answer the question
1. The investment Environment
Instructor: Seongcheol Paeng
6/24/2020
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Introduction
Name: Seongcheol Paeng
Nationality: South Korea, Permanent Resident in the USA
Interests: Finance, Economics, Political Science
Talents: Math, Teaching, Analyzing
Family: Wife and Daughter
Living Place: Brea
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An Investment Is
AN INVESTMENT IS the current commitment of money or other resources in the expectation of reaping future benefits.
You sacrifice something of value now, expecting to benefit from that sacrifice later.
We will focus on investments in securities such as stocks, bonds, or options and futures contracts, but much of what we discuss will be useful in the analysis of any type of investment.
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1.1 Real Assets versus Financial Assets
This capacity is a function of the real assets of the economy: the land, buildings, machines, and knowledge that can be used to produce goods and services.
In contrast to real assets are financial assets such as stocks and bonds.
Such securities are no more than sheets of paper or, more likely, computer entries, and they do not contribute directly to the productive capacity of the economy.
Financial assets are claims to the income generated by real assets (or claims on income from the government).
If we cannot own our own auto plant (a real asset), we can still buy shares in Ford or Toyota (financial assets) and thereby share in the income derived from the production of automobiles.
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1.1 Real Assets versus Financial Assets
Household wealth includes financial assets such as bank accounts, corporate stock, or bonds.
However, these securities, which are financial assets of households, are liabilities of the issuers of the securities.
Your asset (bond) is Toyota’s liability.
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1.1 Real Assets versus Financial Assets
Therefore, when we aggregate over all balance sheets, these claims cancel out, leaving only real assets as the net wealth of the economy.
National wealth consists of structures, equipment, inventories of goods, and land.
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1.2 Financial Assets
It is common to distinguish among three broad types of financial assets: fixed income, equity, and derivatives.
Fixed-income or debt securities promise either a fixed stream of income or a stream of income determined by a specified formula. For example, a corporate bond typically would promise that the bondholder will receive a fixed amount of interest each year.
Unlike debt securities, common stock, or equity, in a firm represents an ownership share in the corporation. Equity holders are not promised any particular payment. They receive any dividends the firm may pay and have prorated ownership in the real assets of the firm.
Finally, 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. For example, a call option on a share of Intel stock might turn out to be worthless if Intel’s share price remains below a threshold or “exercise” price such as $30 a share, but it can be quite valuable if the stock price rises above that level.
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1.3 Financial Markets and the Economy
The Informational Role of Financial Markets
Stock prices reflect investors’ collective assessment of a firm’s current performance and future prospects.
When the market is more optimistic about the firm, its share price will rise. That higher price makes it easier for the firm to raise capital and therefore encourages investment.
The stock market encourages allocation of capital to those firms that appear at the time to have the best prospects. Many smart, well-trained, and well-paid professionals analyze the prospects of firms whose shares trade on the stock market. Stock prices reflect their collective judgment.
Consumption Timing
Some individuals are earning more than they currently wish to spend. Others, for example, retirees, spend more than they currently earn.
In high-earnings periods, you can invest your savings in financial assets such as stocks and bonds. In low-earnings periods, you can sell these assets to provide funds for your consumption needs.
By so doing, you can “shift” your consumption over the course of your lifetime, thereby allocating your consumption to periods that provide the greatest satisfaction.
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1.3 Financial Markets and the Economy
Allocation of Risk
Virtually all real assets involve some risk.
For example, if Toyota raises the funds to build its auto plant by selling both stocks and bonds to the public, the more optimistic or risk-tolerant investors can buy shares of its stock, while the more conservative ones can buy its bonds.
Because the bonds promise to provide a fixed payment, the stockholders bear most of the business risk but reap potentially higher rewards.
Separation of Ownership and Management
Many businesses are owned and managed by the same individual. This simple organization is well suited to small businesses and, in fact, was the most common form of business organization before the Industrial Revolution.
Large group of individuals obviously cannot actively participate in the day-to-day management of the firm. Instead, they elect a board of directors that in turn hires and supervises the management of the firm.
These potential conflicts of interest are called agency problems because managers, who are hired as agents of the shareholders, may pursue their own interests instead.
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1.3 Financial Markets and the Economy
Separation of Ownership and Management
Several mechanisms have evolved to mitigate potential agency problems.
First, compensation plans tie the income of managers to the success of the firm.
Second, while boards of directors have sometimes been portrayed as defenders of top management, they can, and in recent years, increasingly have, forced out management teams that are underperforming.
Third, outsiders such as security analysts and large institutional investors such as mutual funds or pension funds monitor the firm closely and make the life of poor performers at the least uncomfortable.
Finally, bad performers are subject to the threat of takeover.
