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FIN 200 Investments

CHAPTER 1CHAPTER 1

The Investment EnvironmentThe Investment Environment

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Real Assets Versus Financial Assets Essential nature of investment

Reduced current consumption Planned later consumption

Real Assets Assets used to produce goods and services

(tangibles which you can see and touch) Financial Assets

Claims on real assets (ownership) Owners can manage but do not always do so.

Discussion:The Stages of Life

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Q Give an example of real assets.

A Land, buildings, machines and knowledge used to produce goods and services.

Q. Give and example of financial assets.

A Stocks or bonds do not contribute directly to the productive capacity but are claims on real assets and the income generated

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Q. Which is more important, real assets or financial assets? Why?

A They are both necessary in a modern economy.

Read the first paragraph of “Separation of Ownership and Management” Page 6.

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Q. How do the owners of real assets and the owners of financial assets work together?

A. When investors buy newly issued financial securities (assets), the firms use the money to pay for real assets which create more wealth which will be shared as profit.

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Imagine the balance sheet of a company that issues financial assets. What is the formula?

Assets – Liabilities = Net Worth or Equity (commerce)

A bond that you own is your asset but is also a liability (debt) of the company because,

1. You have a claim on the interest income and

2. You must be paid the principal

Therefore, your asset is the companies liability.

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Therefore, only real assets are the net wealth of the economy.

Q. Who can explain in your own words, why this is true?

A1. Because the ownership (paper or journalized computer entry) is a claim on a percentage of the productive assets (land, tools, copyrights, software, etc.)

A2. Because they are really, one in the same.National wealth consists of structures,

equipment, inventories of goods and land.

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The success or failure of the financial assets we choose to purchase depend on the performance of the underlying real assets.

Q. WHY? Write the answer in your notebook.

Share your answers.

Consumer Durables = Mass market heavy goods such as washing machines, refrigerators, furniture intended to last three or more years. Also called durable goods or hard goods.

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Table 1.1 Balance Sheet of U.S. Households, 2007 (page 3)

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Table 1.2 Domestic Net Worth

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A Taxonomy of Financial Assets

1. Fixed income or debt securities Money market instruments

Bank certificates of deposit Capital market instruments

Bonds

2. Common stock or equity

3. Derivative securities

Definitions on page 4 (highlight them)

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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.Short term, highly marketable, and very low risk.Examples: Treasury Bills or bank certificates of deposit (CDs).In contrast: Fixed-income Capital Markets include long term securities such as Treasury bonds as well as bonds issued by federal agencies, state and local municipalities, and corporations. They range from very safe in terms of default risk to relatively risky.Example: each student loans me 100,000 RMB and I pay 4%. I bet I could make 9% in other investments, thereby profiting all of us.

Equity in a firm represents an ownership share in the real assets of the corporation. There is no promise to make scheduled payments.The performance of equity investments is tied to the success of the firm and its real assets.Equity investments are not guaranteed and are therefore riskier.Recall the balance sheet: A-L=NW (personal) or Equity (commerce)

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.

Examples of derivative securities include: call options, futures and swap contracts. Read footnote 2 on page 4 for a definition of a call option.

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Financial Markets and the EconomyInformation Role – Word of Mouth / The Google effect. Investments go to those firms that appear, at the

time, to have the best prospects of success. Share prices increase as confidence builds. Those firms that benefit from good reputations, find

it easier to issue new shares and borrow to finance R&D, build new production facilities, expand and create more profit.

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Consumption Timing – Similar to the stages of life in personal financial planning.

While earning more than you wish to spend, you should invest (store your wealth) in financial assets so that it is available for your use (to sell later) when you are earning less than you need to support yourself.

This is known as shifting your consumption.

Q. When will you start shifting your consumption?

Q. Have you ever purchased a stock or bond?

Susan’s Story Page 5 in text

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Allocation of Risk is a personal choice. Greater risk tolerant investors will invest in

equity such as stock ownership Less risk tolerant investors will invest in bonds

with guaranteed returns and bankruptcy protection.

Do you remember the Risk Tolerance Questionnaire we did in FIN 401 / 403?

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Separation of Ownership and Management

Agency IssuesA topic which relating to: Power and control of business organizations Conflict between owners and managers Distribution of wealth

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What is the Goal of the Firm?

Maximization of Maximization of Shareholder Wealth!Shareholder Wealth!

Value creation occurs when we maximize the share price for

current shareholders.

