FIN4504 -- Investments -- Chapter 1 Lecture/Book Outline
FIN4504 -- Investments -- Chapter 1 Lecture/Book Outline FIN4504
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This 11 page Class Notes was uploaded by Gabrielle Isgar on Saturday January 23, 2016. The Class Notes belongs to FIN4504 at Florida State University taught by Dr. Doug Smith in Winter 2016. Since its upload, it has received 85 views. For similar materials see Investments in Business at Florida State University.
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Date Created: 01/23/16
Book Notes – FIN 4504 – Chapter 1 Chapter 1 -- Investments: Background and Issues 1.1 Real Versus Financial Assets Investment - the current commitment of money or other resources in the expectation of reaping future benefits Real assets - the land, buildings, equipment and knowledge that can be used to produce goods and services Determine the material wealth by their productive capacity to provide goods and services Financial assets - stocks and bonds The means by which individuals in well-developed economies hold their claims on real assets Are claims to the income generated by real assets 1.2 A Taxonomy of Financial Assets There are 3 types of Financial Assets: 1 Debt (Fixed-Income) Securities - promise either a fixed stream of income or a stream of income that is determined according to a specified formula Money market - refers to the fixed-income securities that are short term, highly marketable, and generally of low risk Capital market - long securities such as Treasury Bonds as well as bonds issued by the federal agencies, state and local municipalities, and corporations 1 Equity - (in a firm) represents an ownership share in the corporation o Equity holders are not promised any payment, they receive dividends the firm may pay and have prorated ownership in the real assets of the firm o Tend to be riskier than investments in debt securities 2 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 o Named this because their values derive from the prices of other assets o Primarily used to hedge risk or transfer them to other parties o Commodity and derivative markets allow firms to adjust their exposure to various business risks Stock prices reflect investors' collective assessment of a firm's current performance and future prospects o When the market is more optimistic about the firm, the share price will rise 1.3 Financial Markets and the Economy Consumption Timing Book Notes – FIN 4504 – Chapter 1 Some people are earning more than they currently wish to spend while others spend more than they currently earn You can "store" your wealth in financial assets o High-earnings periods: invest your savings in stocks and bonds o Low-earnings periods: sell these assets to provide funds for your consumption needs Financial assets allow individuals to separate decisions concerning current consumption from constraints that otherwise would be imposed by current earnings Allocation of Risk Capital markets allow that risk that is inherent to all investments to be borne by the investors most willing to bear that risk Also benefits the firms that need to raise capital to finance their investments Separation of Ownership and Management Many businesses are owned and managed by the same individual o Was most common form of business organization before the Industrial Revolution Large groups of individuals are required for a board to oversee all of the activities of a firm since they’re now on such large scales o Elect a board of directors that in turn hires and supervises the management of the firm This structure means that the owners and managers of the firm are different parties Financial assets and the ability to buy and sell those assets in the financial markets allow for easy separation of ownership and management Several mechanism have evolved to mitigate potential agency problems o Compensation plans tie the income of managers to the success of the firm o Boards of directors can force out management teams that are underperforming o Outsiders such as security analysts and large institutional investors such as pension funds monitor the firm closely and make the life of poor performers at the least uncomfortable o Bad performers are subject to threat of takeover Proxy contest - Shareholders can launch to seek to obtain enough proxies to take control of the firm and vote in another board Corporate Governance and Corporate Ethics Market signals help to allocate capital efficiently only if investors are acting on accurate information Scandals occurred such as systematically misleading and overly optimistic research reports put out by the stock market analysts and allocations of initial public offerings to corporate executives as a quid pro quo for personal factors of the promise to direct future business back to the manager of the IPO 1.4 The Investment Process Portfolio - an investor's collection of investment assets Book Notes – FIN 4504 – Chapter 1 Asset allocation - investor decides the choice among the broad asset classes (stocks, bonds, real estate, commodities, etc.) Security selection - the