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SUMMARY INTERNATIONAL INVESTMENT MANAGEMENTWeek 1 Investment environment, trading securities and the concepts of risk
and return
Chapter 1 (1.1-1.6): The investment Environment
1.1 Real assets versus financial assets
The material wealth of a society is determined ultimately by the
productive capacity of its economy, which is a function of the real
assets of the economy: the land, buildings, knowledge, and machines
that are used to produce goods and the workers whose skills are
necessary to use those resources.
Financial assets: like stocks or bonds, contribute to the productive
capacity of the economy indirectly, because they allow for separation of
the ownership and management of the firm and facilitate the transfer of
funds to enterprise with attractive investment opportunities. Financial
assets are claims to the income generated by real assets.
Real vs. Financial assets:
- Real assets produce goods and services, whereas financial assets
define the allocation of income or wealth among investors.
- They are distinguished operationally by the balance sheets of
individuals and firms in the economy. Whereas real assets
appear only on the asset side of the balance sheet, financial
assets always appear on both sides of the balance sheet. Your
financial claim on a firm is an asset, but the firm’s issuance of
that claim is the firm’s liability. When we aggregate over all
balance sheets, financial assets will cancel out, leaving only the
sum of real assets as the net wealth of the aggregate economy.
- Financial assets are created and destroyed in the ordinary course
of doing business. E.g. when a loan is paid off, both the creditor’s
claim and the debtor’s obligation cease to exist. In contrast, real
assets are destroyed only by accident or by wearing out over
time.
1.2 Financial Assets
Fixed income/ debt securities: promise either a fixed stream of
income or a stream of income determined by a specified formula
(for example corporate bond)
Equity: represents an ownership share in the corporation. Equity
holders are not promised any payment. They receive any
dividends the firm may pay and have prorated ownership in the
real assets of the firm
Derivative securities: provides payoffs that are determined by
the prices of other assets such as bonds or stock prices
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, SUMMARY INTERNATIONAL INVESTMENT MANAGEMENT
1.3 Financial markets and the economy
Smoothing consumption: “Store” (e.g. by stocks or bonds) your
wealth in financial assets in high earnings periods, sell these assets
to provide funds for your consumption in low earnings periods (say,
after retirement).
Allocation of risk: virtually all real assets involve some risk (so do
financial assets). If a person is uncertain about the future of GM, he
can choose to buy GM’s stock if he is more risk-tolerant, or he can
buy GM’s bonds, if he is more conservative.
Separation of ownership and management: Let professional managers
manage the firm. Owners can easily sell the stocks of the firm if they
don’t like the incumbent management team or “police” the managers
through board of directors (“stick”) or use compensation plans tie the
income of managers to the success of the firm (“carrot”). In some cases,
other firms may acquire the firm if they observe the firm is
underperforming (market discipline).
1.4 The Investment process
Asset allocation: is the choice among these broad asset classes.
- Top-down method starts with asset allocation and will end with
security selection.
Security selection: is the choice of which securities to hold within
each asset class.
Security analysis: involves the valuation of securities that might
be included in the portfolio. For example: an investor might ask
whether Merck or Pfizer is more attractively prices.
- Bottom up: in contrast to top down, the portfolio is constructed
from securities that seem attractive without much concern for
the resultant asset allocation.
1.5 Markets are competitive
Risk-return trade off: in the securities markets there should be
higher-risk assets prices to offer higher expected returns than
lower-risk assets.
Passive management: calls for holding highly diversified
portfolios without spending effort for other resources attempting
to improve investment performance trough security analysis.
Active management: is the attempt to improve performance by
either identifying misprices securities or by timing the
performance of broad asset classes. For example, increasing
one’s commitment to stocks when one is bullish on the stock
market.
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, SUMMARY INTERNATIONAL INVESTMENT MANAGEMENT
1.6 The players
Three major players in the financial markets:
1. Firms: are net demanders of capital. They raise capital for
investments.
2. Households: 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.
Investment companies: which pool and manage the money of
many investors. They can design portfolios specifically for large
investors, for example hedge funds.
Primary market: market where new issues of securities are
offered to public
Secondary market: investors can trade previously issued
securities among themselves.
Venture capital (VC): equity investment in start ups
Private equity: focusses on firms that may be bought up, improve
them, and sell for a profit. Collectively these investments in firms
that do not trade on public stock exchanges are known as private
equity investments.
Chapter 3 (3.1-3.9): How Securities are traded
3.1 How firms issue securities
Private placement: when private firms wish to raise funds, they sell shares directly
to institutional or wealthy investment in a private placement. This is attractive since
these shares are not traded in secondary markets, which reduces their liquidity and
presumably reduces the prices investors will pay for them.
IPO (initial public offering): the first issues of shares from a private company to the
public and allow investors to freely trade the shares in established security markets.
This process is done by investment bankers advise the firm, who in this role are
called underwriters.
Prospectus: the accepted final registration statement which must be filed with SEC.
It describes the issue and the prospects of a company.
3.2 How securities are traded
Types of markets:
- Direct search markets: it is the least organized market. Buyers and sellers must seek
ach other out directly. For example, selling an old television where sellers advertise
for buyers. Such markets are characterized by sporadic participation and
nonstandard goods.
- Brokered markets: the next level of organization. In markets where trading in a good
is active, brokers find it profitable to offer search services to buyers and sellers. For
example, the real estate market, and the primary market where new securities are
offered to public.
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