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1.3 Financial Markets and the Economy
Corporate Governance and Corporate Ethics
Market signals will help to allocate capital efficiently only if investors are acting on accurate information. We say that markets need to be transparent for investors to make informed decisions. If firms can mislead the public about their prospects, then much can go wrong.
Unending series of scandals: For example, the telecom firm WorldCom overstated its profits by at least $3.8 billion by improperly classifying expenses as investments.
When the true picture emerged, it resulted in the largest bankruptcy in U.S. history, at least until Lehman Brothers smashed that record in 2008.
In 2002, in response to the spate of ethics scandals, Congress passed the Sarbanes Oxley Act to tighten the rules of corporate governance.
For example, the act requires corporations to have more independent directors, that is, more directors who are not themselves managers (or affiliated with managers). The act also requires each CFO (Chief Financial Official) to personally vouch for the corporation’s accounting statements, provides for an oversight board to oversee the auditing of public companies, and prohibits auditors from providing various other services to clients.
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1.4 The Investment Process
An investor’s portfolio is simply his collection of investment assets.
Investment assets can be categorized into broad asset classes, such as stocks, bonds, real estate, commodities, and so on.
Investors make two types of decisions in constructing their portfolios. The asset allocation decision is the choice among these broad asset classes, while the security selection decision is the choice of which particular securities to hold within each asset class.
“Top-down” portfolio construction starts with asset allocation. For example, an individual who currently holds all of his money in a bank account would first decide what proportion of the overall portfolio ought to be moved into stocks, bonds, and so on.
A top-down investor first makes this and other crucial asset allocation decisions before turning to the decision of the particular securities to be held in each asset class.
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1.4 The Investment Process
Security analysis involves the valuation of particular securities that might be included in the portfolio.
For example, an investor might ask whether Merck or Pfizer is more attractively priced.
In contrast to top-down portfolio management is the “bottom-up” strategy.
In this process, the portfolio is constructed from securities that seem attractively priced without as much concern for the resultant asset allocation.
Such a technique can result in unintended bets on one or another sector of the economy.
However, a bottom-up strategy does focus the portfolio on the assets that seem to offer the most attractive investment opportunities.
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1.5 Markets Are Competitive
This competition means that we should expect to find few, if any, “free lunches,” securities that are so underpriced that they represent obvious bargains.
The Risk-Return Trade-Off
There will almost always be risk associated with investments.
If you want higher expected returns, you will have to pay a price in terms of accepting higher investment risk.
We conclude that there should be a risk–return trade-off in the securities markets, with higher-risk assets priced to offer higher expected returns than lower-risk assets.
Diversification means that many assets are held in the portfolio so that the exposure to any particular asset is limited.
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1.5 Markets Are Competitive
Efficient Markets
Financial markets process all available information about securities quickly and efficiently, that is, that the security price usually reflects all the information available to investors concerning its value.
If markets are efficient and prices reflect all relevant information, perhaps it is better to follow passive strategies instead of spending resources in a futile attempt to outguess your competitors in the financial markets.
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1.6 The Players
Three Major Players in the financial markets:
Firms are net demanders of capital.
Households typically are net suppliers of capital.
Governments can be borrowers or lenders, depending on the relationship between tax revenue and government expenditures.
Corporations and governments do not sell all or even most of their securities directly to individuals. For example, about half of all stock is held by large financial institutions such as pension funds, mutual funds, insurance companies, and banks.
They are called financial intermediaries.
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1.6 The Players
Financial Intermediaries
A small investor seeking to lend money to businesses that need to finance investments doesn’t advertise in the local newspaper to find a willing and desirable borrower.
Moreover, an individual lender would not be able to diversify across borrowers to reduce risk.
Finally, an individual lender is not equipped to assess and monitor the credit risk of borrowers.
For these reasons, financial intermediaries have evolved to bring the suppliers of capital (investors) together with the demanders of capital (primarily corporations and the federal government).
These financial intermediaries include banks, investment companies, insurance companies, and credit unions.
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1.6 The Players
Financial Intermediaries
Financial intermediaries are distinguished from other businesses in that both their assets and their liabilities are overwhelmingly financial.
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1.6 The Players
Financial Intermediaries
Compare Table 1.3 to the aggregated balance sheet of the nonfinancial corporate sector in Table 1.4, for which real assets are about half of all assets.
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1.6 The Players
Financial Intermediaries
Other examples of financial intermediaries are investment companies, insurance companies, and credit unions. All these firms offer similar advantages in their intermediary role.
First, by pooling the resources of many small investors, they are able to lend considerable sums to large borrowers.
Second, by lending to many borrowers, intermediaries achieve significant diversification, so they can accept loans that individually might be too risky.
Third, intermediaries build expertise through the volume of business they do and can use economies of scale and scope to assess and monitor risk.
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1.6 The Players
Financial Intermediaries
Investment companies, which pool and manage the money of many investors, also arise out of economies of scale.
