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Intermediate Asset Pricing full summary
- Instelling
- Rijksuniversiteit Groningen (RuG)
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Door: annedeclercqzubli • 4 jaar geleden
I am not satisfied by this summary, it isn't even worth it to call it a summary. Just large parts/sentences from the book copy pasted.. Very disappointed by this summary, definitely not worth >10$.
Voorbeeld van de inhoud
BKM chapter 1 - The investment environmentThe material wealth of a society is determined by the productive capacity of its economy, so the
goods and services it can create, which is a function of the real assets of the economy: land,
buildings, machines, and knowledge used to produce goods.
Financial assets, in contrast, include stocks and bonds. Such securities don’t contribute directly
to the productive capacity of the economy, but are means by which individuals in developed
economies hold claims on real assets. Financial assets are claims to income generated by real
assets: instead of owning an auto plant (real asset), we buy shares in one and share in the income
derived from it through financial assets.
Real assets generate net income to the economy, financial assets simply define the allocation of
income or wealth among investors. Securities sold to investors are used by companies to buy real
assets, making return on financial assets (securities) ultimately derive from the income produced
by real assets.
The balance sheet of US Households includes financial assets, but since these are liabilities for
the issuers of these securities, they cancel out on the scale of the whole economy: national wealth
consists purely of real assets like structures, equipment, etcetera.
1.2 - Financial assets
Three broad types of financial assets are distinguished: Fixed income, equity, and derivatives.
Fixed-income or debt securities promise either a fixed income stream or one determined by a
specified formula, e.g. corporate bonds, both floating and fixed rate. Default is the main risk, tying
investment performance of fixed-income securities closely to issuer’s financial condition.
Maturities and payment provisions come in tremendous variety. On the money market are short
term, highly marketable, and generally very low risk debt securities such as Treasury bills or bank
certificates of deposit CDs.
The fixed-income capital market in contrast includes long-term securities like Treasury and other
bonds, from safe to high-yield or ‘junk’ bonds.
Equity, or common stock, in a firm represents ownership instead of a particular payment. Dividend
and increasing equity value are the goal, tying the performance of equity investments directly to
the firm’s real assets’ success: this makes equity investments risker than debt securities.
Derivative securities like options and futures provide payoffs determined by the prices of other
assets, like bonds or stock prices. Deriving their value from the prices of other assets, the value of
e.g. a call option will depend on the price of the underlying stock. Their primary use is to hedge or
transfer risks, but also for taking highly speculative positions.
1.3 - Financial markets and the economy
Real assets determine the economy’s wealth, financial assets represent claims on these real
assets.
Stock prices reflect investors’ collective assessment of a firm’s current performance and future
prospects, determining allocation of capital as higher stock prices make raising capital easier,
thereby directing capital towards what the market deems its most productive use. Sometimes
resource allocation through capital markets is not efficient, think of the dot-com bubble, but
despite mistakes the stock market encourages allocation of capital to those firms that at the time
have the best prospects, reflecting collective judgement.
Some consumers earn more than they currently wish to spend, or vice versa, and shifting
purchasing power throughout periods of life can be done through storing wealth in financial
assets through financial markets.
Another function of the stock market is the allocation of risk: risk-tolerant individuals can buy
equity, while more conservative resort to bonds, allocating to each their preferred risk.
Large corporations are not owner-operated, but have a strong separation of ownership and
management with millions of stockholders not actively participating in day-to-day management. A
board of directors is elected to supervise management, giving a firm stability that owner-managed
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,firms cannot achieve: stockholders can sell their shares and ownership can trade hands without
impacting management.
Agency problems could arise, and several mechanisms have evolved to mitigate these:
compensation plans tied to firm success, such as stock options, or forcing out of management by
the board. Threats of takeover also loom if the board is lax in monitoring management and a proxy
contest is launched to take control of the firm and elect a new board by unhappy shareholders.
Firms can also take over other underperforming firms and replace management with its own, with
stock prices providing incentives for this as they’d rise if successful.
Corporate governance and corporate ethics
Market signals only allocate capital efficiently if investors act on accurate information:
transparency is required for investors to make informed decisions, as managers misleading the
public makes markets fail. Aligning shareholder and management incentives has failed to prevent
some famous corporate governance and ethics crises, from Lehman to Enron. Other examples
are overly optimistic reports and analyses, or auditors earning depending on firm’s consultancy
fees. Sarbanes-Oxley is legislation passed to tighten corporate governance rules.
The investment process
A portfolio is established and then rebalanced using two types of decisions: Firstly asset
allocation, deciding to choose among the broad asset classes of stocks, bonds, real estate,
commodities, etcetera. Secondly security selection, which security of these particular assets to
hold within each class.
