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ECON0048 (Economics of Finance) Summary - UCL Economics BSc Second Year
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Investment AnalysisLecture 1
1. The Investment Environment
The risk–return trade-off and the efficient pricing of financial assets—are central to the investment process.
Investments are the current commitment of money or other resources in the expectation of future benefits. Investments can
be on real assets or financial assets. While real assets generate net income to the economy, financial assets simply define the
allocation of income or wealth among investors. When investors buy securities issued by companies, the firms use the money
so raised to pay for real assets.
a. Real Assets entail the productive capacity of the economy, i.e. the goods and services.
b. Financial Assets include stocks and bonds. They do not contribute directly to the productive capacity of the
economy. They are means to hold claims on real assets. Financial assets are claims to income generated by real assets.
There are three main types of financial assets:
a. Fixed Income or debt securities promise either a fixed stream of income or a stream of income determined by a
specified formula. E.g. a corporate bond promises a fixed amount of interest each year. Or a bond pays an interest
rate that is fixed at 2 pp above the rate paid on treasury bills. Fixed income securities come in a variety of
maturities and payment provisions. For instance:
a.1 Money Market refers to short-term debt securities that are highly marketable and very low risk. E.g. treasury
bills, or bank certificates of deposit (CDs)
a.2 Capital Market refers to long-term securities, such as treasury bonds. They may have very low default risk
(e.g. treasury securities) or high risk (high-yield or “junk” bonds). They are designed with diverse provisions of
payments to the investor and protection against the bankruptcy of the issuer.
b. Equity or common stock, refers to the ownership share in a corporation. Equity holders are not promised
payment, but they receive dividends or ownership of a firm’s assets. Therefore, the performance of equity is tied
to the success of the firm and its assets. Thus, equity investments are riskier than investments in debt securities.
c. Derivatives include options, futures, and swap contracts. These securities provide payoffs that are determined
by/derived from the prices of other assets such as bond or stock prices. Derivates are mainly used as risk
management tools, as their primary use is to hedge risks or transfer them to other parties.
1.2 Financial Markets and the Economy
1.2.1 The Informational Role of Financial Markets
Stock prices reflect investors’ 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. In this manner, stock prices play a major role in the allocation of capital in market economies.
1.2.2 Consumption Timing
Some individuals are earning more than they currently wish to spend, and vice versa. Financial markets allow individuals to
separate decisions for current consumption from constraints that otherwise would be imposed by current earnings.
E.g. There are two periods: period 1 and period 2. In each period, your income is $10,000. Saving and borrowing from banks
is possible at 5% interest rate. There are three options:
A: save all my money in the first period, consume everything in the second period → save 10,000 at 5%, results in 10,500.
Consume 20,500 in period 2
B: consume 10,000 in each period
,C: consume everything now and do not worry about the future → consume 10,000 in
period 1 + maximum amount that you can borrow at 5%
X+0.05x = 10,000
X=9,524
Therefore, consume 19,524 in period 1.
In period 2, the money you earn will be used to pay off the loan borrowed in period 1.
The utility function of the consumer can be graphed through a Utility/Indifference Curve.
The investor is indifferent between all points/options on the same curve, as he gets the same utility from all of them. Choices
along the highest indifference curve will be preferred to choices in lower curves. The steepness of the curve depends on
personal preferences such as risk aversion.
Optimal point which gives the highest utility is point D, which is on a higher indifference curve compared to point A and B
(which have the same utility, and the consumer is indifferent between them).
1.2.3 Allocation of Risk
Financial markets and the financial instruments traded in them allow risk allocation and portfolio diversification. Risk-loving
investors reap higher rewards, while more risk-averse investors reap lower rewards. For instance, because bonds promise a
fixed payment, the stockholders bear most of the business risk but reap potentially higher rewards. Thus, capital markets allow
the risk that is inherent to all investments to be borne by the investors most willing to bear it.
This allocation of risk also benefits the firms that need to raise capital to finance their investments. When investors are able
to select security types with the risk-return characteristics that best suit their preferences, each security can be sold for the
best possible price. This facilitates the process of building the economy’s stock of real assets.
1.2.4 Separation of Ownership and Management
Many businesses are owned and managed by the same individual. However, this is more well-suited to small businesses.
Larger corporations cannot exist as owner-operated firms while having thousands of stockholders. Thus, stockholders elect a
board of directors that in turn hires and supervises the management of the firm. So the owners and the managers of the firm
are different parties, and thus, the firm gains stability that the owner-managed firm could not achieve.
However, managers might not attempt to maximize the firm value, and may engage in activities that are not in the best interest
of the firm and shareholders. Such conflicts of interest are called agency problems. Mechanisms to mitigate agency problems:
- Compensation plans tie the income of managers to the success of the firm.
- The board of directors can force out underperforming management teams.
- Third parties (security analysts and large institutional investors such as mutual funds, or pension funds) monitor
firms. Such large investors hold about half of the stock in publicly traded firms in the US.
