Chapter One

The Investment
Environment
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 Chapter Overview

• Real Assets versus Financial Assets

• Risk-return trade-off and efficient pricing

• Financial crisis 2008

• Financial system  “Real” economy
• Systemic risk

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 Real Assets vs. Financial Assets

Real Assets Financial Assets

• Have Productive Capacity • Claims on real assets

• Do not contribute directly

to productive capacity

• Examples: Land, buildings, • Examples: Stocks, bonds

machines, intellectual
property

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 Financial Assets
Financial Assets: Claims on Real Assets

Fixed-Income Securities: Equity:

Promises a fixed stream of income Represents ownership share in a
or a stream of income determined corporation; common Stock
by a specified formula; debt

Derivatives:
Provide payoffs that are determined
by the prices of other assets

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 Other Types of Investment

• Investment in currency

• Commodity futures
• Corporations invest in the commodity futures to
hedge the risk

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 Financial Markets and the Economy
(1 of 4)

• The Informational Role

• Consumption Timing

• Allocation of Risk

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Financial Markets and the Economy
(2 of 4)

• Separation of Ownership and Management

• Agency Problems:

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Financial Markets and the Economy
(3 of 4)

• Mechanisms to mitigate Agency Problems:

• Tie managers' income to the success of the firm

• Monitoring from the board of directors

• Monitoring by large investors and security analysts

• Takeover threat

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 Financial Markets and the Economy
(4 of 4)

• Corporate Governance and Corporate Ethics

• Accounting Scandals
• Enron, Rite Aid, HealthSouth
• Auditors: Watchdogs
• Analyst Scandals
• Arthur Andersen
• Sarbanes-Oxley Act
• Corporate governance rules

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 The Investment Process
(1 of 2)

• Portfolio: Collection of investment assets

• Asset allocation
• Choice among broad asset classes
• Security selection
• Choice of securities within each asset class

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 The Investment Process
(2 of 2)

• “Top-down” approach
• Asset allocation followed by security analysis

• “Bottom-up” approach
• Investment based solely on the price-attractiveness

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 Markets Are Competitive
(1 of 3)

Risk-Return Trade-Off
• Higher-risk assets are priced to offer higher
expected returns than lower-risk assets

• Risk and expected return are positively

correlated

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 Markets Are Competitive
(2 of 3)

Efficient Markets
• Efficient markets: prices quickly adjust to all
relevant information

• There should be neither underpriced nor

overpriced securities

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 Markets Are Competitive
(3 of 3)

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

• Active Management
• Finding mispriced securities
• Timing the market

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 The Players
Price of Capital (1 of 2)

Who Supplies Capital? Households

What Demands Capital? Firms

Quantity of Capital
Roll of Government?
Can be either borrowers or lenders

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 The Players
(2 of 2)

• Financial Intermediaries: Pool and invest funds

• Investment Companies
• Banks
• Insurance companies
• Credit unions

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 Universal Bank Activities

Investment Banking Commercial Banking

• Underwrite new • Take deposits and make
securities issues loans

• Sell newly issued

securities to public in the
primary market

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 Financial Crisis of 2008
(1 of 3)

• Antecedents of the Crisis:

• “The Great Moderation”

• Historic boom in housing market

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Financial Crisis of 2008
(2 of 3)

“The Great Moderation”

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 Short-Term LIBOR and
Treasury-Bill Rates and the TED Spread

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 Financial Crisis of 2008
(3 of 3)

Historic boom in housing market

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 Changes in Housing Finance
(1 of 2)
Old Way
• Local thrift institution made
mortgage loans to
homeowners
• Thrift’s possessed a portfolio
of long-term mortgage loans
• Thrift’s main liability: Deposits
• “Originate to hold”
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New Way
• Securitization: Fannie Mae and
Freddie Mac bought mortgage
loans and bundled them into
large pools
• Mortgage-backed securities
are tradable claims against the
underlying mortgage pool
• “Originate to distribute”
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 Changes in Housing Finance
(2 of 2)

• Securitization:

• Inclusion of nonconforming “subprime” loans

• Low/No-documentation loans

• Rising loan-to-value ratio

• Adjustable-Rate Mortgages
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Cash Flows in a Mortgage Pass-
Through Security

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 Mortgage Derivatives

• Collateralized debt obligations (CDOs)

• Mortgage pool divided into tranches to
concentrate default risk:
• Senior tranches:
• Junior tranches:

• Ratings significantly underestimated risk

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 Why Was Credit Risk
Underestimated?
• Default probabilities were misestimated

• Geographic diversification did not reduce risk

sufficiently

• Agency problems with rating agencies

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 Credit Default Swap (CDS)

• A CDS is an insurance contract against

borrower default
• Investors bought sub-prime loans and CDSs

• Some big swap issuers did not have enough capital

to back their CDSs

• This lack of capital resulted in the failure of CDO

insurance
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 Rise of Systemic Risk
(1 of 3)

• Systemic Risk:

Further Defaults
• One default triggers Further Defaults
Further Defaults

• Waves of selling  downward spiral as asset

prices drop

• Potential contagion
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 Rise of Systemic Risk
(2 of 3)

• Banks mismatched maturity/liquidity of their

assets and liabilities:
• Liabilities were short and liquid
• Assets were long and illiquid
• Constant need to refinance

• Banks: highly leveraged  no margin of safety

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 Rise of Systemic Risk
(3 of 3)

• Investors relied too much on credit

enhancement through structured products

• CDS traded mostly over-the-counter

• No posted margin requirements
• Little transparency

• Opaque linkages between instruments and

institutions
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 The Shoe Drops
(1 of 2)

• 2004: Interest rates began rising

• 2006: Home prices peaked
• 2007: Housing defaults and losses on
mortgage-backed securities surged

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 The Shoe Drops
(2 of 2)

• 2008: Troubled firms include Bear Stearns,

Fannie Mae, Freddie Mac, Merrill Lynch,
Lehman Brothers, and AIG
• Money market breaks down
• Credit markets freeze up
• Federal bailout to stabilize financial system

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 The Dodd-Frank Reform Act

• Mechanisms to mitigate systemic risk

• Stricter rules for bank capital, liquidity, and risk
management practices

• Increased transparency, especially in derivatives

markets

• Office of Credit Ratings within the SEC to oversee

the credit rating agencies

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