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Profit MaximizationProfit Maximization = Maximizing a firm’s earnings after taxes.

What What ProblemsProblems might arise if the main objective might arise if the main objective is to maximize the profitis to maximize the profit??

Could increase current profits while the harming firm (e.g., defer maintenance / increase future capital expenses / deplete capital reserves and inflate current accounts, issue common stock to buy T-bills rather than invest in future production, etc.).

= Ignoring changes in the future risk level of the firm.

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The Modern Corporation

There exists a SEPARATION between owners and managers.

Modern Corporation

Shareholders Management

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Role of Management

An agentagent is an individual authorized by another person, called the principal, to act in the latter’s behalf.

Management acts as an agentagent for the owners (shareholders) of the firm.

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Agency Theory

Principals must provide incentivesincentives so that management acts in the principals’ best interests and then monitormonitor results.

If there are no incentives for management, they may create their own, which are not in the best interest of the owners.

Incentives include, stock optionsstock options, , perquisites (perks)perquisites (perks), , and bonusesbonuses.

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Corporate Social Responsibility

Wealth maximization does not preclude (stop) the firm from being socially responsiblesocially responsible at the corporate level.

Assume we view the firm as producing both private and social goods.

Then shareholder wealth maximizationshareholder wealth maximization remains the appropriate goal in governing the firm.

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What is Corporate Social ResponsibilityWhat does the word social mean?

Society, to interact, citizens.

Whose job is it to take care of the citizens…Government or private businesses?

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Corporate Social ResponsibilityQuestion. What are some things that you would expect

from a firm that is socially responsible?Answers:

1. Alcohol companies that promote responsible drinking.

2. Food companies that work towards the elimination of childhood hunger.

3. Haggen-Dazs donates a portion of profit from one brand of natural ice cream to honey bee research (honey bees are necessary for natural pollination and the bee population is decreasing. Don’t be fooled into thinking that a company or government who says

they are CSR is actually contributing a lot. Some do. Some just build an image and don’t do much. That’s life.

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Corporate Governance Corporate governance: represents the system

by which corporations are managed and controlled. Includes shareholders, board of directors, and

senior management. Then shareholder wealth maximizationshareholder wealth maximization

remains the appropriate goal in governing the firm.

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Board of Directors Typical responsibilities:

Set company-wide policy; Advise the CEO and other senior executives; Hire, fire, and set the compensation of the CEO; Review and approve strategy, significant investments, and

acquisitions; and Oversee operating plans, capital budgets, and financial

reports to common shareholders. CEO/Chairman roles commonly same person in US,

but separate in Britain (US moving in this direction).Q. Why would the trend be to divide this position into

two?

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Organization of the Financial Management Function

Board of Directors

President(Chief Executive Officer)

Executive Vice President

(Operations)

Executive Vice President

(Marketing)

Executive Vice President

(Finance - CFO)

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Financial Markets and the Economy Continued

Corporate Governance and Corporate Ethics Accounting Scandals

Examples – Enron, Rite Aid, HealthSouth Auditors—watchdogs of the firms Analyst Scandals

Arthur Andersen (auditing finances & consulting caused conflict)

Sarbanes-Oxley Act Tighten the rules of corporate governance

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The Investment Process Portfolio = a collection of investment assets Asset allocation decision = choice among broad

asset classes Security selection = choice of which securities to

hold within asset class Average returns since 1926 on stock = 12% per year (more risk)

Annual Return Ranges since 1926 from -46% to +55%. Average return on Treasury Bills = 4% per year (less risk)

Page 9 in text

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Security analysis = assigning value to the investment asset. Bonds have fixed rates and the value is easier to

determine. A stocks performance is more sensitive to the

conditions of the issuing firm and market conditions and therefore more difficult to determine.

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Top Down Portfolio Management Starts with asset allocation Choosing investments based on the risk tolerance

of the individual investor (the percentage that will be in bonds versus stocks).

Bottom Up Portfolio Management Choosing investments / securities that are most

attractively priced without the same attention to balancing and managing the risk.

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Q. What might be the differences between the top down and bottom up investors?

A. The bottom up investor has a lower risk tolerance and is more willing to risk losing money to earn money and is likely much wealthier and can still maintain her lifestyle even if the money is lost.

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Markets are CompetitiveNo Free Lunches: There are many experts

searching for undervalued stocks, making it unlikely that they remain a deal for very long.

Risk-Return Trade-Off = higher risk assets priced to offer higher expected returns.

