The equity investment in these young companies

is called venture capital (VC). Sources of venture
capital are dedicated venture capital funds,
wealthy individuals known as angel investors, and
insti- tutions such as pension funds.
Private equity

• Investments in companies that are not traded on

a stock exchange

• Collectively, these investments in firms that do

not trade on public stock exchanges are known as
private equity investments.
THAK YOU FOR
LISTENING!!!
WRITTEN WORK 1: ANSWER THE FOLLOWING
QUESTIONS IN ONE WHOLE SHEET OF PAPER.
Submit output on Thurs next meeting.

• DEFINE THE FOLLOWING 8. FIXED-INCOME (DEBT 16. RISK-RETURN TRADE-

TERMS: SECURITIES) OFF
1. ACTIVE MANAGEMENT 9. INVESTMENT 17. SECONDARY MARKET
2. AGENCY PROBLEMS 10. INVESTMENT BANKERS 18. SECURITIZATION
3. ASSET ALLOCATION 11. INVESTMENT 14. P
7. FINANCIAL
4. DERIVATIVE SECURITIES COMPANIES EQUITY
5. EQUITY 12. PASSIVE AMANGEMENT INTERMEDIARIES
13. PRIMARY MARKET 15. R
6. FINANCIAL ASSETS
19. SECURITY ANALYSIS 20. SECURITY SELECTION
21. SYSTEMATIC RISK
22. VENTURE CAPITAL