The Investment Environment: Financial Assets, Fixed Income, and Derivatives

The Investment Environment

Investment: current_commitment of money in the expectation of reaping future benefits so, basically, you sacrifice something now in order to benefit for that sacrifice later. Capacity: the goods and the services the society's members can create and it's a measure of the material wealth of a society. About that, we distinguish between:

• Real assets: lands, buildings, machines and also knowledge (bc it can be used to produce other good or services) and the capacity is a function of them
• Financial assets: stocks and bonds. They don't contribute directly to the productive capacity of the economy. They are claims to the income generated by the real assets: while real assets generate net income to the economy, financial assets define the allocation of income among investors (who bought the shares) Example: if you can't own a car plant (that's a real asset) you can buy shares in Ford or Toyota (those are financial assets) and so a share in the income derived from the production of automobiles. Moreover, we can say that investors' returns on securities come from the income produced by the real assets that were financed by the issuance of those securities.

Financial Asset Distinctions

Financial assets are distinguished in:

1. Fixed income or debt securities: they promise either a fixed stream of income or a stream of income determined by a specified formula. There are also the floating-rate bonds that promise payments that depend on current interest rates. The investment performance of the securities is tied to the financial condition of the issuer (so I get a fixed income unless the borrower is declared bankrupt). Those securities can have different maturities so we distinguish between the money market, that refers to debt securities that are short term, highly marketable and not so risky, and the fixed-income capital market, that refers to long-term securities (i.e. Treasury bonds) and to bonds issued by federal agencies and they differ in terms of default risk
2. Common stock or equity: it represents an ownership share in the corporation. Equity investments are riskier than investments in debt securities bc their performance is tied directly to the success of the firm and its real asset (if the firm is successful then the value of equity increases, otherwise don't)
3. Derivative securities: examples are options, futures and swap contracts. One use is to hedge risks or transfer them to other parties and another one is to take highly speculative positions. Derivative securities are so called because their values derive from the prices of other assets: the value of a call option depends on the price of the underlying so, if the stock price rises above the exercise price, the call option is valuable. However, this category doesn't really exist

The Role of the Financial Market

• Informational role: stock prices reflect investors' collective assessment (valutazione) of a firm's current performance and future prospects. Stock prices have a major role in the allocation of capital in market economies bc the higher price lead to the raise (raccolta) of capital and so investments are encouraged. However, it's important to consider that the stock market encourages allocation of capital to those firms that appear at the time to have the best prospects
• Consumption timing: refers to the shifting of the consumption over the course of your whole lifetime, thereby allocating the consumption to periods that provide the greatest satisfaction
• Allocation of risk: capital markets allow the risk that is inherent to all investments to be borne (sopportato) by the investors most willing to bear that risk. When investors are able to selectsecurity types with the risk-return characteristics that best suit their preferences, each security can be sold for the best possible price and this facilitates the process of building the economy's stock of real assets

Separation of Ownership and Management

In large firms the individuals can't participate in the daily management of the firm so a board of directors, that hires and supervises the management, is elected by the shareholders. This means that ownership and management are distinguished and this gives stability to the firm. Financial assets and the ability to buy and sell those assets in the financial markets allow for an easy separation of ownership and management. All may agree that the managers should pursue strategies that increase the firm value but they might be tempted to engage in activities that are not in the best interest of shareholders. These potential conflicts of interest are called agency problems bc managers may pursue their own interests and not those of the shareholders. How to solve this problem?

• Compensation plans that tie the income of managers to the success of the firm
• Forcing out those managers who are underperforming
• The outsiders (security analysts or institutional investors such as mutual or pension funds) monitor the firm and make the life of poor performers at the least uncomfortable
• Bad performers are subject to the threat of takeover. Here we distinguish between the proxy contest, through which a different board is elected by the unhappy shareholders if the previous one was lazy in monitoring the managers, and the case of the other firms, so the management of the underperforming firm is replaced by the one of the firm that acquired the underperforming firm

Corporate Governance and Ethics

Markets need to be transparent for investors to make informed decisions indeed market signals will help to allocate capital efficiently only if investors are acting on accurate information. The years from 2000 to 2002 were filled with an unending series of scandals that collectively led to a crisis in corporate governance and ethics.

• Some firms such as WorldCom, Rite Aid, HealthSouth and Enron manipulated and misstated their balance sheets to the tune of billions of dollars. For example, Enron used the "special purpose entities" to move debt off its own books so presenting a misleading picture of its financial status
• Overly optimistic (and manipulated) research reports put out by stock market analysts. However, we must consider that analysts were compensated not for their accuracy but for their role in garnering investment banking businesses for their firms

In 2002, in response to these scandals, the Congress passed the Sarbanes-Oxley Act. This requires corporations to have more independent directors who are not themselves managers, auditors can't provide various other services to clients, each CFO (Chief Financial Officer) must personally vouch for the corporation's accounting statements, defines an oversight board that oversees the auditing of public companies.

