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Overview: Investments

Overview: Investments. Investment Process Taxonomy of Financial Assets Players and Vehicles Market Microstructure Recent Trends. Investment process. Investment Trade current benefit for future payoff Bank deposit, stock purchase, education Real vs Financial Assets

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Overview: Investments

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  1. Overview: Investments Investment Process Taxonomy of Financial Assets Players and Vehicles Market Microstructure Recent Trends

  2. 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.

  3. 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 • Amazon’s stock for the brave and bond for the less adventurous souls • Separation of ownership & management: real asset too big • It’s inefficient for GE’s half-million stock owners to participate day-to-day operations

  4. Taxonomy of Financial Assets • Money and Capital Markets Derivative Securities Debt Instruments Common Stock & Preferred Stock Maturity < 1 Maturity  1 Money Market Capital Market

  5. Investment process • Five step approach Generating sufficient funds 1. Setting investment objectives Guarantee a payment at some time in the future 2. Establishing investment policy Asset allocation decision: stocks, bonds, real estate Active strategy, passive strategy, structured strategy 3. Selecting a portfolio strategy 4. Selecting the assets Portfolio formation: market timing or asset picking Benchmarking: S&P500, risk adjustment 5.Measuring and evaluating performance

  6. Players and Vehicles • Who are they? Companies $ Financial Intermediaries Commercial Bank Taking deposit and making loans Investment Bank Selling securities to investors $ Government $ Consumers/investors

  7. 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)

  8. 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

  9. 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 • Tobin’s 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).

  10. 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

  11. 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

  12. Recent Trends • Financial Engineering • The process of creating customized securities tailored to investor’s 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.

  13. Recent Debacles • Subprime mortgage meltdown • Credit and liquidity crunch • What went wrong? • Video (from Britain)

  14. Wrap-up • What is investment? • What are the differences between financial and real assets? • What’s hot? • What’s not?

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