Diversification = many different types of assets are held within a portfolio so that a big loss in one type does not result in a big loss to the investor.

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Efficient Market TheoryActive Management

Finding mispriced securities Timing the market

Passive Management No attempt to find undervalued securities No attempt to time the market Holding a highly diversified portfolio

Q. Which management style is more expensive and time consuming?

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The Players Business Firms– net borrowers Households – net savers Governments – can be both borrowers and savers

Homework: Read page 11, 1.6 The Players. Stop at the end of the first paragraph on page 12.

In less than 150 words, tell me the benefits and risks of this type of borrowing on the individual and the economy.

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Financial Intermediaries: Bring lenders and borrowers together (2 examples)

The lender (an individual) is: to small do business directly with the borrower would not be able to diversify risk not equipped to assess and monitor credit risk of borrowers

Note: Financial Intermediaries assets are mostly financial and not real assets.

Investment Companies Banks Insurance companies Credit unions

Lender deposits their money and earns 4% profit

Financial Intermediary receives deposits and makes

loans: earns 5% profit

Borrower pays 9% to invest in their own

company

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The Players ContinuedInvestment Bankers Perform specialized services for businesses by

analyzing, valuing and marketing new financial securities to the public.

The reputation of the investment bank is tied to quality of their recommendations.

Investment Bankers market in the primary market where new issues are made available to the public.

Later, smaller investors will in turn be able to buy and sell on the secondary markets.

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Table 1.3 Balance Sheet of Commercial Banks, 2007

Note the small amount of real assets in the balance sheet of the financial intermediary.

Q. What real assets does an intermediary own?

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Table 1.4 Balance Sheet of Nonfinancial U.S. Business, 2007

Answer these questions in your notebook and make reference to slide 1-39 so you can refer to the balance sheet when studying for the exam.1.What is the percent of real to financial assets on this balance sheet?2.Do they have a lot of financial assets?3.Why do they have that much / little financial assets?4.What can they do with their financial assets?

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Recent Trends—Globalization

We must be able to trade throughout the world.

Four ways for US investors to participate in foreign investments:

American Depository Receipts (ADRs): domestically traded securities that represent claims to shares of foreign stocks

Purchase foreign securities offered in dollars Buy mutual funds that invest internationally

Exchange rate risk is an additional variable that domestically traded stocks do not share.

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Exchange Traded Funds (ETFs)

ETFs allow trading in foreign investments.Rather than trading in individual funds, they buy

entire portfolios of stocks. They can specialize in firms of

one particular country, or one particular industry (sector).

The EurozoneThe ideas was to facilitate trade and encourage

integration of markets across national boundaries.

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Figure 1.1 Globalization: A Debt Issue Denominated in Euros

Find 5 useful bits of information on this debt issue.1.Guaranteed by North West Water2.Euro 500 Million3.4.875% earned interest4.Due in 20095.The managing firms are reputable

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Recent Trends—Securitization Pass Through Securities

Mortgages, Car, student loans, home equity, credit card loans

How they work: Large investors (security holders) purchase the debt obligations

from the banks that originated the loans The banks continue to service the loans (fee for service) and

pass the money through to the security holders. The security holders (owners) use the profit to make low risk

loans at lower interest rates than are receiving from pass through securities, thereby making more profit.

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Figure 1.2 Asset-backed Securities Outstanding

Q. Define asset backed security.A.Real Asset which can be used as a security.

Why do you think that some of these asset backed security categories have grown since 1996?

Possible answers.More people are borrowing in these loan classifications, big money institutions realize the potential for profit and purchased the outstanding securities to make profit.

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Recent Trends—Financial Engineering

Use of mathematical models and computer-based trading technology to synthesize new financial products

Bundling and unbundling of cash flows

Read page 17 for more details.

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Figure 1.3 Building Creates a Complex Security

Figure 1.3 is a hybrid security.1.It is structured as a preferred stock for 4 years after which time it is converted into common stock.2.The number of shares of common stock depend on the value of the preferred stock, at the end of the 4 years.3.This means that the owners of the security are exposed to a risk similar to the risk they would bear if they held option positions on the firm.

Examples of derivative securities include: call options, futures and swap contracts. Read footnote 2 on page 4 for a definition of a call option.

If you are not fully confident that this industry and the corporations that are bundled in this security have a very good future, you may risk losing your capital investment after 4 years.

