Chapter 1 - Introduction PDF

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Introduction...

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Chapter 1 Introduction to Investment Management An Investment is the commitment of current resources in the expectation of deriving greater resources in the future. The key idea of an investment is that you sacrifice something of value now expecting to benefit from that sacrifice later.

1.1

Real and Financial Assets

The material wealth of a society is determined by the productive capacity of the economy, which is goods and services, and is a function of the Real Assets of the economy (i.e. land, buildings, equipment and human capital).

Financial Assets (i.e. stocks and bonds) are claims on real assets or the income generated by real assets.

1.2

Financial Assets

Fixed Income or Debt Securities promise either a fixed stream of income or a stream of income that is determined according to a specified formula. The investment performance of fixed income or debt securities is dependent on the financial condition of the issuing firm.

Common Stock or Equity represents an ownership share in a corporation. Equity investments tend to be riskier than investments in debt securities.

Derivative Securities (i.e. options and futures) provide payoffs that are determined by the prices of other assets, such as bonds or stock prices.

1.3

Financial Markets and the Economy

1.3.1

The Informational Role of Financial Markets

Stock prices reflect investor’s collective assessment of a firm’s current performance and future prospects.

1.3.2

Consumption Timing

In high – earning periods, you can invest your savings in financial assets (i.e. stocks and bonds). In low – earning periods, you can sell these assets to provide funds for your consumption needs.

1.3.3

Allocation of Risk

Risk – tolerant investors tend to purchase shares in a corporation, while risk – adverse investors tend to purchase bonds from the issuing firm.

1.3.4

Separation of Ownership and Management

Agency Problems is when there is conflict of interest between managers and shareholders.

1.3.5

Corporate Governance and Corporate Ethics

Markets need to be transparent for investors to make informed decisions.

The Sarbanes – Oxley Act aims to tighten the rules of corporate governance, such as having more independent directors. The act states that the CFO is personally liable for the accounting statements of the corporation. The act also prohibits auditors from providing additional services to its clients.

1.4

The Investment Process

Asset Allocation is the allocation of an investment portfolio across broad asset classes.

Security Selection is the choice of which particular securities to hold within each asset class.

Top – Down Portfolio construction starts with asset allocation.

Bottom – Up Portfolio is constructed on basis of selecting securities that seem attractively priced.

Security Analysis is analysing the value of securities.

1.5

Markets are Competitive

Passive Management is buying and holding a diversified portfolio without attempting to identify mispriced securities.

Active Management attempts to identify mispriced securities or to forecast broad market trends.

1.6

The Players

Financial Intermediaries are institutions that connect borrowers and lenders by accepting funds from lenders and loaning funds to borrowers.

Investment Companies are firms managing funds for investors. An investment company may manage several mutual funds.

The Primary Market is the market where new issues of securities are offered to the public.

Venture Capital is money invested to finance a new firm.

Private Equity is investing in companies that do not trade on the stock exchange.

1.7

The Financial Crisis of 2008

1.7.1

Antecedents of the Crisis

•

Low interest rate.

•

A stable economy.

•

Housing market boom.

•

A search for higher – yield investments.

1.7.2

Mortgage Derivatives

A Collateralised Debt Obligation (CDO) is a complex financial product that is backed by a pool of loans and other assets and sold to institutional investors.

A Credit Default Swap (CDS) is a financial derivative or contract that allows an investor to swap or offset his or her credit risk with that of another investor.

1.7.3

The Dodd – Frank Reform Act

The act aims for stricter rules for bank capital, liquidity and risk management. The act also aims for increased transparency and a stable regulatory system....