Bodie Essentials of Investments 12e Chapter 01 PPT PDF

Chapter Investments: 1 Background and Issues Bodie, Kane, and Marcus Essentials of Investments 12th Edition  1.1 Real versus Financial Assets Real assets Assets used to produce goods and services. Financial assets...

Chapter Investments: 1 Background and Issues Bodie, Kane, and Marcus Essentials of Investments 12th Edition  1.1 Real versus Financial Assets Real assets Assets used to produce goods and services. Financial assets Claims on real assets or the income generated by them. Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. 2  Table 1.1 Balance Sheet, U.S. Households, 2019 Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. 3  1.1 Financial Assets = Financial Liabilities Financial Assets and Liabilities must balance Aggregated balance sheets → only real assets remain Domestic Net Worth = Sum of real assets Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. 4  Table 1.2 Domestic Net Worth, 2019 Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. 5  1.2 Financial Assets Fixed-income (debt) securities Pay a specified cash flow over a specific period Equity An ownership share in a corporation Derivative securities Securities providing payoffs that depend on the values of other assets Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. 6  1.3 Financial Markets and the Economy Informational Role of Financial Markets Capital flow to companies with best prospects Market Price = Fair Value? Do markets allocate capital to best uses? Other mechanisms to allocate capital? Advantages/disadvantages of other systems? Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. 7  1.3 Financial Markets and the Economy Consumption Timing Use securities to store wealth Transfer consumption to the future Risk Allocation Investors select desired risk level Bond vs. stock Bank CD vs. company bond Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. 8  1.3 Financial Markets and the Economy Separation of Ownership and Management Separation → Agency Problems Mitigating Factors Performance-based compensation Boards of directors may fire managers Threat of takeovers Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. 9  1.3 Financial Markets and the Economy Corporate Governance and Corporate Ethics Businesses and markets require trust No trust → additional costly laws and regulations Governance and ethics failures cost the economy Erodes public support and confidence Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. 10  1.3 Financial Markets and the Economy Corporate Governance and Corporate Ethics Accounting scandals Enron, WorldCom, Rite-Aid, HealthSouth, Global Crossing, Qwest Misleading research reports Citicorp, Merrill Lynch, others Auditors: Watchdogs or consultants? Arthur Andersen and Enron Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. 11  1.3 Financial Markets and the Economy Corporate Governance and Corporate Ethics Sarbanes-Oxley Act (SOX): Requires more independent directors CFO personally verifies the financial statements Creates accounting/audit industry oversight board Charges board to maintain culture of high ethical standards Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. 12  1.4 The Investment Process: Asset Allocation Asset Allocation Allocation of an investment portfolio across broad asset classes. Primary determinant of a portfolio's return Percentage of fund in asset classes Top Down Investment Strategies Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. 13  1.4 The Investment Process: Security Selection Security Selection Choice of particular securities within asset class Bottom up Investment strategies Security Analysis Analysis of the value of securities Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. 14  1.5 Markets Are Competitive Risk-Return Trade-Off Higher expected returns → Higher risk Stock portfolios lose money an average of 25% Bonds Lower average rates of return (under 6%) Not lost more than 13% of value in any one year Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. 15  1.5 Markets Are Competitive Risk-Return Trade-Off How do we measure risk? How does diversification affect risk? Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. 16  1.5 Markets Are Competitive Efficient Markets Passive management Buying and holding a diversified portfolio No attempt to identify mispriced securities Active management Identify mispriced securities or Forecast broad market trends Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. 17  1.6 The Players Business Firms (net borrowers) Raise capital now to pay for investments Households (net savers) Purchase securities issued by firms Governments (can be both borrowers and savers) Depends on the relationship between tax revenue and government expenditures Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. 18  1.6 The Players Financial Intermediaries Connectors of borrowers and lenders Commercial banks Investment companies Insurance companies Pension funds Hedge funds Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. 19  1.6 The Players Investment Bankers Specialize in primary market transactions Primary market Newly issued securities offered to public Investment banker “underwrites” issue Secondary market Preexisting securities traded among investors Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. 20  1.6 The Players Investment Bankers Separate from commercial banks' functions by law (1933-1999) Post-1999: Large commercial banks increased investment-banking activities, pressuring investment banks’ profit margins September 2008: Mortgage-market collapse Major investment banks bankrupt; purchased/reorganized Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. 21  1.6 The Players Investment Bankers Investment banks may become commercial banks Obtain deposit funding Have access to government assistance Major banks now under stricter regulations Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. 22  1.6 The Players Venture Capital and Private Equity Venture capital Equity Investment to finance new firm Private equity Investments in privately-held companies Fintech and Financial Innovation Application of technology to financial markets Ex: cryptocurrencies and blockchain technology Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. 23  1.7 The Financial Crisis of 2008-2009 Changes in Housing Finance Old Way New Way Local thrift institution made Securitization: Fannie Mae mortgage loans to and Freddie Mac bought homeowners mortgage loans, bundled Thrift’s possessed a them into large pools portfolio of long-term Mortgage-backed securities mortgage loans are tradable claims against Thrift’s main liability: the underlying mortgage Deposits pool “Originate to hold” “Originate to distribute” Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. 24  Figure 1.1 LIBOR, T-Bill Rates and the TED Spread Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. 25  Figure 1.2 Cumulative Returns Cumulative returns on a $1 investment in the S&P 500 index Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. 26  Figure 1.3 Case-Shiller Index of U.S. Housing Prices Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. 27  1.7 Changes in Housing Finance Securitization Pooling loans into standardized securities back by loans Can be traded like any other security Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. 28  1.7 Changes in Housing Finance (Continued) Inclusion of nonconforming “subprime” loans Low/No-documentation loans Rising loan-to-value ratio Adjustable-Rate Mortgages Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. 29  1.7 The Financial Crisis of 2008-2009 Mortgage Derivatives CDOs: Consolidated default risk of loans onto one class of investor, divided payment into tranches Ratings agencies paid by issuers; pressured to give high ratings Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. 30  1.7 The Financial Crisis of 2008-2009 Credit Default Swaps Insurance contract against the default of borrowers Issuers ramped up risk to unsupportable levels AIG sold $400 billion in CDS contracts Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. 31  1.7 The Financial Crisis of 2008-2009 Systemic Risk Risk of breakdown in financial system — spillover effects from one market into others Banks highly leveraged; assets less liquid Formal exchange trading replaced by over- the-counter markets — no margin for insolvency protection Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. 32  1.7 The Financial Crisis of 2008-2009 The Shoe Drops September 7: Fannie Mae and Freddie Mac put into conservatorship Lehman Brothers and Merrill Lynch verged on bankruptcy September 17: Government lends $85 billion to AIG Money market panic freezes short-term financing market Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. 33  1.7 The Financial Crisis of 2008-2009 Dodd-Frank Reform Act Stricter rules for bank capital, liquidity, risk management Mandated increased transparency Clarified regulatory system Volcker Rule: Separates investment banking, private equity, and proprietary trading sections of financial institutions from lending counterparts Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. 34  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 Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. 35