This is a summary of everything the teacher told during the lesson Q and A's and the exam questions proposed in the second part of the course. The summary is long, because (almost) all tables and graphs are listed in it. It's easy to read.
Investment: the current commitment of money or other resources in the expectation of
reaping future benefits.
- E.g. purchasing shares of stocks anticipating that the future proceeds from the shares
will justify both the time and risk taken.
1.1 Real assets vs. Financial Assets
The material wealth is determined by the productive capacity of the economy: the goods and
services its members can create.
It is a function of real assets: land, buildings, machines & knowledge.
You also have financial assets: stocks and bonds, for example (securities). These do not add
to the productive capacity of the economy. Financial assets: claims to the income generated
by real assets. These assets simply define the allocation of income/wealth among investors.
Household wealth includes financial assets that are liabilities of the issuers of the securities.
1.2 Financial Assets
Three types:
1. Fixed-income/debt securities: promise a fixed stream of income/stream of income
determined by a specified formula.
a. E.g. a bond.
b. Money market refers to short term, highly marketable and very low risk. E.g.
U.S. Treasury bills of bank certificates of deposit.
c. Capital market refers to long-term securities, e.g. Treasury bonds.
2. Equity: represents an ownership share in the corporation. Not promised any particular
payment, just receive dividends.
3. Derivative securities: provide payoffs that are determined by the prices of other
assets, such as bond/stock prices. E.g. options and futures. Derivative comes from its
derived values from the prices of other assets.
a. Mostly to hedge risks or transfer them to other parties.
1.3 Financial Markets and the Economy
Financial assets allow us to make the most of the economy’s real assets.
Information role financial markets
When the market is more optimistic about the firm ® share prices rise ® makes it easier to
raise capital for the firm ® encourages investment.
The stock market encourages allocation of capital to those firms that appear at the time to
have the best prospects. Be skeptical!
Consumption timing
You can ‘shift’ your consumption over the course of your lifetime, thereby allocating your
consumption to periods that provide the greatest satisfaction.
Financial markets allow individuals to separate decisions concerning current consumption
from constraints that otherwise would be imposed by current earnings.
,Allocation of risk
Capital markets allow the risk that is inherent to all investments to be borne by the investors
most willing to bear that risk. This allocation of risk also benefits the firms that need to raise
capital to finance their investments.
Separation of ownership and management
Many businesses are owned and managed by the same individual.
The structure where the owners and managers are different parties provides the firm a stability
that the owner-managed firm can’t achieve.
Financial assets and the ability to buy and sell those assets in the financial markets allow for
easy separation of ownership and management.
Potential agency problems, however, can arise due to managers pursuing their own interests.
Several mechanisms have evolved to mitigate potential agency problems:
1. Compensation plans tie the income of managers to the success of the firm. E.g shares
or stock options. The managers will not do well unless the stock price increases,
benefiting shareholders.
2. Directors can be forced out of the management teams that are underperforming.
3. Outsiders, such as large institutional investors, monitor the firm closely and make the
life of poor performance at the least uncomfortable.
4. Bad performers are subject to the threat of takeover. Unhappy shareholders can launch
a proxy contest in which they seek to obtain enough proxies (right to vote for the
shares of other shareholders) to take control of the firm and vote in another board.
a. Or: if one form observes another underperforming firm, it can acquire the
underperforming business and replace management with its own time. The
stock price could rise due to improved performance, which provides an
incentive for firms to engage in such takeover activity.
Corporate governance and corporate ethics
Markets need to be transparent for investors to make informed decisions.
1.4 The investment process
Investor’s portfolio: his/her collection of investment assets. The portfolio is updated or
‘rebalanced’ by selling existing securities and using the proceeds to buy new securities.
Asset allocation decision: the choice among these broad asset classes.
Security selection decision: the choice of which particular securities to hold within each
asset class.
Security analysis: the valuation of particular securities that might be included in the
portfolio.
- Top down portfolio construction starts with asset allocation.
- Bottom-up portfolio construction from securities that seem attractively priced without
as much concern for the resultant asset allocation.
1.5 Markets are competitive
Implications of the no-free-lunch proposition:
1. Risk-return trade-off
a. Investors invest for anticipated future returns, but those returns rarely can be
predicted precisely. There will almost always be risk involved.
b. The no-free-lunch rule tells us that not all else can be held equal. Higher return
is associated with higher risk.
, c. If higher expected return can be achieved without bearing extra risk ® rush to
buy those high-return assets ® prices driven up ® less attractive to invest ®
price rises further until E(R) is no more than commensurate with risk.
d. There should be a risk-return trade-off in security markets, with higher-risk
assets priced to offer higher expected returns than lower-risk assets.
e. Diversification: many assets are held in the portfolio so that the exposure to
any particular asset is limited.
2. Efficient markets
a. We should rarely expect to find bargains in the security markets.
b. According to the efficient market hypothesis: new information is reflected in
the price of the security. Thus, there would never be underpriced/overpriced
securities according to this hypothesis.
c. Passive management: calls for holding highly diversified portfolios without
spending effort or other resources attempting to improve investment
performance through security analysis.
d. Active management: 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.
1.6 The players
Three major players:
1. Firms are net demanders of capital.
2. Households are net suppliers of capital.
3. Governments are borrowers or lenders.
Corporations and govts do not sell all/most of their securities directly. They use financial
intermediaries: stand between the security issuer and the ultimate owner of the security.
Financial intermediaries have evolved to bring investors together with corporations and
governments.
- E.g. banks, investment companies, insurance companies and credit unions.
o By pooling the resources of man investors, they are able to lend considerable
sums to large borrowers.
o By lending to many borrowers, intermediaries achieve significant
diversification, so they can accept loans that individually might be too risky.
Investment companies: pool and manage money of many investors. And arise out of
economies of scale.
Problem: most household portfolios are not large enough to be spread across a wide variety of
securities.
When investment bankers can offer their services at a cost below that of the maintaining an
in-house security issuance division, they are called underwriters.
The investment banking firm handles the marketing of the security in the primary market,
where the new issues of securities are offered to the public. Later, investors can trade
previously issued securities among themselves in the so-called secondary market.
VC: Venture capital: investors who are willing to invest in young start-up firms in return for
an ownership stake in the firm.
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