ChapterOneTheInvestmentEnvironment“Real”versusfinancialassetsRisk-returntrade-offandefficientpricingoffinancialassetsFinancialcrisisof2008Illustratedconnectionsbetweenfinancialsystemand“real”sideoftheeconomyLessonsaboutsystemicriskChapterOverview1-2?2021McGraw-HillEducationRealAssetsUsedtoproducegoodsandservicesExamples:Land,buildings,machines,intellectualpropertyFinancialAssetsClaimstotheincomegeneratedbyrealassetsorclaimsonincomefromthegovernmentDonotdirectlycontributetotheproductivecapacityoftheeconomyExamples:Stocks,bondsRealAssetsvs.FinancialAssets1-3?2021McGraw-HillEducationFixed-income/DebtsecuritiesPromiseseitherafixedstreamofincomeorastreamofincomedeterminedbyaspecifiedformula(e.g.,corporatebond)EquityRepresentsownershipshareinafirm(e.g.,commonstock)DerivativesecuritiesPayoffdependsonthevalueofotherfinancialvariablessuchasstockprices,interestrates,orexchangeratesTypesofFinancialAssets?2021McGraw-HillEducationCurrency$2trillionofcurrencytradedeachdayinLondonaloneCommoditiesE.g.,corn,wheat,naturalgasOtherTypesofFinancialMarkets1-5?2021McGraw-HillEducationTheInformationalRoleConsumptionTimingAllocationofRiskSeparationofOwnershipandManagementAgencyproblemsFinancialMarketsandtheEconomy1-6?2021McGraw-HillEducationMechanismstomitigatepotentialagencyproblemsCompensationplanstietheincomeofmanagerstothesuccessofthefirmMonitoringfromtheboardofdirectorsMonitoringbylargeinvestorsandsecurityanalystsThreatoftakeoverforpoorperformersFinancialMarketsandtheEconomy

(Continued)1-7?2021McGraw-HillEducationCorporateGovernanceandCorporateEthicsAccountingscandalsEnron,RiteAid,HealthSouthAuditingscandalsArthurAndersen(Enron’sauditor)Sarbanes-OxleyAct(aka“SOX”)Passedin2002inresponsetoethicsscandalsFocusedoncorporategovernanceFinancialMarketsandtheEconomy

(Concluded)1-8?2021McGraw-HillEducationPortfolio:CollectionofinvestmentassetsAssetallocationChoiceamongbroadassetclasses(e.g.,stocks,bonds,realestate,etc.)SecurityselectionChoiceofsecuritieswithineachassetclassTheInvestmentProcess1-9?2021McGraw-HillEducationSecurityanalysisinvolvesthevaluationofparticularsecuritiesthatmightbeincludedintheportfolio“Top-down”approachAssetallocationfollowedbydeterminationofparticularsecuritiestobeheldineachassetclass“Bottom-up”approachInvestmentbasedonattractivelypricedsecuritieswithoutasmuchconcernforassetallocationTheInvestmentProcess

(Continued)1-10?2021McGraw-HillEducationFinancialmarketsarehighlycompetitiveTherewillalmostalwaysberiskassociatedwithinvestmentsRisk-returntrade-off-Higher-riskassetsarepricedtoofferhigherexpectedreturnsthanlower-riskassetsMarketsAreCompetitive1-11?2021McGraw-HillEducationYoushouldrarelyexpecttofindbargainsinthesecuritymarketsSeeCh.11foradiscussionofthetheoryandevidenceoftheefficientmarkethypothesisEfficientmarkethypothesisThepricesofsecuritiesfullyreflectavailableinformationIfthisweretrue,therewouldexistneitherunderpricednoroverpricedsecuritiesMarketsAreCompetitive

(Continued)1-12?2021McGraw-HillEducationPassivemanagementHighlydiversifiedportfolioNoattempttoimproveinvestmentperformancebyidentifyingmispricedsecuritiesActivemanagementFocusonimprovingperformancebyfindingmispricedsecuritiesorbytimingtheperformanceofbroadassetclassesMarketsAreCompetitive

(Concluded)1-13?2021McGraw-HillEducationFirmsNetdemandersofcapitalRaisecapitalnowtopayforinvestmentsinplantandequipmentHouseholdsTypicallynetsuppliersofcapitalPurchasesecuritiesissuedbyfirmsthatneedtoraisefundsGovernmentsCanfunctionasborrowersorlenders,dependingontherelationshipbetweentaxrevenueandgovernmentexpendituresThePlayers

(1of4)?2021McGraw-HillEducationFinancialintermediariesbringthesuppliersofcapital(investors)togetherwiththedemandersofcapital(primarilycorporationsandthefederalgovernment)ExamplesInvestmentcompaniesBanksInsurancecompaniesCreditunionsThePlayers

