Chapter One

The Investment Envirenment

The presentation has been amended/updated by Dr.

Dr. Mounira Ben Arab

1.1 REAL ASSETS VERSUS

FINANCIAL ASSETS
Real
RealAssets
Assets

the
theland,
land,buildings,
buildings,knowledge,
knowledge,and
andmachines
machines
Together,
Together,physical
physicaland
andhuman
humanassets
assetsgenerate
generatethe
theentire
entirespectrum
spectrum
of
ofoutput
outputproduced
producedand
andconsumed
consumedby
bythe
thesociety
society

Financial
FinancialAssets
Assets

Stocks
Stocksor
orbonds
bonds
are
areno
nomore
morethan
thansheets
sheetsof
ofpaper
paperor
ormore
morelikely,
likely,computer
computerentries,
entries,
and
anddo
donot
notdirectly
directlycontribute
contributetotothe
theproductive
productivecapacity
capacityof
ofthe
the
economy.
economy.Instead,
Instead,financial
financialassets
assetscontribute
contributetotothe
theproductive
productive
capacity
capacityof
ofthe
theeconomy
economyindirectly
indirectly

1-2

 Real
RealAssets
Assetsand
andfinancial
financialAssets
Assetsare
aredistinguished
distinguished
-- operationally
operationallyby
bythe
thebalance
balancesheets
sheetsof
ofindividuals
individualsand
andfirms
firmsininthe
the
economy:
economy: Whereas
Whereasreal
realassets
assetsappear
appearonly
onlyon
onthe
theasset
assetside
sideof
ofthe
the
balance
balancesheet,
sheet,financial
financialassets
assetsalways
alwaysappear
appearon
onboth
bothsides
sidesof
of
balance
balancesheets.
sheets.
-- financial
financialassets
assetsare
arecreated
createdand
anddestroyed
destroyedininthe
theordinary
ordinarycourse
course
of
ofdoing
doingbusiness.
business.For
Forexample,
example,when
whenaaloan
loanisispaid
paidoff,
off,both
boththe
the
creditors
creditorsclaim
claim(a(afinancial
financialasset)
asset)and
andthe
thedebtors
debtorsobligation
obligation(a(a
financial
financialliability)
liability)cease
ceasetotoexist.
exist.In
Incontrast,
contrast,real
realassets
assetsare
are
destroyed
destroyedonly
onlyby
byaccident
accidentor
orby
bywearing
wearingout
outover
overtime.
time.

1-3

1.2 FINANCIAL MARKETS AND

THE ECONOMY
Real
Realassets
assetsdetermine
determinethe
thewealth
wealthof
ofan
aneconomy,
economy,
whereas
whereasfinancial
financialassets
assetsmerely
merelyrepresent
representclaims
claimson
on
real
realassets.
assets.
Financial
Financialassets
assetsallow
allowus
usto
tomake
makethe
themost
mostof
ofthe
the
economys
economysreal
realassets.
assets.
Consumption
ConsumptionTiming
Timing::How
Howcan
canyou
youshift
shiftyour
yourpurchasing
purchasing

power
powerfrom
fromhigh-earnings
high-earningsperiods
periodstotolow-earnings
low-earningsperiods
periodsof
oflife?
life?
In
Inhigh-earnings
high-earningsperiods,
periods,you
youcan
caninvest
investyour
yoursavings
savingsininfinancial
financial
assets
assetssuch
suchas
asstocks
stocksand
andbonds.
bonds.
In
Inlow-earnings
low-earningsperiods,
periods,you
youcan
cansell
sellthese
theseassets
assetstotoprovide
provide
funds
fundsfor
foryour
yourconsumption
consumptionneeds.
needs.
1-4

 Allocation
Allocationof
ofRisk
Risk
Financial
Financialmarkets
marketsand
andthe
thediverse
diversefinancial
financial
instruments
instrumentstraded
tradedin
inthose
thosemarkets
marketsallow
allowinvestors
investors
with
withthe
thegreatest
greatesttaste
tastefor
forrisk
riskto
tobear
bearthat
thatrisk.
risk.

-- the
themore
moreoptimistic,
optimistic,or
orrisk-tolerant,
risk-tolerant,investors
investorsbuy
buyshares
sharesof
ofstock
stock
-- the
themore
moreconservative
conservativeindividuals
individualscan
canbuy
buybonds,
bonds,which
whichpromise
promise
totoprovide
provideaafixed
fixedpayment.
payment.

