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Boazii University
Investment Analysis and Portfolio Management
Attila Odaba
Textbook: Investments, Bodie, Kane and Marcus
(BKM)

OUTLINE

Real vs Financial Assets

Clients of Financial System
Financial Institutions & Innovation
Markets and Market Structure
Trends

Investments and Financial

Assets
Real Assets:
Assets used in the production of goods and
services
Land, buildings, machines, knowledge, etc.
Add to productive capacity
Appear on left-hand side of balance sheet
Destroyed by physical damage or wear

Investments and Financial Assets

Financial Assets:
Claims on cash flows from real assets
Appear on both sides of balance sheet
Real versus Financial Assets:

All financial assets (owner of the claim) are offset by a

financial liability (issuer of the claim).
When we aggregate over all balance sheets, only real
assets remain.
Hence the net wealth of an economy is the sum of its
real assets.
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Essential nature of investment

Reduce current consumption in hopes of
greater future consumption
Hence, we invest our surplus funds in
various financial assets
Financial assets are issued by firms (among
others) because the timing of their income
stream typically does not match desired
timing of physical investments.

Major Classes of Financial Assets or

Securities
Debt
o Money market instruments
Bank certificates of deposit, T-bills, commercial
paper, etc.
o Bonds
o Preferred stock
Common stock
o Ownership stake in the entity, residual cash flow
Derivative securities
o A contract whose value is derived from some
underlying market condition.
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Components of a Financial System

Judicial and Admin
Regulations

Firms,
Govnmt:
Demand
funds,
supply
fin assets

Cash
Fin
Instr
Cash +
Interest

Pool of Funds
Financial
Intermediaries,
Comm Banks,
Broker Houses,
Mutual Funds,
etc

Cash
Fin
Instr
Cash +
Interest

Households,
Pension F,
Insurance
Cos:
Supply
funds,
Demand
financial
assets,

The Players
Business Firms net borrowers
Households net savers
Governments can be both borrowers and
savers
Financial Intermediaries Connectors of
borrowers and lenders
o Commercial Banks

Traditional line of business: Make loans funded by

deposits

o Investment companies
o Investment Bankers,
o Mutual Funds,
o Etc.,

The Players Cont.

Investment Bankers

o Firms that specialize in primary market

transactions
o Primary market:

A market where newly issued securities are offered to the

public.
The investment banker typically underwrites the issue.

o Secondary market

A market where pre-existing securities are traded among

investors.
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Investment Bankers
o Commercial and investment banks functions and
organizations were separated by law from 1933 to
1999.
o Post 1999 large investment banks, collectively known
as Wall Street, operated independently from
commercial banks, although many of the large
commercial banks increased their investment
banking activities, pressuring profit margins of
investment banks.
o In September 2008 major investment banks either
went bankrupt, reorganized as commercial banks or
were purchased by commercial banks as a result of
the collapse of the mortgage markets.
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 Investment Bankers
o Some investment banks chose to become
commercial banks to obtain deposit funding and
government assistance
o All of the major investment banks are now under
the much stricter commercial bank regulations.
What are the implications for innovation and capital
issuance resulting from these changes?

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Financial Markets: Institutions &

Innovations
Financial system addresses market
participants needs
Through intermediaries (e.g., banks collect
savings and hand out loans)
By creating suitable securities (e.g., stocks,
bonds, derivatives)

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Financial Markets
Informational Role of Financial Markets

o Do market prices equal the fair value estimate of a

securitys expected future risky cash flows?
o Can we rely on markets to allocate capital to the
best uses?
What other mechanism could we use to allocate
capital?
What would be the advantages and
disadvantages of another system?

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Financial Markets
They allow consumption timing

o People tend to smooth consumption over time.

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.

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Financial Markets
o They enable allocation of risk

o Investors can choose a desired risk level

Bonds versus stock of a given company
Bank CD versus company bond
Tradeoff between risk and return?

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Corporate Governance and

Corporate Ethics
Businesses and markets require trust to operate
efficiently
o Without trust additional laws and regulations are
required
o All laws and regulations are costly
Governance and ethics failures
o Erode public support and confidence in market
based systems
o Cost the economy billions of dollars

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Corporate Governance and

Corporate Ethics
Some examples:
Accounting Scandals
o Enron, WorldCom, Rite-Aid, HealthSouth, Global
Crossing, Qwest,
Misleading Research Reports
o Citicorp, Merrill Lynch, others
Auditors: Watchdogs or Consultants?
o Arthur Andersen and Enron

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Corporate Governance and

Corporate Ethics
Preventie actions:
Sarbanes-Oxley Act
o Increases the number of independent directors on
company boards
o Requires the CFO to personally verify the financial
statements
o Creates a new oversight board for the
accounting/audit industry
o Charges the board with maintaining a culture of
high ethical standards

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The Investment Management Process

1.
2.
3.
4.
5.

Setting investment objectives

Establishing an investment policy
Selecting an investment strategy
Constructing a portfolio
Measuring and evaluating investment
performance

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Setting Investment Objectives

Analysis of the investment objectives of the
entity whose funds are being managed.
Individual investors
Institutional investors

Pension funds, depository institutions, insurance

companies, regulated investment companies (mutual
funds,..), endowments and foundations, and treasury
department of corporations, government agencies.

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Establishing an Investment Policy

Starts with the asset allocation decision
How the funds to be invested should be
distributed among the major classes of
assets
Return vs risk

Take into account any investment constraints

or restrictions
Client constraints, regularity constraints,..