‘Top-down’ portfolio construction starts with asset allocation, so deciding what proportion to be in
bonds, what in stocks, etcetera. Security analysis involves the valuation of particular securities
that might be included in the portfolio; trying to determine which firm or bond is more attractively
priced. Valuation is more difficult for stocks since its performance is more sensitive to firm
conditions. The ‘bottom-up’ portfolio management strategy starts with buying securities that
seem attractively priced, disregarding the resulting asset allocation. This can result in unintended
bets on some sectors, as diversification may not be taken into account, but does focus the
portfolio on assets seemingly offering the most attractive returns.
Markets are competitive
Numerous analysis’s scour markets for attractive buys, so we shouldn’t expect to find few, if any,
‘free lunches’ that are underpriced bargains. There are two implications to this proposition:
-The risk-return trade-off. Investors invest for anticipated future returns, but these are hard to
precisely predict and realised returns will deviate. Holding all else equal, investors prefer
investment with the highest expected returns. The no-free-lunch rule means this is only possible if
they concede something else though, by accepting higher investment risk, as a higher expected
return without extra risk will make investors rush to such assets and drive up their price. Attractive
assets prices will rise until its expected return corresponds to risk, a fair return: there’s a risk-
return trade-off in securities, with higher-risk assets priced to offer higher expected returns.
-Efficient markets. The hypothesis that financial market process all available information about
securities quickly and efficiently to reflect them in their price means prices quickly adjust with new
information, meaning there are no under-or overpriced securities. The efficient market hypothesis
has an important implication for investment-management strategies. Passive management calls
for holding highly diversified portfolios without spending effort to improve returns through security
analysis. Active management is the attempt to improve performance by identifying misplaced
assets or through timing the performance of broad asset classes, e.g. riding the bull market. If
markets are efficient and incorporate all available information, passive strategies would be best
since one could never outguess competitive investors. We usually only observe near-efficiency,
not perfect EMH, as profit opportunities may still exist for creative and diligent investors, since the
market is not 100% efficient.
The players
Generally there are three major players in the financial markets:
-Firms, net demanders of capital, raising it to pay for investments in real assets and returning the
income they generate to investors.
-Households, net suppliers of capital that purchase securities issued by firms.
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,-Governments, can be either, typically borrowing to cover the deficit through Treasury bills, notes,
and bonds.
Large financial institutions hold half of all stock (pension funds, mutual funds, banks, insurance
companies) and stand between the security issuer and the individual investors eventually owning
it. Therefore they’re known as financial intermediaries.
Households and other small investors find direct investment difficult, and diversification
impossible unless they have a lot of capital. Financial intermediaries connect capital suppliers to
capital demanders and help monitor their credit risk, and have both assets and liabilities that are
overwhelmingly financial: the balance sheet of e.g. a commercial bank has only very little real
assets since it merely channels funds from one sector to another. Intermediaries pool investments
of many small investors and are then able to lend considerable sums, as achieve significant
diversification. Their expertise helps use economies of scale and scope to assess and monitor
risk.
Investment companies pool and manage many investors’ funds and achieve low costs through
spreading out brokerage fees through large-scale trading and portfolio management. Investment
companies also design portfolios specifically for large investors and their goals, while mutual
funds are sold in the retail market and cater to a large audience.
Hedge funds also pool money, but are open only to institutional investors like pension funds or
very wealthy individuals, and likely to pursue complex and higher-risk strategies, leading to higher
fees.
When Glass-Steagall was repealed, banks that accept deposits were also allowed to underwrite
securities, ending the separation between investment and commercial banking, creating universal
banks. After ’07, the Volcker rule prohibited banks from proprietary trading (securities for their
own accounts) and restricted hedge of private equity fund investments. This is less restrictive than
Glass-Steagall, but still limited banks somewhat reducing ubiquity of universal banking.
Investment bankers
Economies of scale also create niches for firms performing specialised services: investment
bankers help firms raise capital through selling securities like stocks and bonds to the public,
performing the role of underwriters. Investment bankers handle the marketing of the issue in the
primary market of securities, after which investors can trade previously issued securities on the
secondary market amongst themselves.
Venture capital & Private equity
Firms too small and young to issue securities through IPOs rely on loans and investors. Such
equity investment in young companies is known as venture capital VC and originate from
dedicated VC funds, wealthy individuals known as angel investors, and institutions like pension
funds. Most VC funds are limited partnerships, where the management company raises capital in
addition to its own from limited partners (like pension funds) and invests it in start-ups, sitting on
its board and providing advice and management. After some time the fund is liquidated.
Other companies focus on underperforming firms, buying these and improving them to sell them
again. Both VCs and private equity are actively engaged in management, and both are part of
what we call private equity.