Separation
Separationof
ofOwnership
Ownershipand
andManagement
Management::

Many
Manybusinesses
businessesare
areowned
ownedand
andmanaged
managedby
bythe
thesame
sameindividual.
individual.
with
withglobal
globalmarkets
marketsand
andlarge-scale
large-scaleproduction,
production,the
thesize
sizeand
and
capital
capitalrequirements
requirementsof
offirms
firmshave
haveskyrocketed.
skyrocketed.General
GeneralElectric
Electric
actually
actuallyhas
hasabout
aboutone-half
one-halfmillion
millionstockholders,.
stockholders,.Such
Suchaalarge
large
group
groupof
ofindividuals
individualsobviously
obviouslycannot
cannotactively
activelyparticipate
participateininthe
the
day-to-day
day-to-daymanagement
managementof
ofthe
thefirm.
firm.Instead,
Instead,they
theyelect
electaaboard
boardof
of
directors,
directors,which
whichininturn
turnhires
hiresand
andsupervises
supervisesthe
themanagement
managementof
of
the
thefirm.
firm.
1-5

1.3 CLIENTS OF THE FINANCIAL

SYSTEM
The
TheHousehold
HouseholdSector:
Sector:are
arepotentially
potentiallyinterested
interestedin
inaa
wide
widearray
arrayof
ofassets.
assets.Assets
Assetsthat
thatare
areattractive
attractivecan
canvary
vary
considerably
considerablydepending
dependingon
onthe
thehouseholds
householdseconomic
economic
situation.
situation.

--Taxes
Taxeslead
leadtotovarying
varyingasset
assetdemands
demandsbecause
becausepeople
peopleinindifferent
differenttax
tax
brackets
bracketstransform
transformbefore-tax
before-taxincome
incometotoafter-tax
after-taxincome
incomeatat
different
differentrates
rates
--Risk
Riskconsiderations
considerationsalso
alsocreate
createdemand
demandfor
foraadiverse
diverseset
setof
of
investment
investmentalternatives
alternatives

The
TheBusiness
BusinessSector:
Sector:businesses
businessestypically
typicallyneed
needto
toraise
raise
money
moneyto
tofinance
financetheir
theirinvestments
investmentsin
inreal
realassets
assets
1-6

 The
TheGovernment
GovernmentSector
Sector
-- Like
Likebusinesses,
businesses,governments
governmentsoften
oftenneed
needto
tofinance
finance
their
theirexpenditures
expendituresby
byborrowing.
borrowing.
-- Unlike
Unlikebusinesses,
businesses,governments
governmentscannot
cannotsell
sellequity
equity
shares;
shares;they
theyare
arerestricted
restrictedto
toborrowing
borrowingto
toraise
raisefunds
funds
when
whentax
taxrevenues
revenuesare
arenot
notsufficient
sufficientto
tocover
cover
expenditures.
expenditures.

1-7

1.4 THE ENVIRONMENT RESPONDS

TO CLIENTELE DEMANDS
Financial
FinancialIntermediation
Intermediation
Evolve
Evolveto
tobring
bringthe
thetwo
twosectors
sectorstogether
together(demanders
(demanders
and
andsuppliers)
suppliers)
For
Forexample,
example,aabank
bankraises
raisesfunds
fundsby
byborrowing
borrowingand
and
lending
lendingthat
thatmoney
moneyto
toother
otherborrowers.
borrowers.In
Inthis
thisway,
way,
lenders
lendersand
andborrowers
borrowersdo
donot
notneed
needto
tocontact
contacteach
each
other
otherdirectly.
directly.Instead,
Instead,

1-8

 All
Allthe
theintermediaries
intermediaries,,banks,
banks,insurance,
insurance,investment
investment
companies,
companies,credit
creditunions
unions,
, offer
offersimilar
similaradvantages
advantages
-- First,
First,by
bypooling
poolingthe
theresources
resourcesof
ofmany
manysmall
small
investors,
investors,they
theyare
areable
ableto
tolend
lendconsiderable
considerablesums
sumsto
to
large
largeborrowers.
borrowers.
-- Second,
Second,by
bylending
lendingto
tomany
manyborrowers,
borrowers,intermediaries
intermediaries
achieve
achievesignificant
significantdiversification,
diversification,
-- Third,
Third,intermediaries
intermediariesbuild
buildexpertise
expertisethrough
throughthe
the
volume
volumeof
ofbusiness
businessthey
theydo.
do.
-- Economy
Economyof
ofscale
scalerelated
relatedto
tothe
theexpense
expenseof
ofcollecting
collecting
information
information
Investment
Investmentcompanies
companiesand
andmutual
mutualfunds
fundsarise
ariseout
outthe
thesmallness
smallness
problem.
problem.

