A' Understand Investments

1

• Introduction

2
Introduction

• A. Understand Investments
• B. Understand the Investment Process
• C. Understand differences between financial and
  real assets in the economy
• D. Understand types of financial markets and
  trends in those markets

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Chapter 1

• Toolbox
• Investments - Background and Issues

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A. Understand Investments

• What is an Investment?
• Current commitment of money or other resources in
  the expectation of reaping future benefits.
• Are there priorities of Investments?
• What are your most important investments?

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Investments

• What are your other key investments?
• Education and Skills
• Knowledge and Friendships
• Food Storage and Emergency Funds
• Financial Investments
• Do not be too narrow in your view of investments
• What investments will we be working with in this
  class?
• Generally financial investments
• Stocks (equities), bonds, options, futures, etc,
  (with reference to other important investments as
  well)

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B. Understand the Investment Process

• Not as simple as it seems
• Its a process of determining your current
  financial state, your objectives, constraints,
  policy, investing, and then monitoring your
  investments with the intent of reaching specific
  goals

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The Investment Process

• Four major steps
• 1. Specifying Objectives
• What are your (realistic) risk and return
  expectations?
• What kind of return do you need?
• What amount of risk can you handle?

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The Investment Process (continued)

• 2. Specifying Constraints
• What are your individual circumstances that will
  impact portfolio construction?
• Taxes
• Liquidity
• Time horizon
• Regulations
• Unique needs

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The Investment Process (continued)

• 3. Formulating Policies
• What group of asset classes can be invested in to
  meet your objectives and constraints, and how
  should they be invested?
• Allowable asset classes stocks, bonds, money
  funds, international, real estate, etc.
• How will you invest your assets
• Active or passive (market efficiency)
• Top-down or bottom-up
• Individual stocks or mutual funds

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The Investment Process (continued)

• 4. Monitoring and Updating the Portfolio
• Monitor portfolio performance to ensure it meets
  your goals and objectives
• Monitor asset allocation based on market
  expectations
• Modify and change the portfolio as necessary to
  meet your objects and to take into account
  changes in market expectations, investor
  constraints, and current conditions

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Problem

• What are some advantages and disadvantages of
  top-down versus bottom-up investing styles?

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Answer

• Under top-down investment strategy, you focus on
  the asset allocation or broad composition of the
  entire portfolio, which is the greatest
  determinant of your performance. It is also a
  natural way to establish a portfolio with a risk
  level appropriate for you. The disadvantage is
  that you could give up potential high returns
  from individual securities that may be
  attractive.
• Under bottom-up investing, you try to benefit
  from finding undervalued securities. The
  disadvantage is that you tend to overlook the
  overall composition of your portfolio, which may
  result in a non-diversified portfolio. It also
  tends to require more active management, hence
  higher costs.

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C. Understand the differences between Financial
and Real Assets in the Economy

• The wealth of a society is determined by the
  productive capacity of the economy
• The productive capacity is a function of the
  real assets in the economy
• Real Assets
• Assets used to produce goods and services, e.g.,
  land, machines, buildings, and knowledge
• Financial Assets
• Claims on real assets which only define ownership
  of income streams, e.g., stocks, bonds, warrants,
  etc.

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Financial and Real Assets (continued)

• What are the three purposes of financial assets?
• 1. Consumption timing
• Shift consumption to the most optimal time period
  
• 2. Allocation of Risk
• Shift risk to those most willing to bear it (at
  the expectation of higher return)
• 3. Separation of Ownership and Management
• Separates functions and allows for large firms to
  be managed professionally (hopefully)

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Financial and Real Assets (continued)

• Major Classes of Financial Assets or Securities
• Equity
• Mostly common stock
• Also includes preferred stock, convertible
  bonds, warrants
• Derivatives on equity and equity indices
• Fixed Income
• Money Markets T-bills, Commercial Paper,
  CDs,Eurodollar deposits
• Capital Markets Notes, Bonds, Mortgage Backed,
  Junk bonds
• Derivatives on fixed income assets

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Question

• Suppose you discover a treasure chest of 10
  billion in cash.
• A. Is this a real or financial asset?
• B. Is society any richer for the discovery?
• C. Are you wealthier?
• D. Can you reconcile your answers to (b) and
  (c)? Is anyone worse off as a result?

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Answer

• A. Cash is a financial asset because it is a
  liability of the government.
• B. No. The cash does not directly add to the
  productive capacity of the economy.
• C. Yes.
• D. Society as a whole, since taxpayers as a
  whole will have to make up for the liability.

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D. Understand the 4 Types of Financial Markets
and Trends in those markets

• 1. Direct Search Markets
• Buyers/sellers seek each other out
• Example Classified ads
• 2. Brokered Markets
• Brokers offer search services
• Example Primary market, large block
• 3. Dealer Markets
• Dealers specialize in specific assets
• Example OTC
• 4. Auction Markets
• Traders converge on a single place
• Example NYSE

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Market Structure

• Auction Markets NYSE
• Tends to require a broker.
• A buyer and a seller can potentially trade
  directly with one another.
• The broker receives a commission.
• Dealer Markets NASDAQ
• The dealer carries an inventory of the securities
  he/she makes a market in.
• Buy at one price, sell at another price (higher).
  The markup is called the bid-ask spread.

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Trends

• Four major trends
• 1. Technology and delivery of service
• 2. Globalization
• 3. Securitization
• 4. Financial Engineering
• The Future?

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Trends (continued)

• 1. Technology and Delivery of Service
• Computer advancements reduce costs
• More complete and timely information available
  (and needed)
• Greater competition as domestic firms compete
  globally
• Trading hours widened to meet investor needs

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Trends (continued)

• 2. Globalization
• International and Global Markets continue
  developing to meet needs
• Managing foreign exchange becoming critical to
  returns
• Diversification becomes even more important
• Instruments and vehicles continue to develop to
  meet global needs
• Companies wish to raise capital worldwide.
• Information and analysis improves

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Trends (continued)

• 3. Securitization and Credit Enhancement
• Offers opportunities for investors and
  originators
• Requires changes in financial institutions and
  regulation
• Seeks improvement in information capabilities and
  requirements
• Encourages credit enhancement and its role in
  capital formation
• Bonds are backed by mortgage, student loan
  payments, credit card payments.

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Trends (continued)

• 4. Financial Engineering
• Allows repackaging of services of financial
  intermediaries to meet a specific need or
  objective
• Encourages bundling and unbundling of cash flows
  to meet investor needs for cash flow timing
• The creation and design of securities with
  custom-tailored characteristics, often regarding
  exposure to various source of risk.

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Trends (continued)

• The Future
• Globalization continues and offers more
  opportunities for all
• Securitization continues to develop, and
  increases dramatically in the Emerging Markets
  (less developed countries)
• Continued development of derivatives and exotics
  will meet investor needs
• Greater integration of investments corporate
  finance will lead to greater need for good
  financial analysis

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Problem 1-7

• Why would you expect securitization to take place
  only in highly developed capital markets and
  countries, and not yet in many emerging markets
  such as Russia, Iran, and Pakistan?

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Answer 1-7

• Securitization requires access to a large number
  of potential investors. To attract them the
  capital market needs
• A safe system of business laws and low
  probability of confiscatory taxation/regulation
• A well developed investment banking industry
• A well developed system of brokerage and
  financial transactions
• A well developed media, particularly financial
  reporting
• These functions are found in, and need, a well
  developed capital market.