- Bad performers are subject to the threat of takeover. If the board of directors is lax in monitoring management,
unhappy shareholders in principle can elect a different board. They can do this by launching a proxy contest in which
they seek to obtain enough proxies (i.e., rights to vote the shares of other shareholders) to take control of the firm
and vote on another board. However, this has usually been a minimal threat. Aside from proxy contests, the real
takeover threat is from other firms. The stock price should rise to reflect the prospects of improved performance,
which provides an incentive for firms to engage in such takeover activity.
1.2.5 Corporate Governance and Corporate Ethics
Securities markets play an important role in facilitating the deployment of capital resources to the most productive uses. But
market signals will help to allocate capital efficiently only if investors are acting on accurate info. Markets need to be
transparent for investors to make informed decisions. If firms mislead investors about their prospects, then much can go wrong.
In 2002, in response to the spate of ethics scandals, Congress passed the Sarbanes-Oxley Act, commonly referred to as SOX,
to tighten the rules of corporate governance and disclosure. For example, the act requires corporations to have more
,independent directors, i.e. directors who are not managers (or affiliated with). The act also requires each CFO 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
1.3 The Investment Process
An investment portfolio is a collection of assets, which 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. There are two approaches to constructing a portfolio:
a. Top-down approach starts with the asset allocation, in which the individual determines the amount to be invested
in each asset class (e.g. 40% in stocks, 60% in bonds). Then, the investor selects the particular securities to be held
in each asset class.
b. Bottom-up approach entails a portfolio constructed from securities that seem attractively priced, without much
concern for the asset allocation. Such a technique might result to be inefficient as the portfolio might end up with a
very heavy representation of firms in one industry. However, a bottom-up strategy does focus the portfolio on the
assets that seem to offer the most attractive investment opportunities.
1.4 Markets are Competitive
Investors invest for anticipated future returns, but those rarely can be predicted precisely. There will always be risks associated
with investments. Actual/realized returns will almost always deviate from the expected return. If all else could be held equal,
investors would prefer investments with the highest expected return. However, there is a trade-off between risks and return.
1.4.1 Efficient Markets
We rarely expect to find bargains in security markets. The “efficient market hypothesis” states that financial markets process
all available info quickly and efficiently so that the prices reflects all the info available to investors concerning its value.
According to this, as new information about security becomes available, its price quickly adjusts so that at any time, the price
equals the market consensus estimate of its value. If this were so, there would be neither underpriced nor overpriced securities.
One interesting implication of this “efficient market hypothesis” concerns the choice between active and passive investment-
management strategies.
Passive management regards holding highly diversified portfolios without spending effort or other resources attempting to
improve investment performance through security analysis. Thus, passive management does not attempt to find undervalued
securities or time the market. As a result, trading costs and management fees are lower.
Active management is the attempt to improve performance either by identifying mispriced securities or by timing the
performance of broad asset classes. 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.
1.5 Players in the Financial Markets
From a bird’s-eye view, there would appear to be three major players in the financial markets:
1. Firms are net demanders of capital. They raise capital to pay for investments in plants and equipment. The income generated
by those real assets provides returns to investors who purchase the securities issued by the firm.
2. Households typically are net suppliers of capital. They purchase the securities issued by firms that need to raise funds.
3. Governments can be borrowers or lenders, depending on the relationship between tax revenue and government
expenditures. The government has to borrow funds to cover its budget deficit. Issuance of Treasury bills, notes, and bonds is
the major way that the government borrows funds from the public.
, 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. These
financial institutions stand between the security issuer (the firm) and the ultimate owner of the security (the individual
investor). For this reason, they are called financial intermediaries.
As individual investors may not be able to diversify their portfolios or assess and monitor the credit risk of borrowers,
financial intermediaries have evolved to bring the capital suppliers (investors) together with the capital demanders
(corporations and government). These intermediaries include banks, investment companies, insurance companies, and credit
unions. Financial intermediaries issue their own securities to raise funds to purchase the securities of other corporations.
For example, a bank raises funds by borrowing (taking deposits) and lending that money to other borrowers. The spread
between the interest rates paid to depositors and the rates charged to borrowers is the source of the bank’s profit. Thus, lenders
and borrowers do not need to contact each other directly. Instead, each goes to the bank, which acts as an intermediary.
Investment companies, which pool and manage the money of many investors, also arise out of economies of scale. 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 via a management fee to the mutual fund operator. 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
a. 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.
b. 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 VC are dedicated venture capital
funds, wealthy individuals known as angel investors, and institutions such as pension funds. Venture capital investors
commonly take an active role in the management of a start-up firm. 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.
2. Asset Classes and Financial Instruments
Each broad asset class contains many specific security types. We will look at the important features of the broad classes of
securities. Financial markets are traditionally segmented into money markets and capital markets.
2.1 The Money Market
The money market consists of short-term, highly marketable debt securities. Many of these securities trade in large
denominations and are out of the reach for individuals. Money market funds, however, are easily accessible to small investors.
Treasury Bills are the most marketable of all money market instruments. They represent the simplest form of borrowing: the
government raises money by selling bills to the public. Investors buy the bills at a discount from the stated maturity
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