1-9

 Investment
InvestmentBanking
Banking
-- Because
Becausethey
theyare
areconstantly
constantlyin
inthe
themarket,
market,Investment
Investment
bankers
bankerscan
canprovide
providemore
morethan
thanjust
justexpertise
expertiseto
to
security
securityissuers
issuers
-- Exemple,
Exemple,Merrill
MerrillLynch,
Lynch,Salomon
SalomonSmith
SmithBarney,
Barney,or
or
Goldman,
Goldman,Sachs
Sachsadvise
advisethe
theissuing
issuingfirm
firmon
onthe
theprices
prices
ititcan
cancharge
chargefor
forthe
thesecurities
securitiesissued,
issued,market
market
conditions,
conditions,appropriate
appropriateinterest
interestrates,
rates,and
andso
soforth.
forth.
Financial
FinancialInnovation
Innovationand
andDerivatives
Derivatives
-- The
The mortgage-backed
mortgage-backedsecurities
securities such
suchas
as::
mortgage
mortgagepass-through
pass-throughsecurities
securities(first
(firstintroduced
introducedby
bythe
the
Government
GovernmentNational
NationalMortgage
MortgageAssociation
Association
the
thecollateralized
collateralizedmortgage
mortgageobligation,
obligation,or
orCMO.
CMO.
-- Derivatives
Derivativeshave
havebecome
becomean
anintegral
integralpart
partof
ofthe
theinvestment
investment
environment.
environment.
1-10

1.5 MARKETS AND MARKET

STRUCTURE
Direct
Directsearch
searchmarkets,
markets,
Brokered
Brokeredmarkets,
markets,
Dealer
Dealermarkets
markets
Auction
Auctionmarkets.
markets.

1-11

1.6 ONGOING TRENDS

Globalization,
Globalization,
Securitization,
Securitization,
Financial
FinancialEngineering
Engineering
Computer
ComputerNetworks.
Networks.

1-12

Globalization of Financial Markets and

Institutions
Reasons
Reasonsof
ofGrowth
Growthin
inForeign
ForeignFinancial
FinancialMarket
Market
1.The
1.Thepool
poolof
ofsavings
savingsfrom
fromforeign
foreigninvestors
investors(i.e
(i.efrom
fromEU)
EU)isisincreasing
increasing
and
andinvestors
investorslook
lookto
todiversify
diversifyglobally
globallynow
nowmore
morethan
thanever
everbefore
before
2.Information
2.Informationon
onforeign
foreignmarkets
marketsand
andinvestments
investmentsisisbecoming
becomingreadily
readily
accessible
accessibleand
andderegulation
deregulationacross
acrossthe
theglobe
globeisisallowing
allowingeven
evengreater
greater
access
access
3.International
3.Internationalmutual
mutualfunds
fundsallow
allowdiversified
diversifiedforeign
foreigninvestment
investmentwith
with
low
lowtransactions
transactionscosts
costs
4.Euro
4.Euroisisalso
alsohaving
havingaanotable
notableimpact
impacton
onthe
theglobal
globalfinancial
financialsytem.
sytem.
5.Global
5.Globalcapital
capitalflows
flowsare
arelarger
largerthan
thanever
evermainly
mainlydue
duetotoderegulation
deregulationinin
many
manyforeign
foreigncountries.
countries.

McGraw-Hill/Irwin

1-13

Globalization of Financial Markets and

Institutions
While US financial
markets dominate
world markets, the
growth of US financial
markets depends more
and more on the
growth and
development of other
economies.
The success of other
economies depends to
a significant extent on
their financial market
development

Globalization of Financial Markets and

Institutions
The
The Largest
Largest Banks
Banks in
in the
theWorld
World

Competition
Competitionisisalso
alsoincreased
increaseddue
dueto
toglobal
globalmarkets.
markets.

McGraw-Hill/Irwin

1-15

Secondary Mortgage Market

Mortgage Sales

Mortgage
Mortgagesellers:
sellers:money
moneycenter
centerbanks,
banks,smaller
smallerbanks,
banks,
foreign
foreignbanks,
banks,investment
investmentbanks
banks
Mortgage
Mortgagesales
salesallow
allowFIs
FIsto
tomanage
managecredit
creditrisk,
risk,achieve
achieve
better
betterasset
assetdiversification,
diversification,and
andimprove
improvetheir
theirliquidity
liquidityand
and
interest
interestrate
raterisk
riskpositions
positions
FIs
FIsare
areencouraged
encouragedto
tosell
sellloans
loansfor
foreconomic
economicand
and
regulatory
regulatoryreasons
reasons

sold
soldmortgages
mortgagescan
canstill
stillgenerate
generatefee
feeincome
incomefor
forthe
thebank
bank
sold
soldmortgages
mortgagesreduce
reducethe
thecost
costof
ofreserve
reserveand
andcapital
capitalrequirements
requirements