Here, the problem is that most household portfolios are not large enough to be spread across a wide variety of securities.
In terms of brokerage fees and research costs, purchasing one or two shares of many different firms is very expensive. Mutual funds have the advantage of large-scale trading and portfolio management, while participating investors are assigned a prorated share of the total funds according to the size of their investment.
This system gives small investors advantages they are willing to pay for via a management fee to the mutual fund operator.
Mutual Funds: Mutual funds are investments that pool your money together with other investors to purchase shares of a collection of stocks, bonds, or other securities, referred to as a portfolio, that might be difficult to recreate on your own. Mutual funds are typically overseen by a portfolio manager.
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1.6 The Players
Financial Intermediaries
Investment companies also can design portfolios specifically for large investors with particular goals.
In contrast, mutual funds are sold in the retail market, and their investment philosophies are differentiated mainly by strategies that are likely to attract a large number of clients.
Like mutual funds, hedge funds also pool and invest the money of many clients. But they are open only to institutional investors such as pension funds, endowment funds, or wealthy individuals.
They are more likely to pursue complex and higher-risk strategies. They typically keep a portion of trading profits as part of their fees, whereas mutual funds charge a fixed percentage of assets under management.
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1.6 The Players
Investment Bankers
Firms raise much of their capital by selling securities such as stocks and bonds to the public.
Because these firms do not do so frequently, however, investment bankers that specialize in such activities can offer their services at a cost below that of maintaining an in-house security issuance division.
In this role, they are called underwriters.
Investment bankers advise the issuing corporation on the prices it can charge for the securities issued, appropriate interest rates, and so forth.
Ultimately, the investment banking firm handles the marketing of the security in the primary market, where new issues of securities are offered to the public.
Later, investors can trade previously issued securities among themselves in the so-called secondary market.
Ex) Goldman Sachs, Merrill Lynch, and Lehman Brothers.
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1.6 The Players
Venture Capital and Private Equity
While large firms can raise funds directly from the stock and bond markets with help from their investment bankers, smaller and younger firms that have not yet issued securities to the public do not have that option.
Start-up companies rely instead on bank loans and investors who are willing to invest in them in return for an ownership stake in the firm. The equity investment in these young companies is called venture capital (VC). Sources of venture capital are dedicated venture capital funds, wealthy individuals known as angel investors, and institutions such as pension funds.
Other active investors may engage in similar hands-on management but focus instead on firms that are in distress or firms that may be bought up, “improved,” and sold for a profit. Collectively, these investments in firms that do not trade on public stock exchanges are known as private equity investments.
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1.7 The Financial Crisis of 2008
Antecedents of the Crisis
The last significant macroeconomic threat had been from the implosion of the high-tech bubble in 2000–2002.
But the Federal Reserve responded to an emerging recession by aggressively reducing interest rates.
Figure 1.1 shows that Treasury bill rates dropped drastically between 2001 and 2004, and the LIBOR rate, which is the interest rate at which major money-center banks lend to each other, fell in tandem.
LIBOR stands for London Interbank Offer Rate. It is a rate charged in an interbank lending market outside of the U.S. (largely centered in London). The rate is typically quoted for 3-month loans.
TED stands for Treasury–Eurodollar spread. The Eurodollar rate in this spread is in fact LIBOR.
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1.7 The Financial Crisis of 2008
Antecedents of the Crisis
These actions appeared to have been successful, and the recession was short-lived and mild.
Figure 1.2 shows that it reversed direction just as dramatically beginning in 2003, fully recovering all of its post-tech-meltdown losses within a few years.
Some observers wondered whether we had entered a golden age for macroeconomic policy in which the business cycle had been tamed.
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1.7 The Financial Crisis of 2008
Antecedents of the Crisis
The combination of dramatically reduced interest rates and an apparently stable economy fed a historic boom in the housing market.
Figure 1.3 shows that U.S. housing prices began rising noticeably in the late 1990s and accelerated dramatically after 2001 as interest rates plummeted.
On the one hand, the Fed’s policy of reducing interest rates had resulted in low yields on a wide variety of investments, and investors were hungry for higher-yielding alternatives.
On the other hand, low volatility and optimism about macroeconomic prospects encouraged greater tolerance for risk in the search for these higher-yielding investments.
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1.7 The Financial Crisis of 2008
Changes in Housing Finance
Fannie and Freddie quickly became the behemoths of the mortgage market, between them buying around half of all mortgages originated by the private sector.
Figure 1.4 illustrates how cash flows passed from the original borrower to the ultimate investor in a mortgage-backed security.
The loan originator might make a $100,000 home loan to a homeowner. The homeowner would repay principal and interest (P&I) on the loan over 30 years.
But then the originator would sell the mortgage to Freddie Mac or Fannie Mae and recover the cost of the loan.
