Investments (Hsin, C.

)
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General classifications:
Chapter 1 • Real Investment - investment in “real asset”
• Real assets:
Investments – assets used to produce goods and services
e.g., machine, land, real estate. Property, plant &
Background and Issues equipment, human capital, etc

• Financial Investment - investment in “financial

asset”
– Financial assets:
• claims on real assets or claims on the income
generated by real assets
– e.g., bonds, stocks.

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Real Assets vs. Financial Assets

1.1 Real Versus Financial Assets
• All financial assets (owner of the claim) are
• Investment, Real assets, and offset by a financial liability (issuer of the
Financial assets claim).
• When we aggregate over all balance sheets,
only real assets remain.
• consuming today vs. investing • Hence the net wealth of an economy is the
for the future sum of its real assets.

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Investment usually involves:

Investment:
initial cash outflow
<def.>
subsequent (uncertain) cash flows (CFs)
– A sacrifice of 'certain' 'present' cash
flows for certain/uncertain 'future'
cash flows. Two attributes of cash flows generated from an
investment:
– Commitment of current resources in the
– (i) time - time of occurring for future CF's
hope of deriving greater resources in the
future. – (ii) risk - uncertainty of future CF's

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1.2 A TAXONOMY OF FINANCIAL

e.g. Purchase a machine: ASSETS
• Security:
• Suppose the price of the machine is
– A legal representation of the right to
$100,000. Are you going to buy it? receive prospective future benefits under
• You have to ask yourself some stated conditions.
questions.
- usually at least 2 parties involved:
sec.
capital  capital
demander  supplier
$

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Q1: What are the projected future e.g.

(uncertain) cash flows? • GM (General Motors) bond
– capital demander =
$12,000 over the next 3 years. – capital supplier =
– prospective benefit =

Also, we need to know:

• GM common stock
 timing of expected cash flows – capital demander =
– capital supplier =
0 1 2 3 – prospective benefit =
+-----------+-----------+-----------+
Some types of financial assets can be transferred
-100,000 3,000 4,000 5,000
from one owner to another, e.g., common stocks
and bonds.

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Three broad types of financial assets:

Q2: We need to evaluate the ‘quality’ of
these expected CF‘s
(1) Fixed Income Securities
 the uncertainty or the risk of CFs (2) Equity Securities
 determination of the “discount rate”.
(3) Derivatives

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(1) Fixed Income Securities: 1.3 Financial Markets and

- promises to pay a series of specified cash
flows over a specific period
the Economy

- Fixed income securities promise either

- a fixed stream of income, or
- a stream of income that is determined
according to a specified formula.
- eg. Fixed rate bond, Preferred stocks, or
floating rate bond

- Unless the borrower is declared bankrupt,

the payment must be paid.
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– a.) Securities issued by government
e.g. Issued by US Department of Treasury
• Treasury Bills (T-Bills):
Financial Markets
issued w terms to maturity < 1 yr (4, 13, 26, 52 wks) (no
coupons)
• Treasury Notes (T-Notes):
• Informational Role of Financial Markets
issued w terms to mat btw 2-10 yrs (coup) o Market price = Fair Value ?
• Treasury Bonds (T-bonds):
Do market prices equal the fair value estimate
issued w terms to maturity 20-30 yrs
• Treasury Inflation Protected Securities (TIPS): of a security’s expected future risky cash
inflation-indexed bonds (1997). flows?
principal is adjusted to CPI: CPI up -> Principal up o Can we rely on markets to allocate capital to
constant coupon rate -> variable interest payment
the best uses?
=> protecting against inflation rate
- Terms to maturities: 5, 10, 30 yrs • What other mechanism could we use to
allocate capital?
- Other examples: municipal bonds
• What would be the advantages and
b.) Corporate bonds disadvantages of another system?
– issued by corporations
– pay par and, usually, int payments
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(2) equity: Consumption Timing
• An ownership share in a corporation. Ownership stake
in the entity, residual cash flow o People tend to smooth consumption over time.
– common stocks
– issued by corporations
– pay dividends, stockholders have voting rights. o If one has more than enough cash to meet
their basic needs in the current time period
one might shift consumption through time by
investing the surplus.
(3) derivative securities:
• Securities providing payoffs that depend on the values
of other assets.
• A contract whose value is derived from some
underlying market condition.
– e.g. options and futures

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Allocation of Risk 1.4 THE INVESTMENT PROCESS

o Investors can choose a desired risk level Suppose you have $1 million, what are
you going to do with the money?
• Bond vs. stock (of a given company)

• Bank CD vs. company bond • Portfolio:

a collection of investment assets
• Tradeoff between risk and expected return?
→ update, rebalance periodically.

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Investors make two types of decisions in
Separation of Ownership and Management constructing their portfolios:

• Large size of firms requires separation of (1) Asset allocation資產配置

ownership and management – Allocation of investment portfolio across broad
o Owners (principals) ≠ Managers (agents) asset classes (stocks, bonds, money market)
 Money market assets
 Fixed-income securities
o Agency costs: Owners’ interests may not align
 Stocks
with managers’ interests
 International securities
 Real estate
o Mitigating factors:  Precious metals and other commodities
• Performance based compensation
• Boards of Directors may fire managers
• Threat of takeovers

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Corporate Governance and Corporate Ethics (2) Security selection 選擇投資證券

• Business and market require trust to operate – Choice of specific securities within each asset
efficiently classes.
o No trust  additional laws and regulations are
required – Security Analysis:
o All laws and regulations are costly Analysis of the value of securities
 Fundamental analysis vs.
• Governance and ethics failures cost the economy Technical analysis
o Eroding public support and confidence in
market based systems

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Risk-Return Trade- Off

• “top-down” approach: – How do we measure risk?
– Asset allocation  Security selection
– How does diversification affect risk?