choice of which particular securities to hold within each asset class "Top-down" portfolio construction - starts with asset allocation Security analysis -involves the valuation of particular securities that might be included in the portfolio "Bottom-up" portfolio construction - the portfolio is constructed from the securities that seem attractively priced without as much concern for the resultant asset allocation Focuses the portfolio on the assets that seem to offer the most attractive investment opportunities 1.5 Markets are Competitive The Risk-Return Trade-Off Risk-return trade-off - higher-risk assets should be priced to offer higher expected returns than lower-risk assets Diversification - many assets are held in the portfolio so that the exposure to any particular asset is limited Modern portfolio theory - theory by Harry Markowitz and William Sharpe; the implications of the proper measurement of risk and the risk-return relationship Efficient Markets Passive Management - holding highly diversified portfolios without spending effort or other resources attempting to improve investment performance through security analysis Active Management - the attempt to improve performance either by identifying mispriced securities or by timing the performance of broad asset classes 1.6 The Players 1 Firms are net demanders of capital. 2 Households typically are suppliers of capital. 3 Governments can be borrowers or lenders, depending on the relationship between tax revenue and government expenditures. Financial Intermediaries -- connectors of borrowers and lenders; stand between the security issuer and the ultimate owner of the security Banks Investment companies Insurance companies Credit unions o Issue their own securities to raise funds to purchase the securities of other corporations o Distinguished from other businesses in that both their assets and their liabilities are overwhelmingly financial Investment companies -- firms managing funds for investors; pool and manage the money of many investors, also arise out of economies of scale Book Notes – FIN 4504 – Chapter 1 Mutual funds are sold in the retail market o Charge a fixed percentage of assets under management Hedge funds also pool and invest the money of many clients o Only open to institutional investors such as pension funds, endowment funds, or wealthy individuals o Typically keep a portion of trading profits as part of their fees Investment bankers -- firms specializing in the sale of new securities to the public, typically by underwriting the issue Advise an issuing corporation on the prices it can charge for the securities issued, appropriate interest rates, and so forth Primary Market -- where new issues of securities are offered to the public Secondary Market -- investors can trade previously issued securities among themselves here 1.7 Recent Trends Venture capital (VC) -- the equity investment in young companies Sources of venture capital are: o Dedicated venture capital funds o Wealthy individuals --> angel investors o Institutions such as pension funds Most are set up as limited partnerships After a period of time, the fund is liquidated and proceeds are distributed to the investors Private equity -- investments in firms that do not trade on public stock exchanges Antecedents of the Crisis The Federal Reserve responded to an emerging recession by aggressively reducing interest rates o Investors became hungry for higher-yielding alternatives o Low volatility and growing competency about risk encouraged greater tolerance for risk in the search for these higher-yielding alternatives Changes in Housing Finance Prior to 1970, mortgage loans would come from a local tender such as a neighborhood bank or credit union Changed in the 1970s when Fannie Mae (FNMA, or Federal National Mortgage Association) and Freddie Mac (FHLMC, or Federal Home Loan Mortgage Corporation) began buying large quantities of mortgage loans from originators and bundling them into pools that could be traded like any other financial asset o These pools were soon dubbed "mortgage-backed securities" o Process was called securitization Conforming mortgages -- eligible loans for agency securitization couldn't be too big and homeowners had to meet underwriting criteria establishing their ability to repay the loan Book Notes – FIN 4504 – Chapter 1 Nonconforming -- securitization by private firms of "subprime" loans with higher and default risk Biggest difference is that the investor in the private-label pool would bear the risk that homeowners might default on their loans o Originating mortgage brokers has little incentive to perform due diligence on the loan as long as the loans could be sold to an investor By 2006, the majority of subprime borrowers purchased houses by borrowing the entire purchase price Adjustable rate mortgages (ARMs) -- offered borrowers low initial or "teaser" interest rates, but these rates eventually would reset to current market interest yields Starting in 2004, the ability of refinancing to save a loan began to diminish Mortgage Derivatives Collateralized debt obligations = CDOs o Designed to