Chapter 01 – Investments: Background and Issues
CHAPTER ONE
INVESTMENTS: BACKGROUND AND ISSUES
INTRODUCTION TO THE INSTRUCTOR’S MANUAL
Welcome to the Instructor’s Manual (IM) for the ninth edition of the Essentials of Investments
text by Bodie, Kane, and Marcus. This market-leading text provides comprehensive information
on investments. Designed to prepare students for a career in the investment industry, it also
serves as an excellent resource for investment knowledge that every individual can use in making
personal-investing decisions.
All data has been updated and sections added that cover new information on topics such as the
causes and effects of the financial crisis of 2008; the hedge fund industry; and the rise of electronic
trading, to name a few. In addition, the comprehensive section on risk now includes more detail
on Value at Risk, (VaR).
The IM makes extensive reference to the companion PowerPoint (PPT) files. In the PPT, we
have chosen to provide a high-level of information intended to jog the instructor’s memory rather
than detailed sentences that divert student attention from the instructor. This approach promotes
a more seamless quality in presentation delivery.
Many students request a study guide to prepare for examinations. Saving the PPT as a PDF in the
“Outline” view is an easy way to accommodate student demand while maintaining the integrity of
the content. You may also wish to consider printing the slide view of the PPT as a PDF and
posting the electronic file online for student review.
I have found that providing students with an excellent education on investments is a very
rewarding profession. The availability of high-quality and accurate materials enables the
instructor to spend more time engaged with students and less in content administration.
Please feel free to contact me at catherinet@corelm.com .
Professor Catherine Teutsch, CFP®, CLU
Reiman School of Finance
University of Denver
CHAPTER OVERVIEW
The purpose of this book is to a) help students in their own investing and b) pursue a career in the
investments industry. To help accomplish these goals Part 1 of the text (Chapters 1through 4)
introduces students to the different investment types, the markets in which the securities trade and
to investment companies. In this chapter the student is introduced to the general concept of
investing, which is to forgo consumption today so that future consumption can be preserved and
hopefully increased in the future. Real assets are differentiated from financial assets, and the
major categories of financial assets are defined. The risk/return tradeoff, the concept of efficient
markets, and current trends in the markets are introduced. The role of financial intermediaries and
in particular, investment bankers is discussed, including some of the recent changes due to the
financial crisis of 2007-2008.
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Chapter 01 – Investments: Background and Issues
LEARNING OBJECTIVES
After studying this chapter, students should have an understanding of the overall investment
process and the key elements involved in the investment process such as asset allocation and
security selection. They should have a basic understanding of debt, equity and derivatives
securities. Students should understand differences in the nature of financial and real assets; be
able to identify the major players in the markets; differentiate between primary and secondary
market activity; and describe some of the features of securitization and globalization of markets.
CHAPTER OUTLINE
1. Real versus Financial Assets
PPT 1-2 through PPT 1-5
Investing involves sacrifice. One gives up some current consumption to be able to consume more
in the future (or to be able to consume at all in the future if the goal is simply capital
preservation). Financial assets provide a ready vehicle to transfer consumption through time.
There may be more appropriate investments than real assets for many investors. The distinctions
between real and financial assets (see below) can be used to discuss key differences in their nature
and in their appropriateness as investment vehicles. For instance, financial assets are more liquid
and often have more transparent pricing since they are traded in well-functioning markets.
However, real-asset investment generates growth in the capital stock and this allows a society to
become wealthier over time.
The material wealth of a society will be a function of the inputs to production, including quality
and quantity of its capital stock, the education, innovativeness and skill level of its people, the
efficiency of its production, the rule of law, and so called “providential” factors such as location
on a global trade route. The quantity and quality of its real assets will be a major determinant of
that wealth. Real assets include land, buildings, equipment, human capital, knowledge, etc. Real
assets are used to produce goods and services. Financial assets are basically pieces of paper that
represent claims on real assets or the income produced by real assets. Real assets are used to
generate wealth for the economy. Financial assets are used to allocate the wealth among different
investors and to shift consumption through time. Financial assets of households comprise about
62% of total assets in 2008, up from 60% in 2006. Interestingly, domestic net worth fell between
September 2006 and June 2008 from $45,199 billion to $40,925 billion in 2008. This is due to
the financial crisis and the drop in real estate values. It is worth thinking about the effect that
decline in wealth will have for consumer spending.
The discussion of real and financial assets can be used to assess key differences in the assets and
their appropriateness as investment vehicles. For instance, financial assets are more liquid and
often have more transparent pricing since they are traded in well-functioning markets.
