Chapter 1

The Investment Environment

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Investments
• An investment is the current commitment of money or
other resources in the expectation of reaping future
benefits. You sacrifice something of value now,
expecting to benefit from that sacrifice later.
• Having studied this course you are expected learn the
concepts and tools to become an informed practitioner of
investments.
• Our focus will be on investments in financial assets
(securities) such as stocks, bonds, or options and futures
contracts as opposed to real assets.

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Real Assets Vs Financial Assets

• Real Assets: Assets used to produce goods and
services. Examples include land, buildings,
machines, knowledge used to produce goods and
services. Real assets determine the productive
capacity and net income of the economy.
• Financial Assets: Claims on real assets such as
stocks and bonds. They define the allocation of
income or wealth among investors.
Financial assets of the holders (e.g., households) represent financial
liabilities of the issuers (e.g., businesses) and hence cancel out each
other at the aggregate national level; leaving only real assets as the
net wealth of the economy.

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Major categories of financial assets

• Fixed income or debt securities – Payments fixed or
determined by a formula. Some are short term, highly
marketable, usually low credit risk (money market debt);
some other are long term bonds, can be safe or risky
(capital market debt).
• Common stock or equity – Represent ownership in a
corporation. Payments are not fixed, but depend on the
success of the firm.
• Derivative securities - Value derives from prices of other
securities, such as stocks and bonds. Used to transfer
risk.

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Financial Markets and the Economy

• Information Role: Capital flows to companies with best
prospects for future profitability.
• Consumption Timing: Use securities to store wealth and
transfer consumption to the future.
• Allocation of Risk: Investors can select securities
consistent with their tastes for risk.
• Separation of Ownership and Management: With stability
comes agency problems.

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Financial Markets and the

Economy (Ctd.)
• Agency Problem: Managers may not work in the best
interest of the shareholders.
• Mechanism that may mitigate agency problem:
– Tying managerial compensation to the success of the
firm (stock options, restricted stocks).
– The board of directors and major shareholders may
force out underperforming management team.
– The threats of takeover: The proxy contest and the
threat of takeover from other firms.

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The Investment Process

• Capital allocation – allocating investible capital
between the risky portfolio and risk-free asset.
Having decided an appropriate capital allocation, investors confront
two types of decisions as they assemble a portfolio of risky assets (a
collection of investment assets). Once established, it is updated
(rebalanced) as and when needed.
• Asset allocation - Choice among broad asset classes
(stocks, bonds, real estate, commodities and so on).
• Security selection - Choice of which securities to hold
within asset class. Security analysis is conducted to
value securities and determine investment
attractiveness.
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Markets are Competitive

• The environment where we make investment (portfolio)

decisions is highly competitive; no-free-lunch. The
competition in financial markets has two implications
(means two things).
– Risk-Return Trade-Off: Trade-off between expected return and
risk (nondiversifiable) of investment; the theme of modern
portfolio theory.
– Efficient Markets: Financial markets process all available value-
relevant information rapidly and unbiasedly and hence one can
rarely expect to find bargains.

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Markets are Competitive (Ctd.) –

Management of Portfolio
• Active Management
• Finding mispriced securities
• Timing the market
• Passive Management
• No attempt to find undervalued securities
• No attempt to time the market
• Holding a highly diversified portfolio
Note that, without ongoing security analysis, prices will eventually depart from
‘correct’ values, creating new incentives for experts to move in. Hence, even in
environment as competitive as the financial markets, we may observe only near-
efficiency, and profit opportunities may exist for especially diligent and creative
investors. In addition, investors’ desire to maintain a particular risk-return tradeoff
for their portfolio will lead them to trade (actively manage their portfolios).

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The Players
• Business Firms – typically net borrowers.
• Households – typically net savers.
• Governments – can be both borrowers and savers.
Firms and governments do not sell all or even most of their securities
directly to individuals/households.
• Financial Intermediaries: Pool and invest funds; bring
suppliers and demanders of capital together. Examples
include, investment companies (mutual funds, hedge
funds), commercial banks, insurance companies,
pension funds.
Unlike other businesses, both their assets and liabilities are
overwhelmingly financial.

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The Players (Ctd.)

• Investment/merchant bankers: Mainly act as agents of
security issuing companies (underwriting) in the primary
market. They also provide advisory services (M&A
consulting), wealth management for individuals or
institutions, brokerage services.
• Private equity investments by venture capital funds and
angel investors (wealthy individuals): Make equity
investment (take ownership stake and control) in
privately held startups or younger firms to sell the
investment for a profit in future.

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