concentrate the credit risk of a bundle of loans on one class of investors, leaving the other investors in the pool relatively protected from that risk o Idea to divide the pool into senior vs. junior slices called tranches Large amounts of AAA-rated securities were thus carved out of pools of low- rated mortgages Liar loans = no-documentation loans Credit default swaps (CDS) -- an insurance contract against the default of one or more borrowers Became an alternative method of credit enhancement Seemingly allowing investors to buy subprime loans and insure their safety Some swap issuers ramped up their exposure to credit risk to unsupportable levels, without sufficient capital to back those obligations The Rise of Systematic Risk Many large banks and related financial institutions began borrowing short- term at low interest rates to finance holdings in higher-yielding, long-term, illiquid assets and treating the interest rate differential between their assets and liabilities as economic profit o Constantly needed to refinance or would need to sell off their loans (which would be difficult) o Institutions were highly leveraged and had little capital as a buffer against losses Margin -- a type of collateral which was necessary in formal exchanges to guarantee their ability to make good on their obligations Gains and losses are continually added or subtracted to each trader's margin account If a margin account runs low, the investor can be required to either contribute more collateral or close out the position before actual insolvency ensues The Shoe Drops Commercial paper -- short-term, unsecured debt Major customers included money market mutual funds Book Notes – FIN 4504 – Chapter 1 The Dodd-Frank Reform Act Passed in 2010 Proposes several mechanisms to mitigate systematic risk Calls for stricter rules for bank capital, liquidity, and risk management practices, especially as banks become larger and their potential failure would be more threatening to other institutions Mandates increased transparency, especially in derivative markets Attempts to limit the risky activities in which banks can engage Volcker Rule -- limits a bank's ability to trade for its own account and to own or invest in a hedge fund or private equity fund Addresses shortcoming of the regulatory system that became apparent in 2008 Seeks to unify and clarify lines of regulatory authority Addresses incentive issues o Proposals to force employee compensation to reflect longer-term performance o Requires public companies to set "claw back provisions" to take back executive compensation if it was based on inaccurate financial statements o To discourage excessive risk taking Creates an Office of Credit Ratings within the Securities and Exchange Commission to oversee the credit rating agencies Lecture Notes – 1/12 – Chapter 1 Chapter 1 -- Investments: Background and Issues 1.1 Real Versus Financial Assets Essential nature of investment - reduce current consumption in hopes of greater future consumption Real Assets - used to produce goods and services: property, plant & equipment, human capital, etc. Financial Assets - claims on real assets or claims on asset income What makes something valuable? What makes some money worth more than others? 1.2 A Taxonomy of Financial Assets Major Classes of Financial Assets or Securities Debt o Money market instruments o Bonds o Preferred stock Common stock (equity) o Ownership stake in the entity, residual cash flow Derivative securities o A contract whose value is derived from some underlying market condition We're used to viewing things from a commercial stand point when we should be looking at everything from an institutional stand point, elevating our point of view and thus making better financial decisions 1.3 Financial Markets and the Economy Financial Markets Informational Role: Do market prices equal the fair value estimate of a security's expected future risky cash flows? Can we rely on markets to allocate capital to the best uses? What other mechanism could we use to allocate capital? What would be the advantages and disadvantages of another system? Allocation of Risk Investors can choose a desired risk level o Bonds vs. stock of a given company o Bank CD vs. company bond Tradeoff between risk and return? One of the ways you can control risk because you have your assets spread out enough to where even if something is going well and another is not, investment wise, you're still breaking even Clairvoyant? "you need to be consistent and clairvoyant" Lecture Notes – 1/12 – Chapter 1 Corporate Governance and Corporate Ethics Business and market require trust to operate efficiently Accounting Scandals o Enron, WorldCom, Rite-Aid, HealthSouth, Global Crossing, Qwest Misleading Research Reports o Citicorp, Merrill Lynch, others Auditors: Watchdogs or Consultants? o Arthur Andersen and Enron --- Watch The Big Short?? --- Sarbanes-Oxley Act (SOX) o Increases the number of independent directors on company boards o Requires the CFO to personally verify the financial statements o Created a new oversight board for the accounting/audit industry o