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Figure 1.4 Unbundling of Mortgages into Principal- and Interest-Only Securities

A stripped mortgage-backed security (SMBS) where each mortgage payment is partly used to pay down the loan's principal and partly used to pay the interest on it. These two components can be separated to create SMBS's, of which there are two subtypes:

An interest-only stripped mortgage-backed security (IO) is a bond with cash flows backed by the interest component of property owner's mortgage payments.

A net interest margin security (NIMS) is resecuritized residual interest of a mortgage-backed securityA principal-only stripped mortgage-backed security (PO) is a bond with cash flows backed by the principal repayment component of property owner's mortgage payments.

See next slide for more details about Figure 1.4

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Stripped mortgage backed securities

Does the interest rate paid on the stripped mortgage backed security (figure 1.4) seem unreasonably high?

In 2012, yes, that is a very high interest rate.In 1987, mortgage rates in the USA and Canada were as high as 18%, making it possible to use the profit from mortgages to create securities that paid rates of 9½% as seen in the FannieMae security.

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Recent Trends—Computer Networks

Individual Investing and Day Trading from home is made possible by:

Online information dissemination Information is made cheaply and widely

available to the public Automated trade crossing Direct trading among investors

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Reading for Chapter 2

We will cover the entire chapter, so read as much of it as you can.

The PPTs will cover the highlights and I will be asking you questions about the different topics.

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Discuss the agency problem in detail. 

Managers are the agents of the shareholders, and should act on their behalf to maximize shareholder wealth (the value of the stock). A conflict (the agency conflict) arises when managers take self-interested actions to the detriment of shareholders. The roles of the board of directors selected by the shareholders are to oversee management and to minimize agency problems. However, often these boards are figureheads, and individual shareholders do not own large enough blocks of the shares to override management actions. One potential resolution of an agency problem occurs when inefficient management actions cause the price of the stock to be depressed. The firm may then become a takeover target. If the acquisition is successful, managers may be replaced and potentially, stockholders benefit.Feedback: The question is designed to ascertain that the student understands the corporate relationship between shareholders, management, and the board of directors. In addition, this problem has been addressed extensively in recent years, both in the popular financial press during the mergers and acquisitions mania of the 1980s, and in the academic literature as agency theory.

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Discuss the euro in relation to its impact on globalization. How is it currently used and what are the plans for its future use? 

The euro was introduced in 1999 as a new currency and has replaced the currencies of twelve participating countries so there will be one common European currency in the participating countries. A common currency is expected to facilitate global trade and encourage the integration of markets across national boundaries.Feedback: The purpose of this question is to test the student's understanding of the use and impact of the euro.

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Discuss the following ongoing trends as they relate to the field of investments: globalization, financial engineering, securitization, and computer networks. 

Globalization offers a wider array of investment choices than what would be available to investors who could only choose domestic securities. As efficient communication technology has become available, globalization of markets has been significantly enhanced. There are many mechanisms by which one country's investors can hold foreign companies' securities. Some examples are ADRs, WEBS, and direct purchase of foreign securities.Securitization refers to aggregating underlying financial assets, such as mortgages, into pools and then offering a security that represents a claim on these underlying assets. Examples are GNMAs. Securitization allows investors to hold partial ownership in financial assets that would otherwise be beyond their reach (e.g., mortgages).Financial engineering involves bundling or unbundling. Bundling involves combining separate securities together into one composite security. Examples are combining primitive and derivative securities, and combining three primitive securities such as common stock, preferred stock, and bonds. Unbundling is the opposite - two or more security classes are created by separating a composite security into parts.Computer networks have permitted online trading, online information dissemination and automated trade crossing. Each of these major breakthroughs has significant implications for investments.Feedback: The purpose of this question is to test the student's understanding of the major trends that impact the field of investments.

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Discuss the similarities and differences between real and financial assets. 

Real assets represent the productive capacity of the firm, and appear as assets on the firm's balance sheet. Financial assets are claims against the firm, and thus appear as liabilities on the firm's balance sheet. On the other hand, financial assets are listed on the asset side of the balance sheet of the individuals who own them. Thus, when financial statements are aggregated across the economy, the financial assets cancel out, leaving only the real assets, which directly contribute to the productive capacity of the economy. Financial assets contribute indirectly only.Feedback: The purpose of this question is to ascertain if the student understands the difference between real and financial assets, both in the aggregate balance sheet context and the relative contribution of the two types of assets to the productive capacity of the economy.