The 2008 Financial Crisis
In early 2007 most observers were optimistic about the next two years. Following the high-tech
bubble in 2000-2002 the Fed responded to an emerging recession by aggressively reducing
interest rates, dropping Treasury bills and the LIBOR rate drastically and preventing a potential
recession. In 2003 the TED spread, between Treasury-bill and LIBOR, was at 25 basis points very
low, suggesting counterpart risk in the banking sector was extremely low.
Investors describe the 3 decades up to the Great Recession as the Great Moderation, with mild
business cycles and stable economic growth. The booming housing market started in the 90s and
accelerated dramatically as a consequence of plummeting interest rates: In the decade after
1997, US housing prices tripled, sowing the seeds of the crisis. The Fed’s reduced interest rates
made investors seek higher-yield alternatives, and low volatility led to complacency about risk.
Prior to the 70s mortgages came from local lenders, but Fannie Mae and Freddie Mac (Federal
mortgage association/corporation) began buying mortgage loans from originators and bundling
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, them into pools that were essentially claims on underlying mortgages. These mortgage-backed
securities were part of securitisation and meant the loan originator would often pass on the loan
payments to an investor buying the pooled mortgages. The agency (Fannie or Freddie) would
typically guarantee the credit risk of the pools in exchange for a fee before passing the remaining
cash on to the investor: these mortgage backed securities were known as pass-throughs.
These guaranteed securities were low-risk conforming mortgages, meaning they had certain
mortgage to house value restrictions and other risk reducing measures, but securitisation gave
rise to a new market niche: originate to distribute, rather than originate to hold, its purpose of
extending mortgages being to sell them on.
Whereas conforming loans were pooled through Fannie and Freddie, private firms started
engaging in nonconforming or subprime loans with higher default risk. The private investor would
bear the risk of default, rather than the government agency, meaning originating mortgage brokers
had little incentive to perform due diligence as long as they were able to resell the mortgages to
an investor and have him bear default risk.
Low-and eventually no-documentation loans emerged, requiring little verification of a borrower’s
ability to carry a loan. Subprime underwriting standard deteriorated, and the leverage (loan-to-
value ratios) rose dramatically with the majority reaching 100%, meaning these loans came
underwater as soon as prices fell. This incentivised homeowners to walk away from the house,
foregoing collateral since the loans were worth more than the house itself.
Adjustable-rate mortgages ARMs grew in popularity, offering low teaser rates that eventually grew
to current yield, such as Treasury bill plus 3%, meaning monthly payment soared when rates
grew. Starting in 2004, the ability of refinancing to save a loan began to diminish as higher interest
rate put pressure on homeowners with ARMs, and when house prices peaked in ’06 the ability to
refinance a loan using built-up equity declined, and defaults started to surge: losses on mortgage-
backed securities were mounting as house prices stopped growing or started going down.
All these risky subprime mortgages were traded through securitisation, restructuring, and credit
enhancement: risk shifting tools allowed banks to achieve AAA-rates on junk loans, with
Collateralised Debt Obligations or CDOs being the most important and damaging of such
innovations. CDOs concentrate the credit risk (default risk) of a bundle of loans on one class of
investors, leaving the other investors relatively protected: claims on loan repayments were
prioritised to the senior tranches. The junior tranches would be paid only after the seniors had
their cut, meaning a 70% senior and 30% junior CDO would see the seniors be repaid fully as
long as default rates remained below 30%. This was seemed highly likely, and senior tranches
were often granted AAA rating by Moody’s, S&P, and Fitch, allowing AAA-rated securities to be
created out of a package containing subprime mortgages that on their own would be junk-rated.
The CDO tranches offered far less protection than initially anticipated, and when housing prices
started falling, defaults increased, and it turned out rating agencies had dramatically
underestimated credit risk. Historical default data was unrepresentative since it was based on a
recession-free economy with a housing boom. The rating agencies extrapolated historical defaults
of vanilla mortgages to ARMs, and low-or no-documentation mortgages, or liar loans, meaning
they gravely underestimated defaults. Secondly, they counted on cross-regional diversification to
minimise risk, expecting one area not to experience a housing crisis simultaneously with the other,
which turned out wrong too. And lastly, agency problems were present: rating agencies were paid
by the issuers of the securities, not the buyers, facing pressures to issue high ratings.
The market in credit default swaps also exploded in this period. A CDS is an insurance against the
default of a borrower, where the purchaser pays an annual premium (like an insurance premium) in
exchange for a seller bearing the credit risk. The largest insurance company, AIG, sold more than
$400 billion of CDS, which it would never be able to actually insure without going bankrupt.
By 2007 many large banks and other financial institutions had started borrowing short term at low
interest rates to finance higher-yield, long-term illiquid assets. They treated the interest rate
spread between assets and liabilities as economic profit, but the constant need for refinancing of
their short-term liabilities would cause difficulties when having to roll them over in a crisis. The
alternative, a ‘fire sale’ or quickly selling illiquid assets, would be hard too. These highly leveraged
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