Mortgage
Mortgagebuyers:
buyers:foreign
foreignand
anddomestic
domesticbanks,
banks,insurance
insurance
companies,
companies,pension
pensionfunds,
funds,closed-end
closed-endbank
bankloan
loanmutual
mutual
funds,
funds,and
andnonfinancial
nonfinancialcorporations
corporations
1-16

Secondary Mortgage Market

Mortgage Backed Securities
There
Thereare
are33different
differentmajor
majortypes
typesof
ofmortgage
mortgagebacked
backedsecurities.
securities.
Pass
Passthrough
throughand
andCMOs
CMOsare
aresecuritized
securitizedmortgages
mortgages
Three
Threeagencies
agenciesare
aredirectly
directlyinvolved
involvedininthe
thecreation
creationof
ofpass-through
pass-through
securities
securities

Fanniemae
Fanniemaeand
andFreddiemac
Freddiemacisisaastockholder
stockholderowned
ownedcorporation
corporationwith
withaa
line
lineof
ofcredit
creditfrom
fromthe
theUS
USTreasury.
Treasury.Its
Itsbonds
bondsare
arerated
ratedAAA.
AAA.
Pass-through
Pass-throughsecurities
securitiespass
passthrough
throughpromised
promisedprincipal
principaland
andinterest
interest
payments
paymentstotoinvestors
investors
Private
Privatemortgage
mortgagepass-through
pass-throughissuers
issuerscreate
createpass-throughs
pass-throughsfrom
from
nonconforming
nonconformingmortgages
mortgages

1-17

Mortgage Backed Securities

Collateralized
Collateralizedmortgage
mortgageobligations
obligations(CMOs)
(CMOs)are
are
multiclass
multiclasspass-throughs
pass-throughswith
withmultiple
multiplebond
bondholder
holderclasses
classes
or
ortranches
tranches
Unlike
Unlikeaapass
passthrough
througheach
eachbond
bondholder
holderclass
classhas
hasaadifferent
different
guaranteed
guaranteedcoupon
coupon
mortgage
mortgageprepayments
prepaymentsretire
retireonly
onlyone
onetranche
trancheatataatime,
time,so
soall
all
other
othertrances
trancesare
aresequentially
sequentiallyprepayment
prepaymentprotected
protected

Mortgage
Mortgagebacked
backedbonds
bonds(MBBs)
(MBBs)

MBBs
MBBsallow
allowFIs
FIstotoraise
raiselong-term
long-termlow-cost
low-costfunds
fundswithout
without
removing
removingmortgages
mortgagesfrom
fromtheir
theirbalance
balancesheets
sheets
The
Thecash
cashflow
flowon
onthe
themortgages
mortgagesbacking
backingthe
thebond
bondare
arenot
not
necessarily
necessarilydirectly
directlyconnected
connectedtotointerest
interestand
andprincipal
principalpayments
payments
on
onthe
theMBB.
MBB.
1-18

WEBSITES
http://www.financewise.com
http://www.financewise.com
This
Thisisisaafinance
financesearch
searchengine
enginefor
forother
otherfinancial
financialsites.
sites.
http://www.federalreserve.gov/otherfrb.htm
http://www.federalreserve.gov/otherfrb.htm
This
Thissite
sitecontains
containsaamap
mapthat
thatallows
allowsyou
youtotoaccess
accessall
allof
ofthe
theFederal
Federal
Reserve
ReserveBank
Banksites.
sites.
http://www.cob.ohio-state.edu/fin/journal/jofsites.htm
http://www.cob.ohio-state.edu/fin/journal/jofsites.htm
This
Thissite
sitecontains
containsaadirectory
directoryof
offinance
financejournals
journalsand
andassociations
associations
related
relatedtotoeducation
educationininthe
thefinancial
financialarea.
area.
http://finance.yahoo.com
http://finance.yahoo.com
This
Thisinvestment
investmentsite
sitecontains
containsinformation
informationon
onfinancial
financialmarkets.
markets.
Portfolios
Portfolioscan
canbe
beconstructed
constructedand
andmonitored
monitoredatatno
nocharge.
charge.Limited
Limited
historical
historicalreturn
returndata
dataisisavailable
availablefor
foractively
activelytraded
tradedsecurities.
securities.
http://moneycentral.msn.com/home.asp
http://moneycentral.msn.com/home.asp
Similar
SimilartotoYahoo!
Yahoo!finance,
finance,this
thisinvestment
investmentsite
sitecontains
containsvery
verycomplete
complete
information
informationon
onfinancial
financialmarkets.
markets.
1-19

End of Chapter 1
Thanks

1-20