• “bottom-up” approach: – Discussed in Part 2 of the text

– Security selection  Asset allocation

- The definition of “Risk” concerns with the
• The asset allocation decision is the concept of “Diversification”:
primary determinant of a portfolio’s - Mean-Variance portfolio theory
return - relevant risk and expected return

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1.5 MARKETS ARE COMEPETITIVE Efficient Markets

o Market efficiency:
- Competition  few “free lunch” o Securities should be neither underpriced nor
(few highly under-priced securities) overpriced on average

o Security prices should reflect all information

- Implications: available to investors
 Risk-return trade-off
 Assets with greater risk should have o Whether we believe markets are efficient
higher expected returns. affects our choice of appropriate investment
management style.

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Risk-Return Trade- Off Active vs. Passive management

Active management:
o Assets with higher expected returns have higher • Attempt to identify mis-priced securities and/or to forecast broad
market trends.
risk. – Believe: market is inefficient
Average Annual Minimum Maximum
– Security selection: Actively seeking undervalued securities
Return (1931) (1933)
– Asset Allocation: Timing the market (asset allocation)
Stocks About 12% -46% 55%
 Frequent buy and sell assets

 Passive management:
o Stocks: a stock portfolio can be expected to lose • Buy and hold a diversified portfolio without attempting to identify
mis-priced securities.
money about 1 out of every 4 years. 買入持有風險分散之投資組合，並不特意選擇價格被市場誤估之證券
– Believe: market is efficient
o Bonds: – Security selection: No attempt to find undervalued securities
– Asset Allocation: No attempt to time the market
‐ much lower average rate of return (under 6%)  Holding an efficient portfolio:
‐ have not lost more than 13% of their value in • Indexing, Constructing an “efficient” portfolio
any one year.
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1.6 THE PLAYERS Advantages of financial intermediaries:

Major players:
 by pooling the resources of many small
 Firms: net borrowers (capital demanders)
investors, they are able to lend considerable
(receive $capital from investors)
 Households: net savers (capital suppliers) sums to large borrowers.
(provide $ in the market)  by lending to many borrowers, f.i. achieve
 Governments: can be borrowers or lenders, significant diversification (e.g. mutual fund)
depending on the relationship between tax
revenue and government expenditures. (if  f.i. build expertise through the volume of
deficits, then borrowers) business they do and can use economies of
 Financial Intermediaries: Connectors of scale to assess and monitor risk.
borrowers and lenders

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• Corporations and governments do not sell all or

even most of their securities directly to Investment Companies:
“individual investors”.
Firms managing funds for investors. An
• Many of the stocks and bonds are held by
“institutional investors”
investment company may manage
e.g. mutual funds, pension funds, banks and several mutual funds.
insurance companies

• These financial institutions stand between the

security issuer (the firm) and the ultimate
owner of the security (the individual investor):

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Financial Intermediaries
Investment Bankers:
 Firms specializing in the sales of new securities to the
 Institutions that connect borrowers and public, typically by underwriting (承銷) the issue.
lenders by accepting funds from lenders and
loaning funds to borrowers • Primary market 初級市場 (發行市場):
o Commercial Banks – A market where newly issued securities are offered to
the public.
• Traditional line of business: Make loans funded • The investment banker typically ‘underwrites’ the issue.
by deposits
o Insurance companies • Secondary market 次級市場:
o Pension funds – A market where pre-existing securities are traded
o Hedge funds among investors.
o bank, mutual fund companies

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MARKETS AND MARKET STRUCTURE 1.7 RECENT TRENDS

 Globalization
Four types of markets (evolving upwards)
 Tendency towards a worldwide investment
environment, and the integration of national
1. Direct Search Market: least organized market. capital market.
– Buyers and sellers must seek each other out  examples:
directly. (e.g. sell a used textbook) Depository Receipts (存託憑證)
 ADRs (American Depository Receipts) shares
of foreign stocks traded in US
 TDR, GDR
2. Brokered Markets 仲介市場
purchase foreign securities
– In markets where trading is active, brokers find buy mutual funds that invest internationally
it profitable to offer services to buyers and buy derivatives with payoffs that depend on
sellers. (e.g. real estate market) prices in foreign security market.

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3. Dealer Markets: 經紀人市場  Securitization

 Pooling loans into standardized securities backed by those
– A market where traders specializing in loans, which can then be traded like any other securities.
particular assets, buy and sell for their own
accounts. (e.g. OTC markets)  Financial Engineering
• Repackaging cash flows of a security to enhance marketability
4. Auction Markets 拍賣市場 • Bundling and unbundling of cash flows
o Bundling:
– A market where all traders in a good meet Combining more than one asset into a composite security,
at one place to buy or sell an asset. (e.g. for example securities sold backed by a pool of mortgages.
NYSE or TSE) o Unbundling
Selling separate claims to the cash flows of one security
• Advantage: need not search across - A trend allowing creation of securities either by combining
dealers to find the best price primitive and derivative securities into one composite hybrid
or by separating returns on an asset into classes.

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1.7 RECENT TRENDS • Computer Networks

• Globalization • Online low cost trading

• Information made cheaply and widely available
• Securitization • Direct trading among investors via electronic
communication networks

• Financial Engineering

• Information and Computer Networks

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