Chapter 1 The Investment Environment

have better access to available capital so they can invest in productive assets

Borrowers

virtually all real assets involve some

risk

what are the general mechanisms to mitigate agency problems

-Tie manager's income to the success of the firm (major part of total compensation of top execs is often in the form of stock options which means managers are incentivized to maximize the value of the shares) -Monitoring from the board of directors -Monitoring by large investors and security analysts -Takeover threat (bad performers are subject to this - if BOD is lax in monitoring management, unhappy shareholders in principle can elect a different board by launching a proxy contents)

why do we have a stock market

-US has the largest stock market in the world -access to capital, gives valuations, allows anyone to invest -switch purchasing power (grows money), deferring compensation

how to invest in a bear market bottom line

-diversify your investments by investing in low-fee index funds according to your risk tolerances (if you have more time you can invest in riskier things) -invest regularly, dont attempt to time market swings, and remember that you are in it for the long run -over the long-run your investments will likely give you a good returns over inflation, but remember that the intervening years will be volatile, especilaly if you have a heavy concentration in stock funds

2000-2002: filled with endless scandals, corporate governance crisis what about the auditors that are supposed to be the --- of the firm?

-incentives were skewed -changes in business practice had made the consulting business more lucrative than the auditing function

what are the biggest mistakes investors typically make? ****FILL THE REST IN*****

-not understanding the risk/reward tradeoff of different asset classes -following the advice of the prophets in an attempt to make profits -trying to time the market -being overconfident -

who are the three major players in the financial markets

1. firms are the demanders of capital. they raise capital now to pay for investments. income generated by real assets provides returns to investors who buy securities issued by the firm 2. households are the net suppliers of capital. they purchase the securities issued by firms that need to raise the funds 3. governments can be either borrowers or lenders

what are the 3 broad types of financial assets

1. fixed income 2. equity 3. derivatives

housing default rates began to surge in --- as did losses on mortgage-backed securities

2007

New issues of securities are sold in the ________ market(s).

A. primary

--- ---arise when managers start pursuing their own interests instead of maximizing firm's value

Agency Problems

for example enron's auditor ---- earned more money consulting for Enron than by auditing it, given the company's incentive to protect its consulting profits, we should not be surprised that it and other auditors were overly lenient in their auditing work

Arthur Andersen

Financial assets permit all of the following except: A. consumption timing B. allocation of risk C. separation of ownership and control D. elimination of risk

D

created the Office of Credit Ratings within the SEC to oversee the credit rating agencies

Dodd-Frank Reform Act of 2010

proposes several mechanisms to mitigate systematic risk

Dodd-Frank Reform Act of 2010

calls for stricter rules for bank capital, liquidity, and risk management practices , especially as banks become larger and their potential failure would be more threatening to other institutions

Dodd-Frank Reform Act of 2010 -with more capital supporting banks, the potential for one insolvency to trigger another could be contained

mandates increased transparency, especially in derivatives markets

Dodd-Frank Reform Act of 2010 ex: standardize CDS contracts so they can trade in centralized exchanges where prices can be determined in a deep market and gains or losses can be settled on a daily basis

help companies, governments and individuals allocate resources

Financial markets

STUDY 1 Are firms rewarded for good corporate governance structures?

Firms with the greatest shareholder rights outperformed firms with the fewest shareholder rights by a risk-adjusted 8.5% per year (0.29 - - 0.42 = 0.71 x 12 = 8.52%) democracy firms had 0.29 return dictatorship firms had a -0.42 return

Which of the following are mechanisms that have evolved to mitigate potential agency problems? I) Using the firm's stock options for compensation II) Hiring bickering family members as corporate spies III) Boards of directors forcing out underperforming management IV) Security analysts monitoring the firm closely V) Takeover threats

I, III, IV, V

in 2002, in response to the spate of ethics scandals, Congress passed ----- to tighten the rules of corporate governance

Sarbanes-Oxley Act

the act requires corporations to have more independent directors, that is more directors who are not themselves a manager. Also requires each CFO to personally vouch for the company's accounting statements, created an oversight board to oversee the auditing of public companies and prohibits auditors from providing various other services to clients

Sarbanes-Oxley act

---- ---- helps us value securities & determine which assets should be included in the portfolio

Security analysis

STUDY 1 Are shareholder rights related to future firm performance?