Charged the board with maintaining a culture of high ethical standards 1.4 The Investment Process (said to know this slide fasho) Asset allocation o Choosing the percentage of funds in asset classes Stocks = 60% Bonds = 30% Alternative assets = 6% Money Market securities = 4% Security and fill in from slides 1.5 Markets are Competitive Risk-return trade-of - assets with higher expected returns have higher risk A stock portfolio can be expected to lose money about 1 out of every 4 years Bonds have a much lower average rate of return and have not lost more than 13% of their value in any one year How do we measure risk? How does diversification affect risk? Efficient Markets Market efficiency: Securities should be neither underpriced nor overpriced on average Security prices should reflect all information available to investors Whether we believe markets are efficient affects our choice of appropriate investment management style Active vs. Passive Management Lecture Notes – 1/12 – Chapter 1 Active Management (inefficient markets) - finding undervalued securities (security selection), timing the market (asset allocation) Passive Management (efficient markets) - no attempt to find undervalued securities, no attempt to time, holding a diversified portfolio: indexing, constructing an "efficient" portfolio 1.6 The Players Business firms -- net borrowers Households -- net saves Governments -- can be both borrowers and savers Financial Intermediaries "Connectors of borrowers and lenders" Commercial banks Investment companies Insurance companies Pension funds Hedge funds Investment Bankers -- firms that specialize in primary market transactions Primary market: a market where newly issued securities are offered to the public; the investment banker typically "underwrites" the issue Secondary market: a market where pre-existing securities are traded among investors Some investment banks chose to become commercial banks to obtain deposit funding and government assistance All of the major investment banks are now under the much stricter commercial bank regulations What are the implications for innovation and capital issuance resulting from these changes? 1.7 Recent Trends Globalization - domestic firms compete in global markets Performance in one country or region depends on other regions Opportunities for better returns & implications for risk Securitization - loans of a given type placed into a "pool" and new securities are issued that use the loan payments as collateral Ex. Mortgages "Shadow Banking System" - the securities are marketable and are purchased by many institutions End result -- more investment opportunities for purchasers and spreading loan credit risk among more institutions Has grown rapidly due to: o Changes in financial institutions and regulation permitting its growth, particularly lower capital requirements on securitized loans o Improvement in information capabilities o Credit enhancement provided by pool issuers has improved marketability Pool organizers typically have a contingent liability for the securities Lecture Notes – 1/12 – Chapter 1 o When the mortgage markets collapsed, this led to the financial crisis of 2007 and 2008 Financial Engineering - repackaging cash flows of a security to enhance marketability Bundling and unbundling of cash flows: Bundling: combining more than one asset into a composite security, for example, securities sold backed by a pool of mortgages Unbundling: selling separate claims to the cash flows of one security, for example a CMO CMO = collateralized mortgage obligation Type of mortgage backed security that takes payments from a mortgage pool and separates them into separate classes of payments that investors can by CDO = collateralized debt obligation An unbundling example Simpler version of unbundling would be a Treasury Strip Computer Networks Online low cost trading Information made cheaply and widely available Direct trading among investors via electronic communication networks Technological advances that promoted widespread securitization changed the business model of commercial banks o Responded by engaging in riskier trading activities and increasing leverage to bolster rates of return What have been the effects on Wall Street firms' profit margins? How has Wall Street responded? The Future Globalization will continue and investors will have far more investment opportunities than in the past Securitization will continue to grow after the crisis Continued development of derivatives and exotics, more regulation for "over the counter" derivatives Strong fundamental foundation of understanding is critical Understanding corporate finance requires understanding investments 1.8 Text Outline Part One: Introduction to Financial Markets, Securities and Trading Methods Part Two: Modern Portfolio Theory Part Three: Debt Securities Part Four: Equity Security Analysis Part Five: Derivative Markets Part Six: Active Investment Management Strategies: Performance Evaluation, Global investing, Taxes, and the Investment Process Lecture Notes – 1/12 – Chapter 1
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