Chapter

Investments:
1 Background and Issues

Bodie, Kane, and Marcus

Essentials of Investments
Tenth Edition
 Outline and major learning objectives

 Distinguish between real assets and financial assets.

 Explain the economic functions of financial markets and the

role of the governance of corporations.

 Describe the major steps in the construction of an investment

portfolio.

 Explore the different types of participants in financial markets

Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 2
1.1 Real versus Financial Assets within an economy

The wealth of an economy depends on its productive capacity that is the

goods and services its member can create. This capacity is an increasing
function of the real assets.

Financial Assets
Real Assets Claims on Real
Used to produce Assets or the income
goods and generated by them
services: e.g. stocks , bonds
e.g. Land,
buildings,
equipment, human While real assets generate net
capital, etc. income to the economy, financial
assets simply define the
allocation of income or wealth
among investors.

Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 3
 Table 1.2 Domestic Net Worth of the U.S Economy, 2014

Assets $ Billion
Commercial real estate $20,092

Sum of Residential real estate 22,820

real Equipment and software 7,404
assets
Inventories 2,514
Consumer durables 5,041
TOTAL NET
WORTH $57,873 1 trillion US =
1,000 billion
Note: Column sums may differ from total because of rounding error.

SOURCE: Flow of Funds Accounts of the United States, Board of Governors of the
Federal Reserve System, June 2014.

Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 4
 1.2 Major Classes of Financial Assets
1. Common stock: Ownership share in the corporation
2. Fixed income securities (debt securities)=promise fixed stream
of income

o Money market instruments (short term debt)

• Bank certificates of deposit, T-bills etc.
o Capital market instruments ( long term debt)

Bonds
o Preferred stocks (hybrid security with fixed
dividend rate)
- have priority over common stock in the payment of dividends and upon
liquidation, but subordinate to bonds  in terms of claim.
- Like bonds, preferred stocks are rated by major credit rating companies.
5
Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
 1.2 Major Classes of Financial Assets

3. Derivative securities
A contract whose value is derived by the prices
of other assets and from some underlying market condition
e.g. options and futures contracts

Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 6
 1.3 Financial Markets and the Economy
When trading in financial markets, investors needs to be
aware of :

• Tradeoff between risk and return of financial assets

• Agency problems = conflicts of interest

• Corporate governance and corporate ethics issues

Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 7
 1.3 Financial Markets and the Economy
Risk-Return Trade-Off
• Assets with higher expected returns have higher
risk

Investors with excess cash can choose a desired risk level

for their investments:

o Bonds versus stocks of a given company

o Bank Certificate of deposit versus company bond

Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 8
 1.3 Financial Markets and the Economy
Average Annual Return Minimum (1931) Maximum (1933)
Stocks About 12% −46% 55%

• Stock portfolio loses money 1 of 4 years on

average
• Bonds
• Have lower average rates of return (under 6%)
• Have not lost more than 13% of their value in any one
year

Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 9
 1.3 Financial Markets and the Economy
 Agency problems
Principal hires an agent to represent his/her interests

Agent:
you hire an agent to do the
Principal: selling job
You wish to Sell your
car

-Fixed commission : not necessarily get you the best

price ( Agency prob)
-Or 10% from sales price

Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 10
 1.3 Financial Markets and the Economy
• Agency problems : Separation of Ownership and
Management
o Large size of firms requires separation of principals and
agents: Owners (principals) ≠ Managers (agents).
In 2017 General Electric Company had about 440,000
stockholders and about 8.7 billion shares outstanding:
dispersion of ownership.

Will management necessarily act in the best interests of

the stockholders? 

o Agency problem: Conflict of interest between

managers and owners
.
Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 11
 1.3 Financial Markets and the Economy
• Managing managers/ Mitigating Factors:
o Performance-based compensation: promotions,
higher salaries etc.

Charter Communications CEO Tom Rutledge Made $98.5M

In 2016

o Boards of directors may fire managers

o Threat of takeovers

Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 12
 1.3 Financial Markets and the Economy
Agency Problems: Example 1.1
o In February 2008, Microsoft offered to buy Yahoo at
$31 per share when Yahoo was trading at $19.18
o Yahoo rejected the offer, holding out for $37 a share
o Proxy fight to seize control of Yahoo's board and
force Yahoo to accept offer
o Proxy failed; Yahoo stock fell to$21
o Did Yahoo managers act in the best interests of their
shareholders?

Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 13
 1.3 Financial Markets and the Economy
Corporate Governance and Corporate Ethics
 Corporate governance is the system of rules, practices,
control, policies by which a firm is directed and controlled
 Businesses and markets require trust to operate
efficiently
o Without trust additional laws and regulations are
required. However, laws and regulations are costly

 Governance and ethics failures cost the

economy billions, if not trillions

Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 14
 1.3 Financial Markets and the Economy
• Governance and Ethics failures
o Accounting scandals

• Enron, WorldCom, Rite-Aid, HealthSouth, Global

Crossing, Qwest (see next slide)
o Misleading research reports (optimistic research reports
done by market analysts )

• Citicorp, Merrill Lynch, others

o Auditors: Watchdogs or consultants?

• Arthur Andersen and Enron

Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 15
 1.3 Financial Markets and the Economy
• Unethical scandals examples:

• WorldCom : overstated its profits by at least $3.8 billion by

improperly classifying expenses as investments one of the
largest bankruptcy in U.S. history
• Enron manipulated its financial status by moving debt off +
Enron's auditor Arthur Andersen earned more money
consulting for Enron than auditing it; given its incentive to
protect its consulting profits

Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 16
 1.3 Financial Markets and the Economy
• Sarbanes-Oxley Act of 2002 : set by the US congress for publicly
traded corporations in response to the scandals in the early 2000.
o Requires more independent directors on company boards.

o Requires CFO to personally verify and sign the financial

statements. Officers who sign inaccurate financial statements
are subject to penalties.
o Sets new rules that affect recordkeeping (defines the type of
business records to be kept (including electronic
communications), retention period for storing records etc.

Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 17
 1.3 Financial Markets and the Economy
o Audit firms cannot provide auditing and
consulting services at the same time for the same
company.

o Companies must also establish internal controls

to prevent fraud.
o Created new oversight board for the audit firms :
Public Company Accounting Oversight Board
(PCAOB)  regulates , oversees and monitors
the auditing firms

Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 18
 1.4 The Investment Process: Asset Allocation
 Types of decisions when constructing portfolios : 1000

1. Asset Allocation
• Choosing the percentage of money allocated for each
asset classes:
10%
25% 25%
Equity
30%
Bonds
60%
Bills 50%

 Top Down Investment Strategies starts with Asset Allocation

decision before turning to more specific security selection decision
Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 19
 1.4 The Investment Process: Security Selection

2. Security Selection & Analysis

Choice of which particular securities to
hold within each asset class (attractively
priced securities)

Bottom Up Investment Strategies starts

with Security Selection without as much
concern on the resultant asset allocation

Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 20
 1.5 Markets Are Competitive
• In Efficient Markets Securities should

• be neither underpriced nor overpriced on average

• Security prices reflect all information available to

investors

Choice of
Your Belief
Investment-
in Market
Managemen
Efficiency
t Style

Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 21
 1.5 Markets Are Competitive

Active Passive
Management Management

Markets are… Inefficient Efficient

Actively Seeking No Attempt to Find

Security Selection: Undervalued Undervalued
Stocks Securities

No Attempt to
Asset Allocation Market Timing
Time Market

Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 22
 1.6 The Players in financial markets
1. Business Firms (net borrowers, demanders of
capital)
2. Households investors(net savers, suppliers of
capital)
3. Governments (can be both borrowers and savers)

4. Financial Intermediaries (connectors of borrowers

and lenders) See “Other examples …” p. 12

o Commercial banks
o Insurance companies
o Hedge funds , mutual funds
o Investment companies
Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 23
 How do investment companies (mutual funds) operate?

po
Investors m ol t
on he
e n e y ir
v
Gi k to in
c
ba Experienced fund
managers +
specialized financial
Mutual Hire analysts
Returns Funds

T
gen hat Portfolio e,
er a s
te s of h oo t in
C es
Securities inv
Information on
mispriced
securities
Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 24
 1.6 The Players
5. Investment Banks
Specialize in primary market transactions
(Primary market: a market where newly issued
securities are offered to the public).
• Investment bankers help and advise an issuing
firm on the prices it can charge for the newly
issued securities & handles the marketing job
in the primary market. In this role, the banks
are called underwriters. 

Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 25
 1.6 The Players
Investment Bankers
• Commercial and investment banks' functions were
separated by law 1933-1999.
• Post-1999: Those regulations were eliminated
(allowing investment banking activities of
commercial banks). On the other hand, large investment
banks, collectively known as “Wall Street,” operated
independently from commercial banks.
• September 2008: Mortgage-market collapse. Major
investment banks bankrupt; some were reorganized as
commercial banks or were purchased by commercial
banks

Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 26
 1.6 The Players
Investment Bankers
• Investment banks may become commercial
banks to:
• Obtain deposit funding = source of money

• Have access to government assistance

Commercial bank investment bank

Deposits fees and
commission
Central bank assistance no help

Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 27