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1.7 The Financial Crisis of 2008
In turn, Freddie or Fannie would pool the loans into mortgage-backed securities and sell the securities to investors such as pension funds or mutual funds.
The agency (Fannie or Freddie) typically would guarantee the credit or default risk of the loans included in each pool, for which it would retain a guarantee fee before passing along the rest of the cash flow to the ultimate investor.
A strong trend toward low-documentation and then no-documentation loans, entailing little verification of a borrower’s ability to carry a loan, soon emerged. Other subprime underwriting standards quickly deteriorated.
When housing prices began falling, these loans were quickly “underwater,” meaning that the house was worth less than the loan balance, and many homeowners decided to walk away from their loans.
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1.7 The Financial Crisis of 2008
Despite these obvious risks, the ongoing increase in housing prices over the last decade seemed to lull many investors into complacency, with a widespread belief that continually rising home prices would bail out poorly performing loans.
Mortgage Derivatives
New risk-shifting tools enabled investment banks to carve out AAA-rated securities from original-issue “junk” loans.
Even with pools composed of risky subprime loans, default rates above 30% seemed extremely unlikely, and thus senior tranches were frequently granted the highest (i.e., AAA) rating by the major credit rating agencies, Moody’s, Standard & Poor’s, and Fitch.
Large amounts of AAA-rated securities were thus carved out of pools of low-rated mortgages.
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1.7 The Financial Crisis of 2008
Why had the rating agencies so dramatically underestimated credit risk in these subprime securities?
First, default probabilities had been estimated using historical data from an unrepresentative period characterized by a housing boom and an uncommonly prosperous and recession-free macroeconomy.
Moreover, Past default experience was largely irrelevant given these profound changes in the market.
Moreover, the power of cross-regional diversification to minimize risk engendered excessive optimism.
Finally, agency problems became apparent. The ratings agencies were paid to provide ratings by the issuers of the securities—not the purchasers. They faced pressure from the issuers, who could shop around for the most favorable treatment, to provide generous ratings.
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1.7 The Financial Crisis of 2008
Credit Default Swaps
A credit default swap, or CDS, is in essence an insurance contract against the default of one or more borrowers.
For example, the large insurance company AIG alone sold more than $400 billion of CDS contracts on subprime mortgages.
The Rise of Systemic Risk
By relying primarily on short-term loans for their funding, these firms needed to constantly refinance their positions, or else face the necessity of quickly selling off their less-liquid asset portfolios, which would be difficult in times of financial stress.
Moreover, these institutions were highly leveraged and had little capital as a buffer against losses.
Another source of fragility was widespread investor reliance on “credit enhancement” through products like CDOs (Collateralized Debt Obligation).
This new financial model was brimming with systemic risk, a potential breakdown of the financial system when problems in one market spill over and disrupt others.
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1.7 The Financial Crisis of 2008
The Shoe Drops
By fall 2007, housing price declines were widespread (Figure 1.3), mortgage delinquencies increased, and the stock market entered its own free fall (Figure 1.2).
The crisis peaked in September 2008. On September 7, the giant federal mortgage agencies Fannie Mae and Freddie Mac, both of which had taken large positions in subprime mortgage–backed securities, were put into conservatorship.
By the second week of September, it was clear that both Lehman Brothers and Merrill Lynch were on the verge of bankruptcy.
The Treasury unveiled its first proposal to spend $700 billion to purchase “toxic” mortgage-backed securities.
Fears spread that other funds were similarly exposed, and money market fund customers across the country rushed to withdraw their funds.
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1.7 The Financial Crisis of 2008
The unemployment rate rose rapidly, and the economy was in its worst recession in decades.
The crisis was not limited to the United States. Housing markets throughout the world fell, and many European banks had to be rescued by their governments, which were themselves heavily in debt.
Greece was the hardest hit. Its government debt of about $460 billion was considerably more than its annual GDP. In 2011 it defaulted on debts totaling around $130 billion.
The Dodd-Frank Reform Act
These eventually led to the passage in 2010 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, which proposes several mechanisms to mitigate systemic risk.
The act 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.
Dodd-Frank also attempts to limit the risky activities in which banks can engage.
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1.7 The Financial Crisis of 2008
The act also addresses incentive issues. Among these are proposals to force employee compensation to reflect longer-term performance.
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Assignments
Problem Sets (Paraphrase with your own words.)
1. What are the differences between real assets and financial assets?
2. Explain three broad types of financial assets.
3. Explain the informational role.
4. Explain several mechanism that mitigate potential agency problems.
5. Explain efficient markets.
6. Why had the rating agencies so dramatically underestimated credit risk in these subprime securities?
Deadline: before next class (6/29)
Submit it via email to paengsc@gmail.com or seongcheol.paeng@csusb.edu
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