Investments: Background and Issues

Investments: Background and Issues

• Investments involve choosing between real assets (physical things) and financial assets (claims on things and earnings of entities).
• Financial assets play a crucial role in the economy:
  • Information dissemination
  • Timing of consumption
  • Allocation of risk
  • Separating ownership and management (corporate governance)
• Investment process involves identifying opportunities, analyzing them, and managing portfolios.
• Markets are competitive, reflecting a risk-return trade-off.
• Efficient markets are characterized by rapid adjustments to new information.
• Key players in financial markets include financial intermediaries, investment bankers, venture capital/private equity firms, and fintech firms.
• The 2008-2009 financial crisis originated from housing finance changes, mortgage derivatives, and credit default swaps, leading to systemic risk.
• Dodd-Frank Act aimed to reform the financial system.

Asset Classes and Financial Instruments

• Money market instruments include Treasury bills, certificates of deposit, commercial paper, bankers' acceptances, Eurodollars, repos, reverses, brokers' calls, federal funds, LIBOR, and money market funds.
• Bond market includes Treasury notes/bonds, inflation-protected Treasury bonds, federal agency debt, international bonds, municipal bonds, and corporate bonds.
• Equity securities include common stock (representing ownership), preferred stock, and depositary receipts.
• Stock and bond market indexes measure overall market performance (Dow Jones Industrial Average, S&P 500).
• Derivative markets involve options and futures contracts.

Securities Markets

• Firms issue securities in primary markets through private or public offerings or via shelf registration (initial public offerings).
• Secondary markets trade existing securities using different mechanisms: dealer markets, electronic markets, computerized order crossing.
• Electronic trading (including ECNs, algorithmic trading, high-frequency trading, and dark pools) influences market structure.
• Globalization affects stock market trading.
• Trading costs involve commissions and market fees.
• Margin buying allows investors to leverage their investments, while short sales let investors profit from anticipated price declines.
• Regulations in securities markets including self-regulation, Sarbanes-Oxley Act, and insider trading laws.

Mutual Funds and Other Investment Companies

• Investment companies (unit investment trusts, managed investment companies, exchange-traded funds) pool investor funds.
• Mutual funds offer diversification and professional management.
• Investment policies, fund sale mechanisms, costs (fees, tax implications), and performance evaluation of mutual funds are of concern.
• Exchange-traded funds (ETFs) resemble mutual funds but trade like stocks.

Portfolio Theory

• Describing investment returns involves measures of risk, return, and the historical record.
• Inflation impacts real interest rates.
• Historical record shows variations in risk/return.
• Diversification reduces portfolio risk.
• Investors can use the capital asset pricing model (CAPM) and arbitrage pricing theory (APT) to evaluate stocks and their portfolios.

Efficient Market Hypothesis (EMH)

• Market efficiency suggests securities reflect available information.
• EMH has implications for active and passive management.
• Empirical evidence supports and refutes EMH.

Behavioral Finance and Technical Analysis

• Behavioral finance examines investor biases and psychological factors.
• Information processing, limits to arbitrage, bubbles, and market anomalies can all influence investment decisions.
• Technical analysis involves studying market trends and patterns for identifying trading opportunities.

Debt Securities

• Bond characteristics include maturities and payment schedules (coupon dates), affecting pricing and yields.
• Factors like default, market conditions, and investor demand influence bond pricing and yields.
• Yield curve reflects expected interest rates, affected by liquidity preference or expectations theories.
• Managing bond portfolios involves considering interest rate risk, duration, immunization, and active/passive strategies.

Macroeconomic and Industry Analysis

• Global economic factors shape macroeconomic conditions (GDP, employment, inflation).
• Interest rate trends/cycles, government policies (fiscal & monetary), and business conditions impact asset valuation.
• Industry analysis scrutinizes factors like industry structure, life cycle, and performance, influencing investment strategy selections.

Equity Valuation

• Estimating intrinsic stock values using tools like dividend discount model, price-earnings ratio, and free cash flow analysis.
• Assessing the relationship between valuation ratios and growth opportunities.
• Identifying limitations of valuation models.

Financial Statement Analysis

• Analyzing firm performance through key financial statements.
• Metrics like profitability (return on assets, return on capital, return on equity) and ratios reflect performance and industry comparisons.
• Identifying differences in financial statement quality in the context of value investing (Graham techniques) is integral to financial analysis.

Derivative Markets (Options & Futures)

• Fundamentals of options, futures, and swaps contracts.
• Option valuation, including binomial and Black-Scholes models.
• Futures markets & strategies for hedging and speculation.

Active Investment Management

• Measuring and evaluating investment performance (using risk-adjusted methods such as Sharpe Ratio, Treynor Ratio, & Information Ratio).
• Understanding active management strategies like market timing & performance attribution.

International Diversification

• Global equity markets, exchange rate risk, political risk, & international performance attribution.

Hedge Funds

• Comparing hedge funds and mutual funds; strategies and performance measurement.
• Analyzing hedge fund performance and fee structure, considering liquidity and selection bias.

Taxes, Inflation, and Investment Strategy

• Understanding the impact of taxes and inflation on investment returns and long-term strategies.
• Considering retirement plans, tax shelters, and home ownership decisions.

Investors and the Investment Process

• Investor objectives, constraints (liquidity, horizon, regulation).
• Investment policies for individual and institutional investors.
• Monitoring and revising investment portfolios.