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Summary - Investments
1.1 Real assets vs financial assets
What are real assets
Physical or tangible assets that have value, due to their substance and properties. The land, buildings, machines and knowledge that can be used to produce goods and services.
What are financial assets
Stocks and bonds, not contributing directly to the productive capacity of the economy. They are claims to the income generated by real assets. Real assets generate net income to the economy, financial assets simply define the allocation of income or wealth among investors
When we aggregate the financial assets of households and liabilities of the issuers over all balance sheets, these claims cancel out, leaving only real assets as the net wealth of the economy. National wealth consists of structures, equipment, inventories of goods and land.
Real assets create wealth. Financial assets represent claims to parts or all of that wealth. Financial assets determine how the ownership of real assets is distributed among investors.
1.2 Financial assets
What are fixed-income or debt securities?
They promise either a fixed stream of income or a stream of income determined by a specified formula.
Unless the borrower is declared bankrupt, the payments on these securities are either fixed or determined by formula. For this reason, the investment performance of debt securities typically is least closely tied to the financial condition of the issuer.
What is equity?
Common stock, or equity, in a firm represents an ownership share in the corporation. Equityholders are not promised any particular payment. They receive any dividends the firm may pay and have prorated ownership in the real assets of the firm. If the firm is successful, the value of equity will increase; if not, it will decrease. The performance of equity investments, therefore, is tied directly to the success of the firm and its real assets.
What are derivative securities?
Derivative securities such as options and futures contracts provide payoffs that are determined by the prices of other assets such as bond or stock prices. One use of derivatives, perhaps the primary use, is to hedge risks or transfer them to other parties.
Financial assets can be categorized as fixed income, equity, or derivative instruments. Top- down portfolio construction techniques start with the asset allocation decision—the allocation of funds across broad asset classes and then progress to more specific security-selection decisions.
What is the money market?
The money market refers to debt securities that are short term, highly marketable, and generally of very low risk
What is the capital market?
The fixed-income capital market includes long-term securities such as Treasury bonds. These bonds range from very safe in terms of default risk (for example, Treasury securities) to relatively risky (for example, high-yield or “junk” bonds).
1.3 Financial markets and the economy
What roles does financial markets have?
- The informational role of financial markets
- Consumption timing
- Allocation of risk
- Separation of ownership and management
What is the informational role of financial markets?
If a corporation seems to have good prospects for future profitability, investors will bid up its stock price. If, on the other hand, a company’s prospects seem poor, investors will bid down its stock price. The stock market encourages allocation of capital to those firms that appear at the time to have the best prospects.
What is consumption timing?
Shifting the purchasing power from high-earnings periods to low-earnings periods of life. Thus, financial markets allow individuals to separate decisions concerning current consumption from constraints that otherwise would be imposed by current earnings.
What is allocation of risk?
Financial markets and the diverse financial instruments traded in those markets allow investors with the greatest taste for risk to bear that risk, while other, less risk-tolerant individuals can, to a greater extent, stay on the sidelines.
This allocation of risk 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 best suit their preferences, each security can be sold for the best possible price.
What is separation of ownership and management?
The owners and managers of the firm are different parties. This gives the firm a stability that the owner-managed firm cannot achieve. For example, if some stockholders decide they no longer wish to hold shares in the firm, they can sell their shares to other investors, with no impact on the man- agement of the firm. Thus, financial assets and the ability to buy and sell those assets in the financial markets allow for easy separation of ownership and management.
What are agency problems and how are they mitigated?
They arise because managers, who are hired as agents of the shareholders, may pursue their own interests instead.
They can by mitigated trough;
First, compensation plans tie the income of managers to the success of the firm.
Second, while boards of directors are sometimes portrayed as defenders of top management, they can, and increasingly do, force out management teams that are underperforming.
Third, outsiders such as security analysts and large institutional investors such as pension funds monitor the firm closely and make the life of poor performers at the least uncomfortable.
Finally, bad performers are subject to the threat of takeover.
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Capital markets (assets with >1 year maturity)
3. Federal agency debt
4. International bonds
5. Municipal bonds
6. Corporate bonds (secured, unsecured debentures & senior/subordinated)
7. Mortgages & MBS
2. Certificate of deposit
3. Commercial paper (unsecured, like bank credit)
4. Bankers acceptance (postdated check)
6. Repurchase agreements
7. Federal funds
Thus the passive strategy of investing in a market index portfolio is efficient. For this reason, we sometimes call this result a mutual fund theorem.
When all investors avoid Delta stock, the demand is zero, and Delta’s price takes a free fall. As Delta stock gets progressively cheaper, it becomes ever more attractive and other stocks look relatively less attractive. Ultimately, Delta reaches a price where it is attractive enough to include in the optimal stock portfolio.
Such a price adjustment process guarantees that all stocks will be included in the optimal portfolio. It shows that all assets have to be included in the market portfolio. The only issue is the price at which investors will be willing to include a stock in their optimal risky portfolio.
All investors will choose to hold a portfolio of risky assets in proportions that duplicate representation of the assets in the market portfolio (M), which includes all traded assets.
Not only will the market portfolio be on the efficient frontier, but it also will be the tangency portfolio to the optimal capital allocation line (CAL) derived by each and every investor. As a result, the capital market line (CML), the line from the risk- free rate through the market portfolio, M, is also the best attainable capital alloca- tion line. All investors hold M as their optimal risky portfolio, differing only in the amount invested in it versus in the risk-free asset.
The risk premium on the market portfolio will be proportional to its risk and the degree of risk aversion of the representative investor.
The risk premium on individual assets will be proportional to the risk premium on the market portfolio, M, and the beta coefficient of the security relative to the mar- ket portfolio.
1. There are many investors, each with an endowment (wealth) that is small compared to the total endowment of all investors. Investors are price-takers, in that they act as though security prices are unaffected by their own trades. This is the usual perfect competition assumption of microeconomics.
2. All investors plan for one identical holding period. This behavior is myopic (short-sighted) in that it ignores everything that might happen after the end of the single-period horizon. Myopic behavior is, in general, suboptimal.
3. Investments are limited to a universe of publicly traded financial assets, such as stocks and bonds, and to risk-free borrowing or lending arrangements. This assumption rules out investment in nontraded assets such as education (human capital), private enterprises, and governmentally funded assets such as town halls and international airports. It is assumed also that investors may borrow or lend any amount at a fixed, risk-free rate.
4. Investors pay no taxes on returns and no transaction costs (commissions and service charges) on trades in securities. In reality, of course, we know that investors are in different tax brackets and that this may govern the type of assets in which they invest. For example, tax implications may differ depending on whether the income is from interest, dividends, or capital gains. Furthermore, actual trading is costly, and commissions and fees depend on the size of the trade and the good standing of the individual investor.
5. All investors are rational mean-variance optimizers, meaning that they all use the Markowitz portfolio selection model.
6. All investors analyze securities in the same way and share the same economic view of the world. The result is identical estimates of the probability distribution of future cash flows from investing in the available securities; that is, for any set of security prices, they all derive the same input list to feed into the Markowitz model. Given a set of security prices and the risk-free interest rate, all investors use the same expected returns and covariance matrix of security returns to generate the efficient frontier and the unique optimal risky portfolio. This assumption is often referred to as homogeneous expectations or beliefs.
First, it provides a benchmark rate of return for evaluating possible investments. Second, the model helps us to make an educated guess as to the expected return on assets that have not yet been traded in the marketplace.