(2of4)1-15?2021McGraw-HillEducationInvestmentbankersspecializeinthesaleofnewsecuritiestothepublic,typicallybyunderwritingtheissueAdvisetheissuingcorporationonappropriateprice,interestrates,etc.NewissuesofsecuritiesareofferedtothepublicintheprimarymarketInvestorstradepreviouslyissuedsecuritiesamongstthemselvesinthesecondarymarketThePlayers

(3of4)1-16?2021McGraw-HillEducationVenturecapital(VC)referstomoneyinvestedtofinanceanew,notyetpubliclytradedfirmVCinvestorscommonlytakeanactiveroleinthemanagementofastart-upfirmPrivateequityreferstoinvestmentsincompanieswhosesharesarenotpubliclytradedinastockmarketThePlayers

(4of4)1-17?2021McGraw-HillEducationAntecedentsoftheCrisisFedresponsetohigh-techbubbleof2000-2002wasanaggressivereductionininterestratesT-billratesdroppeddrasticallybetween2001and2004Asaresult,thisrecessionwasmildandbrief,engenderinganewterm,the“GreatModeration”HistoricboominhousingmarketresultedfromseeminglystableeconomyanddramaticallyreducedinterestratesGreatertoleranceforrisk,suchassecuritizedmortgagesTheFinancialCrisisof20081-18?2021McGraw-HillEducationCumulativeReturnsofS&P500Index1-19?2021McGraw-HillEducationShort-termLIBORand

Treasury-billRatesandtheTEDSpread1-20?2021McGraw-HillEducationTheCase-ShillerIndexofU.S.HousingPrices1-21?2021McGraw-HillEducationChangesinHousingFinance

(1of2)OldWayMortgageloanscamefromalocallender,suchasaneighborhoodsavingsbankorcreditunionTypicalthriftinstitutionwouldhaveasitsmajorassetaportfoliooftheselong-termhomeloansThrift’smainliabilitywouldbeaccountsofitsdepositorsNewWaySecuritizationisthepoolingofloansforvariouspurposesintostandardizedsecuritiesbackedbythoseloans,whichcanthenbetradedlikeanyothersecurityFannieMaeandFreddieMacbecamethebehemothsofthemortgagemarket1-22?2021McGraw-HillEducationConformingmortgageswerepooledalmostentirelythroughFreddieMacandFannieMaeLow-riskrequiringdemonstrationofabilitytorepayloanNewproductresultingfromsecuritizationmodelSecuritizationbyprivatefirmsofnonconforming“subprime”loanswithhigherdefaultriskTrendtowardslow-andno-documentationloansLittleverificationofborrower’sabilitytorepayChangesinHousingFinance

(2of2)1-23?2021McGraw-HillEducationCashFlowsinaMortgagePass-ThroughSecurity1-24?2021McGraw-HillEducationCollateralizeddebtobligations(CDOs)Designedtoconcentratethecreditriskofabundleofloansononeclassofinvestors,leavingtheotherinvestorsinthepoolrelativelyprotectedfromthatriskPrioritizationofclaimsonloanrepaymentsbydividingthepoolintoseniorversusjuniortranchesSeniortranches–firstclaimonrepaymentsfromtheentirepoolJuniortranches–paidonlyaftertheseniortrancheshadreceivedtheircutRatingssignificantlyunderestimatedcreditriskMortgageDerivatives1-25?2021McGraw-HillEducationDefaultprobabilitieshadbeenestimatedusinghistoricaldatafrombothanunrepresentativeperiodoftimeandaverydifferentborrowerpoolCross-regionaldiversificationdidnotreduceriskasmuchasanticipatedAgencyproblemswithratingagenciesWhyWasCreditRiskUnderestimated?1-26?2021McGraw-HillEducationACDSisaninsurancecontractagainstthedefaultofoneofmoreborrowersPurchaseroftheswappaysanannualpremiumforprotectionfromcreditriskInvestorsboughtCDSstoinsuresafetyagainstsubprimeloansSomeswapissuersdidnothaveenoughcapitaltobacktheirCDSsE.g.,AIGalonesoldmorethan$400bofCDScontractsonsubprimemortgagesCreditDefaultSwap(CDS)1-27?2021McGraw-HillEducationSourcesoffragilityin2007Manyhighlyleveraged,largebankswererelyingprimarilyonshort-termloansforfundingWidespreadinvestorrelianceon“creditenhancement”viaCDOsSystemicriskistheriskofbreakdowninthefinancialsystem,particularlyduetospillovereffectsfromonemarketintoothersRise