Overview: Investments

Investment Process
Taxonomy of Financial Assets
Players and Vehicles
Market Microstructure
Recent Trends
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Investment process
Investment
Trade current benefit for future payoff
Bank deposit, stock purchase, education
Real vs Financial Assets
Real Assets: assets for generating goods
and services
Factory, farm, gas station, restaurant, etc.
Financial Assets: claims on real assets
Bank loans, stocks, bonds, options, etc.
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Taxonomy of Financial Assets
Why financial assets?
Consumption timing: to shift consumption
needs across time
Savings to buy a house
Allocation of risk: real asset too risky
Amazons stock for the brave and bond for the
less adventurous souls
Separation of ownership & management:
real asset too big
Its inefficient for GEs half-million stock owners
to participate day-to-day operations
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Taxonomy of Financial Assets
Money and Capital Markets
Debt Instruments Common Stock & Preferred Stock
Maturity < 1 Maturity 1
Money
Market
Capital Market
Derivative Securities
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Investment process
Five step approach
1. Setting investment objectives
2. Establishing investment policy
3. Selecting a portfolio strategy
4. Selecting the assets
5.Measuring and evaluating performance
Generating sufficient funds
Guarantee a payment at
some time in the future
Asset allocation decision:
stocks, bonds, real estate
Active strategy,
passive strategy,
structured strategy
Portfolio formation:
market timing or asset
picking
Benchmarking:
S&P500, risk adjustment
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Players and Vehicles
Who are they?
Financial Intermediaries
Commercial Bank
Taking deposit and making loans
Investment Bank
Selling securities to investors

Consumers/investors
Companies
Government
$
$
$
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Market Microstructure
Primary Market
New issue of securities to the public
Secondary Market
Trading places for existing securities
OTC Market
(Over-the-Counter)
Exchange (e.g. NYSE)
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Market Microstructure
Direct Search Market
Buyers/sellers search each other directly
Brokered Market
Brokers search buyers/sellers for sellers/buyers
Moderate trading activity, e.g., real estate, IPO
Dealer Market
Dealers buy/sell for their own accounts
Active trading, e.g., OTC, NASDAQ
Auction Market
Players buy/sell in one centralized place
Active trading, e.g., NYSE
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Recent Trends
The milestones of modern finance
Return-Risk Tradeoff
Markowitz (1952; Nobel Prize in 1990)
Security selection from a view of overall portfolio Risk
preference (or tolerance)
Equity Valuation and Asset Allocation
Tobins q (1958; Nobel Prize in 1981)
Mutual Funds
Performance Evaluation
CAPM, Sharpe-Linter (1964; Nobel Prize in 1990).
Mutual fund performance
Derivative Security Valuation
Black and Scholes, Merton (1973, Nobel Prize in 1997).
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Recent Trends
Globalization
An Integration of worldwide economic environment
and national capital markets
Major Activities
International diversification
US market down, Asia markets up, average out
Cross border trading
Local stocks, ADRs, mutual funds, WEBS (World Equity
Benchmark Shares) now part of iShares, etc.
Foreign exchange risk
Exchange rate fluctuation affects foreign stock returns
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Recent Trends
Securitization
Pooling loans/mortgages/debts to create
standardized securities
Efficiency gain (in theory )
Improved information flow based on market
activity increases liquidity
Service and financing separation encourages
specialization and results better risk allocation
Reduced cost for originator
Enhanced yield for investor
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Recent Trends
Financial Engineering
The process of creating customized
securities tailored to investors need
Bundling
Combining cash flows together
Straight bond+call option=convertible bond
Unbundling
Slicing and dicing cash flow of an asset to
several classes
CMO to mortgage pass-through tranches and
treasury strips.
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Recent Debacles
Subprime mortgage meltdown

Credit and liquidity crunch

What went wrong?
Video (from Britain)
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Wrap-up
What is investment?
What are the differences between
financial and real assets?
Whats hot?
Whats not?