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Chapter 1: The Investment Enviroment 2.
Equity or common stock – represents an ownership

share in the corporation.
Real assets vs. Financial assets
• Equity holders are not promised any particular
• Real assets – land, buildings, machines, and knowledge
payment.
that can be used to produce goods and services.
• They receive any dividends the firm may pay and have
• Financial assets – such as stocks and bonds. prorated ownership in the real assets of the firm.
• If individuals choose to invest, they may place their • If the firm is successful, the value of equity will
wealth in financial assets by purchasing various securities. increase; if not, it will decrease.
• When investors buy these securities from companies, • The performance of equity investments, therefore, is
the firms use the money so raised to pay for real assets, tied directly to the success of the firm and its real assets.
such as plant, equipment, technology, or inventory.
• For this reason, equity investments tend to be riskier
than investments in fixed-income securities.
• So investors’ returns on securities ultimately come
from the income produced by the real assets that were 3. Derivative securities – such as options and futures
financed by the issuance of those securities. contracts provide payoffs that are determined by the
prices of other assets such as bonds or stock prices.
• Securities, which are financial assets, are liabilities of
the issuers of the securities. • Derivative securities are so named because their values
derive from the prices of other assets.
• Therefore, when we aggregate overall balance sheets,
these claims cancel out, leaving only real assets as the • Derivatives have become an integral part of the
net wealth of the economy investment environment.
• One use of derivatives, perhaps the primary use, is to

• We should not lose sight of the fact that the successes
or failures of the financial assets we choose to purchase hedge risks or transfer them to other parties.
ultimately depend on the performance of the underlying • Derivatives also can be used to take highly speculative
real assets.
positions.
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A Taxonomy of Financial Assets
Financial Markets and the Economy
1. Fixed-income securities – promise either a fixed
stream of income or a stream of income according to a • 1. The informational role of financial markets – the
specified formula. stock market encourages allocation of capital to those
firms that appear at the time to have the best prospects.
A. Money market – refers to fixed-income securities that
are short-term, highly marketable, and generally of very • 2. Consumption timing – financial markets allow
low risk. Ex. Treasury bills and bank certificates of deposit individuals to separate decisions concerning current
(CDs) consumption from constraints that otherwise would be
imposed by current earnings.
B. Capital market – includes long-term securities such as
Treasury bonds, as well as bonds issued by federal • An individual can “store” his wealth in financial assets.
agencies, state and local municipalities, and corporations. In high-earning periods, an individual can invest his
savings in financial assets. In low-earning periods, he can
These bonds range from very safe in terms of default risk
sell these assets to provide funds for his consumption
to relatively risky.
needs
They also are designed with extremely diverse provisions
• 3. Allocation of risk – financial markets allow the risk
regarding payments provided to the investors and
that is inherent to all investments to be borne by the
protection against bankruptcy of the issuer.
investors most willing to bear that risk.
• 4. Separation of ownership and management –
financial assets and the ability to buy and sell those
assets in the financial markets allow for easy separation
of ownership and management
Do Managers Really Attempt to Maximize Firm Value?
• Agency problems – potential conflicts of interest

because managers, who are hired as agents of the
shareholders, may pursue their own interests instead.
Mechanisms to Mitigate Potential Agency Problems
• 1. Compensation plans tie the income of managers to

the success of the firm.
• 2. Boards of directors can force out management teams

that are underperforming.
• 3. 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.
• 4. Bad performers are subject to the threat of takeover.
• 5. Corporate governance and corporate ethics– Wall

Street and its regulators are seeking ways to restore
credibility.
The Investment Process
• Saving – means not spending all of your current income

on consumption.
• Investing – choosing what assets to hold. You may

choose to invest in safe assets, risky assets, or a
combination of both.
• An investor’s portfolio – is his collection of investment

assets.
• Once the portfolio is established, it is updated or

“rebalanced” by selling existing securities and using the
proceeds to buy new securities, by investing additional
funds to increase the overall size of the portfolio, or by
selling securities to decrease the size of the portfolio.

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Chapter 1: The Investment Enviroment 2.

Equity or common stock – represents an ownership

• One use of derivatives, perhaps the primary use, is to

Do Managers Really Attempt to Maximize Firm Value?

• Agency problems – potential conflicts of interest

Mechanisms to Mitigate Potential Agency Problems

• 1. Compensation plans tie the income of managers to

• 2. Boards of directors can force out management teams

• 3. Outsiders, such as security analysts and large

• 4. Bad performers are subject to the threat of takeover.

• 5. Corporate governance and corporate ethics– Wall

The Investment Process

• Saving – means not spending all of your current income

• Investing – choosing what assets to hold. You may

• An investor’s portfolio – is his collection of investment

• Once the portfolio is established, it is updated or

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