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Investment/Portfolio Strategy
Active portfolio strategy:
Seek a better performance than a simply
diversified portfolio via
Finding undervalued securities (Security
Selection)
Timing the market (Asset allocation)

Passive portfolio strategy:

Relies on diversification to match the
performance of some market index
Which would you select? Why?

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Efficient Markets
o What we mean by Market efficiency?
o Securities should be neither underpriced

nor overpriced on average

o Security prices should reflect all

information available to investors

o Markets should be competitive.

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Constructing the Portfolio

Select the specific assets to be included in the
portfolio
Aim to construct an efficient portfolio
One that provides the greatest expected
return for a given level of risk, or
equivalently, the lowest risk for a given
expected return
Need to quantify (measure) risk!
How diversification reduces risk?

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Measuring and Evaluating

Performance
Calculating return over the evaluation period
and comparing with a benchmark (index)
Different return measures
Arithmetic average
Geometric average
Time-weighted rate of return

Single-index performance measures

Sharpe ratio, etc.

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The Investment Management Process

The above mentioned process is a top-down
approach
Starts with asset allocation
Then Security selection

Alternative approach is Bottom-up

Security selection first

Reminder: Asset allocation decision is the

primary determinant of a portfolios return

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Recent Trends
Globalization
Securitization
Financial Engineering
Information and Computer Networks

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Globalization
Domestic firms compete in global markets
Performance in one country or region depends on
other regions
Internationl Opportunities for better returns &
implications for risk
o International diversification reduces risk
o Instruments and vehicles continue to develop
(ADRs and WEBs)
o Information and analysis improves
o Managing foreign exchange
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Securitization
Loans of a given type such as mortgages are placed
into a pool and new securities are issued that use
the loan payments as collateral.
The new securities are marketable and are
purchased by many institutions.

Credit enhancement provided by pool

issuers has improved marketability.

End result is more investment opportunities for

purchasers, and spreading loan credit risk among
more institutions

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Financial Engineering
Repackaging cash flows of a security to enhance
marketability
Bundling and unbundling of cash flows
o Bundling:
Combining more than one asset into a composite
security, for example securities sold backed by a pool
of mortgages.
o Unbundling
Selling separate claims to the cash flows of one
security, for example a CMO

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Computer Networks
Online low cost trading
Information made cheaply and widely available
Direct trading among investors via electronic
communication networks
What have been the effects on Wall Street firms profit
margins?
o How has Wall Street responded?

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The Future
Globalization will continue and investors will
have far more investment opportunities than
in the past
Securitization will continue to grow after the
crisis
Continued development of derivatives and
exotics, more regulation for over the counter
derivatives
Strong fundamental foundation of
understanding is critical
Understanding corporate finance requires
understanding investments
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The Financial Crisis of 2008

http://www.youtube.com/watch?v=bx_LWm6_6tA
Showed intimate links between real and financial
economies.
Antecedents of the crisis:

High-tech bubble, 2000-2002

Low interest rates to prevent recession
That leads to a boom in housing market,
Changes in Housing Finance:

1970s, Fannie Mae, Freddie Mac, started Securitization,

Mortgage-backed securities, pass throughs...

Securitization by private firms of nonconfirming

subprime loans with higher default risk / high
leverage home loans

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The Financial Crisis of 2008

Adjustable-rate mortgages also grew in popularity
Low initial or teaser rates
These rates were reset to current market rates later

Starting by 2004 interest rates started to increase

This put pressure on payments
House prices peaked in 2006 and started to decline in
2007
Housing default rates began to surge in 2007

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The Financial Crisis of 2008

Mortgage derivatives
CDOs (Collateralized debt obligations):

Innovation,
Based on: Securitization, restructuring, and
credit enhancement
Output: AAA-rated securities from original-issue
junk loans.

Credit rating agencies were wrong.

Why? Default probabilities were based on

historical data from recession-free economy
Geographical diversification proved excessive
optimism
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The Financial Crisis of 2008

Credit Default Swaps (CDS) market also
exploded in the same period:

In essence an insurance contract against the

default of one or more borrowers.
Swap purchaser pays an annual premium for
protection from credit risk.
Credit enhancement method: Buy subprime
loans and insure their safety.

Some swap issuers took unsupportable credit

risk without sufficient capital to back those
obligations (eg AIG sold $400 bio of CDS) .
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The Rise of Systemic Risk

By 2007 some financial institutions used to:

Borrow short-term at low rates to finance holdings

in higher yielding long-term illiquid assets.
High leverage (up to 30:1),
Constant Refinancing needs due to mismatch
They had little capital

This made these institutions vulnerable to

crises of confidence
High reliance on CDO products created other
problems
By Aug 2008, $63 trillion CDS outstanding (US
GDP $14 trillion)

All these increased the systemic risk!

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The Financial Crisis of 2008

The Shoe Drops: First signs, summer of 2007

Bear Stearns announce huge losses on subprime,

Fall 07: housing prices decline, stock market too
March 08: Bearn Stearns acquired by JPMorgan
Chase with some gov. guarantee,
Sep 08: Fannie Mae and Freddie Mac put into
conservatorship,
Sep 14, 08: Merrill Lynch sold to Bank of America,
Sept 15: LehmanBrothers filed for bankcruptcy,
Sep 17: US Gov lent $85 billion to AIG,
Sep 18: Treasury unveiled the proposal to spend
$700 bio to purchase toxic mortgage-backed
securities.
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Reading assignment:

The first four chapters in Investments, BKM.

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