Shareholder rights are positively related to future stock returns and negatively related to wasteful capital expenditures and acquisitions.

what are examples of money market securities

US treasury bills, bank certificates of depoist (CDS)

are the following assets real or financial a. patents b. lease obligations c. customer goodwill d. a college education e. a $5 dollar bill

a. real b. financial c. real d. real e. financial

enron, rite aid, and healthsouth are all examples of...

accounting scandals -presented a misleading picture of its financial status -manipulated and misstated their accounts to the tune of billions of dollars

attempt to improve the performance either by identifying misspriced securities or by timing the performance of the broad asset classes

active management ex: increasing commitment to stocks when one is bullish on the stock market

by pooling the resources of many small investors, they are able to lend considerable sums to large borrowers. and by lending to many borrowers, ---- achieve significant diversification, so they can accept loans that individually would be too risky.

advantages of intermediaries

---- -- ---- also benefits the firms that need to raise capital to finance their investments. when investors are able to select security types with the risk-return characteristics that suit their preferences, each security can be sold for the best possible price. this facilitates the process of building the economy's real assets

allocation of risk

investors can select securities that are consistent with their tastes for risk.

allocation of risk -example buying a bond (less risk) versus buying stock from Tesla (more risky)

sacrifice something of value now expecting to benefit from the sacrifice later

an investment

includes the decision of how much one's portfolio to place in a safe assets like bank accounts or money market securities versus in risky assets

asset allocation

the choice among these broad asset classes

asset allocation decision

investors make two types of decisions in creating their portfolios:

asset allocation decision and security selection decision

do capital markets actually channel resources to the most efficient use?

at times doesnt work. companies or industries can be hot for a period of time (example is the dot-com bubble) and attract a large inflow of investor capital then fail no one knows with certainty what will fail/be successful. stock market encourages allocation of capital to firms that appear at the time to have the best propsects.

Allocate funds between the risky portfolio and risk-free asset

capital allocation

Take deposits and make loans

commercial banking

Savers have the ability to invest in financial assets so that they can defer ---

consumption -they earn a return for compensating them for doing so

2000-2006 Sharp increase in housing prices caused many investors to believe that...

continually rising home prices would bail out poorly performing loans -by 2004 the ability of refinancing to save a loan diminished

the investment performance of --- --- typically is least closely tied to the financial condition of the issuer

debt securities

on the governance index, G<5 was a --- portfolio and G>15 was a ---- portfolio

democracy, dictatorship lower is better

--- ---- such as options and future contracts provide payoffs that are determined by the prices of other assets such as bond or stock prices

derivative securities

means that many assets are held in the portfolio so that the exposure to any particular asset is limited

diversification

the performance of --- investments is tied directly to the success of the firm and its real assets

equity

----- ---- such as stocks and bonds

financial assets

claims to the income generated by real assets. ex if we cant own our own auto plant we can still buy shares in ford or toyota and thereby share in the income created by the production of cars

financial assets

do not contribute directly to the productive capacity of the economy

financial assets

these assets are the means by which individuals in well-developed economies hold their claims on real assets

financial assets

corporations and governments do not sell all of even most of their securities directly to individuals. 1/2 of all stock is held by large --- ---- such as pension funds, mutual funds, insurance companies, and banks

financial institutions/intermediaries

Investment Companies Banks Insurance companies Credit unions

financial intermediaries that pool and invest funds

evolved to bring the suppliers of capital (investors) together with the demanders of capital (companies and the federal gov)

financial intermediaries, solves the problem of matching lenders with borrowers

promise either a fixed stream of income or a stream of income determined by a specific formula

fixed income

Higher-risk assets are priced to offer ------- than lower-risk assets

higher expected returns

if you want higher expected returns you will have to pay a price in terms of accepting...

higher investment risk

the combination of dramatically reduced interest rates and an apparently stable economy fed a boom in the...

