Financial Investments 3324 Part 1 Notes: Investment: The current commitment of money or other resources with an expectation of future benefits. A reduction of current consumption with an expectations of greater consumption in the future Real Asset: Used to produce goods and services Examples: Real Estate, consumer durables Financial Asset: Claims on real assets or the income generated by them Examples: Deposits, life insurance reserves, pension reserves, corporate equity, mutual funds, debt securities (bonds) Domestic Net worth Includes: 1. commercial real estate 2. residential real estate 3. equity and intellectual property 4. inventories 5. consumer durables Household wealth Includes: 1. bank accounts 2. corporate stock 3. bonds (debt securities) Examples questions answered: 1. Do Stock prices play a major role in the allocation of capital in the market economies? 2. What should someone do in order to avoid reduction of purchasing power during low-earning periods in life? 3. True or False: virtually all real assets involve some risk? 4. What act was passed by congress in 2002 in response to all the financial ethic scandals? Answers: 1. Yes, stock prices do play a major role in the allocation of capital in the market economies 2. During high-earning periods invest in savings/bonds 3. True 4. Sarbares-Oxley Act What are Financial Assets? - claims on real assets or claims on the income generated by them - all financial assets (owner of the claim-saver) are offset by financial liabilities (issuer of the claim-borrower) Types of Financial Assets: 1. Fixed income (debt)- securities, money market investment, CD, T-Bills Bonds, and preferred stock 2. Common Stock (equity): residual cashflow and partial ownership in the company 3. Derivative Securities: contract from an underlying market condition • Security Selection= the act of selecting and choosing each asset class (ex: technology/retail) • Security Analysis= the act of analyzing the values of securities Investors should consider the following when forming a portfolio: 1. Risk allocation: adjusting the risk and risk free assets 1. Investing in Bond (less risky) or stocks (more risky) 2. Bank CD (less risky) or Company Bond (more risky) Risk and Return trade off: Risk and return have a positive relationship, the higher the risk the higher the return, a stock has a higher return than a bond or bank CD but much higher risk 1 of 2• Stocks have an average return of 12%. In history the lowest return was in 1931 at -46% then in history the highest rate of return just a few years later in 1933 was 55% return. • Bonds on the other hand have an average rate of return less than 6%, however, they have never dropped more than 13% in value in any year in history. Much less risky than stocks. • Diversification (creating a very diversified portfolio in financial asset types and security categories) in the risk return trade off will reduce risk. Modern Portfolio Theory is the framework for forming portfolios: - It identifies optimal portfolios weights - It Identifies the combination of risky assets and less risky or risk free assets like T-Bills (diversification) - It takes investors risk preferences into account • Securities should NOT be under or over priced • Securities price should reflect ALL information available to investors Investment Management Styles: Active vs. Passive
Should be used when markets are:
Security Selection process:
Actively seeking securities below market value
no attempt to find below market securities
Asset allocation Timing:
Tries to anticipate market timing
no attempt to time the market
Value and growth security selection strategies
Indexing, and constructing an efficient portfolio
What are Financial Assets?
What act was passed by congress in 2002 in response to all the financial ethic scandals?
What should someone do in order to avoid reduction of purchasing power during low-earning periods in life?
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Players in the financial market: 1. Business firms (new borrowers- issuers) 2. Households (net savers-investors) 3. Governments (can be a saver or a borrower) 4. Financial Intermediaries (the connectors between borrowers and savers) - Investment Companies: Specialize in primary market transactions - Commercial Banks - Insurance companies - Pension funds (retirement funds) - Hedge funds (only for the very wealthy) Primary Market: - Newly issued securities (IPO’s) - Investment Companies usually underwrite the issues Secondary Market: pre-existing securities traded among investors (NYSE) Venture Capital: investment to finance NEW firms Private Equity: Investment in a company NOT traded on the market 2 of 2