The Investment Process

An investor's portfolio is the collection of his investment assets. Once the portfolio is established, it's updated:

• By selling existing securities so the income is used to buy new securities
• By investing additional funds to increase the overall size
• By selling securities to decrease the size of the portfolio

In constructing the portfolio, the investors make 2 types of decisions:

• Asset allocation decisions: is the choice among broad asset classes
• Security selection decision: is the choice of the securities within each asset class

There are two techniques to construct the portfolio

• Top-down strategy: it starts with asset allocation. This type of investor firstly considers the implication, in terms of risk and return, on the portfolio before turning the decision of the particular securities to be held in each asset class and, about this, the security analysis involves the valuation of particular securities that might be included in the portfolio
• Bottom-up strategy: the portfolio is constructed from securities that seem attractively priced without concerning too much on the resultant asset allocation. This type of strategy does focus the portfolio on the assets that seem to offer the most attractive investment opportunities

Competitive Markets

Investors invest for anticipated future returns even if realized returns will always deviate from the expectations done at the start of the investment period. Obviously, investors would prefer investments with the higher expected return but there is a risk-return trade off in the securities markets, with higher expected returns for those assets that are riskier (if higher expected returns can be achieved without bearing extra risk, there will be a rush to buy these high-return assets and their prices will be driven up). This leads us thinking that risk is linked to the volatility of an assets's return but it's only partly correct bc, when we mix assets into diversified portfolios, we should consider correlation among them and then the impact on the risk portfolio diversification: we hold many assets in a portfolio so that the exposure to any particular asset is limited An implication of the "efficient market hypothesis" concerns the choice between:

• Passive management: consist in holding highly diversified portfolios without spending effort in order to improve investment performance through security analysis
• Active management: is the attempt to improve the investment performance by identifying mispriced securities or by timing the performance of broad asset classes

Note: it markets are efficient and the prices reflect perfectly all relevant information, it's better to follow a passive strategy

The Players

• Firms: are net demanders of capital. They raise capital now to pay for investments and the income generated by the real assets provides the returns to investors who purchase the securities issued by the firm
• Households: are net suppliers of capital. They purchase the securities issued by firms that need to raise funds
• Government: can be borrower or lender

Corporations and governments don't sell most of their securities directly to individuals but they "use" financial intermediaries (banks, pension and mutual funds, insurance companies), so called bc they stand between the security issuer (the firm) and the owner of the security (the investor). Financial intermediaries issue their own securities to raise funds to purchase the securities of other corporations.

• Banks: they raise funds by borrowing (taking deposits) and lending that money to other borrowers. The spread between the interest rate paid to depositors and the rates charged to borrowers is the source of the bank's profit
• Investment companies, insurance companies and credit unions: these offer advantages (1) by pooling the resources of many small investors, they are able to lend considerable sums to large borrowers; (2) by lending to many borrowers, intermediaries achieve significant diversification so that they can accept loans that individually might be too risky; (3) they use economies of scale and scope to estimate and monitor risk
• Mutual funds: participating investors are assigned a prorated share of the total funds according to the size of their investment. They have advantage of large-scale trading and portfolio management
• Hedge funds: pool and invest the money of institutional investors (pension funds, endowment funds, wealth individuals). They are more likely to pursue complex and higher-risk strategies
• Investment bankers that specialize in the selling of securities can offer their services at a cost that's lower than the one of maintaining an in-house security issuance division. In this role they are called underwriters. The investment banking firm handles the marketing of the security in the primary market, where new issues of securities are offered to the public. Later, investors can trade issued securities among themselves in the secondary market.

Venture Capital and Private Equity Investments

The equity investments in young companies are called venture capital. Most venture capital funds are set up as limited partnerships: a management company starts with its own money and raises additional capital from limited partners, such as pension funds. The management company usually sits on the start-up company's board of directors, helps recruit senior managers, and provides business advice. It charges a fee to the VC fund for overseeing the investments. After some period of time, for example, 10 years, the fund is liquidated and proceeds are distributed to the investors. Venture capital investors commonly take an active role in the management of a start-up firm. Collectively, these investments in firms that do not trade on public stock exchanges are known as private equity investments.

The Financial Crisis of 2008

The Great Moderation is a period starting from the mid-1980s until 2007, characterized by a decreased macroeconomic volatility. During this period there is low inflation, positive economic growth and the reduction in the volatility of business cycle fluctuations (intervals of economic expansion followed by recession in economic activity). After the danger of a recession due to the high-tech bubble in 2002, the FED respondend reducing interest rates: the lowering was successful and the recession was short-lived. Also, the spread between the LIBOR and the Treasury-bill rate (this spread is called TED spread) (LIBOR is the rate at which banks borrow from each other and treasury bill rate and the treasury bill rate is the rate at which the US government borrows) was very low and, since it's a measure of credit risk in the banking sector, this suggests that the fear of default in the sector was very low. The combination of the reduced