housing market

what happened in 2004 and 2006

interest rates were higher and started to put payment pressure on homeowners who had taken out adjustable rate mortgages also housing prices peaked in 2006 so homeowners ability to refinance a loan using built-up equity in the house declined

corporations do not market their own securities to the public instead they hire agents called --- --- to represent them to the investing public

investment bankers

-firms raise much of their capital by selling securities like stocks and bonds to the public -but they do not do so frequently so they hire --- --- that specialize in this and can offer their services at a cost below that of maintaining a in-house security issuance division -in this role they --- new securities that are issued and advise the issuing corporation on the pricing

investment bankers, underwrite

fixed income capital market includes ---- ---- such as treasury bonds as well as bonds issued by federal agencies, state and local municipalities and corporations

long-term securities -opposite of the money market

we conclude that there should be a risk-return tradeoff in the securities market, where higher-risk assets priced to offer higher expected returns than..

lower-risk assets

owners can sell their shares in a firm with no impact on the ---- thus financial assets and the ability to buy and sell those assets in the financial markets allow for easy separation of

management...ownership and management

the --- --- refers to debt securities that are short term, highly marketable, and generally of very low risk

money market

capital markets allow the risk that is inherent to all investments to be borne by the investors....

most willing to bear that risk

how can you shift your purchasing power from high-earning periods of life to lower-earning periods?

one way is to store wealth in financial assets. in high-earnings you can invest savings and in low earnings you can sell the assets to provide funds for your compensation needs. by doing so you can shift your compensation over the course of your life, allocating consumption --->Consumption timing

calls for holding highly diversified portfolios without spending effort or other resources attempting to improve investment performance through security analysis

passive management

investment companies

pool and manage the money of many investors

an investor's ---- is simply the collection of investment assets

portfolio

risk and expected return are --- correlated

positively

handles selling the newly issued securities to the public in the --- --- where new issues of securities are offered to the public

primary market

the land, buildings, machines and knowledge that can be used to produce goods and services

real assets

while ---- generate net income to the economy, --- ---- simply define the allocation of income or wealth among investors

real assets, financial assets

Financial markets also provide us with information about the returns that are required for various levels of ---

risk

later investors can trade previously issued securities among themselves in the so-called ----- -----

secondary market

involves the valuation of particular securities that might be included in the portfolio

security analysis

choice of which particular securities to hold within each asset class

security selection

structure with separation of ownership and management --> stockholders elect a BOD who hires and supervises the management of the firm --> gives the firm a --- that the owner-managed firm cant achieve

stability

money market breaks down-->credit market freezes up which has ripple effects to other markets --> federal bailout to ....financial system

stabilize -ex lent 85B to AIG reasoning that its failure would have been highly destabilizing to the banking industry which was holding massive amounts of its credit guarantees in the form of CDS contacts -treasury spent 700B to purchase toxic mortgage-based securities

a potential breakdown of the financial system when problems in one market spill over and disrupt others

systematic risk

potential breakdown of the financial system in which problems in one market spill over and disrupt others.

systematic risk

•One default may set off a chain of further defaults •Waves of selling may occur in a downward spiral as asset prices drop •Potential contagion from institution to institution, and from market to market

systematic risk

stock prices reflect investors' collective assessment of a firm's current performance and future prospects. when the market is optimistic about the firm, the share price rises. in this manner, stock prices play a role in the allocation of capital in market economies, directing capital to the firms and applications with the greatest perceived potential.

the informational role of financial markets --> capital flows to companies with the best prospects

the successes or failures of the financial assets that we choose to purchase ultimately depend on the performance of..

the underlying real assets

the material wealth of a society is ultimately determined by the productive capacity of its economy (and the net income of the economy), that is the good and services the members can create

this capacity is a function of the real assets of the economy

In fully efficient markets when prices quickly adjust to all relevant information, there should be neither .... or .... securities

underpriced nor overpriced securities because the security price would equal the market consensus estimate of the value of the security

Banks mismatched maturity/liquidity of their assets and liabilities:

•Liabilities were short term and liquid •Assets were long term and illiquid •Constant need to refinance the asset portfolio banks were also highly levered giving them almost no margin of safety