2. A Financial Assets
PPT 1-6
Fixed-income securities include both long-term and short-term instruments. The essential element
of debt securities and the other classes of financial assets is the fixed or fixed-formula payments
that are associated with these securities. Common stock, on the other hand, features uncertain
residual payments to the owners. Typically preferred stock pays a fixed dividend but is riskier
than debt because there is no principal repayment and preferred stock has a lower claim on firm
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Chapter 01 – Investments: Background and Issues
assets in the event of bankruptcy. A derivative is a contract for which the value is derived from
some underlying market condition such as the price of another security. The instructor may wish
to briefly describe an option or a futures contract to illustrate a derivative. In a listed-call stock
option the option buyer has the right, but not the obligation, to purchase the underlying stock at a
fixed price. Therefore one of the determinants of the value of the call option will be the value of
the underlying stock price.
3. Financial Markets and the Economy
PPT 1-7 through PPT 1-14
Do market prices equal the fair-value estimate of a security’s expected future risky cash flows, all
of the time, some of the time or none of the time?
This question asks whether markets are informationally efficient. The evidence indicates that
markets generally move toward the ideal of efficiency but may not always achieve that ideal due
to market psychology (behavioralism), privileged information access or some trading cost
advantage (more on this later).
A related question may be stated as “Can we rely on markets to allocate capital to the best uses?”
This refers to allocational efficiency and is related to the informational efficiency arguments
above. If we don’t believe the markets allocate efficiently then we need to discuss what other
mechanisms should be used to allocate capital and the advantages and disadvantages of these.
Because it is likely that any other system of allocation will be far more inefficient, we will likely
conclude that a market-based system is still the best even if it’s not perfectly efficient.
Financial markets allow investors to shift and perhaps to increase their consumption capability
over time. Markets allow investors to choose their desired risk level. A widow may choose to
invest in a company’s bond, rather than its stock, but a younger, upwardly mobile person may
choose to invest in the same company’s stock in the hopes of higher return. A risk-intolerant
investor may choose to invest in a government-insured CD to protect their principal. Of course,
the less risk an investor takes, the lower the expected return.
The large size of firms requires separation of ownership and management in today’s corporate
world.
The text states that in 2008 GE had over $800 billion in assets and over 650,000 stockholders.
This gives rise to potential agency costs because the owners’ interests may not align with
managers’ interests. There are mitigating factors that encourage managers to act in the
shareholders’ best interest:
Performance based compensation
Boards of Directors may fire managers
Threat of takeovers
Text Application 1.2 is summarized in slide 1-11 and can be used to generate class discussions.
In February 2008, Microsoft offered to buy Yahoo at $31 per share when Yahoo was trading at
$19.18.
Yahoo rejected the offer, holding out for $37 a share.
Billionaire Carl Icahn led a proxy fight to seize control of Yahoo’s board and force the
firm to accept Microsoft’s offer.
He lost, and Yahoo stock fell from $29 to $21.
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Chapter 01 – Investments: Background and Issues
Did Yahoo managers act in the best interests of their shareholders?
The answer to this question really revolves around whether you believe stock prices reflect the
long-term prospects of firm performance or are focused primarily on short-term results. Despite
some long-time periods to the contrary, stock prices do tend to conform to their fundamental
values over the long term. In this case Yahoo managers were acting in the best interest of their
shareholders only if they had sufficiently positive inside information and/or they believe an offer of
$37 a share would be forthcoming.
Corporate Governance and Ethics
Businesses and markets require trust to operate efficiently. Without trust additional laws and
regulations are required and all laws and regulations are costly. Governance and ethics failures
have cost our economy billions if not trillions of dollars and, even worse, are eroding public
support and confidence in market-based systems of wealth allocation. PPT slides 1-16 and 1-17
list some examples of failures and some of the major effects of the Sarbanes-Oxley Act. For a
lucid article on ethics and the financial crisis see, “Can Ethical Restraint Be Part of the Solution to
the Financial Crisis?” by Stephen Jordan, a fellow of the Caux Round Table for Moral Capitalism
for a Better World. The article may be found at:
4. The Investment Process
PPT 1-15
The two major components of the investment process are described in PPT 1-15, namely asset
allocation and security selection. Asset allocation is the primary determinant of a portfolio‘s
return. Security selection refers to the process of choosing specific securities within asset classes.
5. Markets are Competitive
PPT 1-16 through PPT 1-19
Previewing the concept of risk-return trade-off is important for the development of portfolio
theory and many other concepts developed in the course. The discussion of active and passive
management styles, is in part, related to the concept of market efficiency. The discussion of
market efficiency ties directly with the decision to pursue an active-management strategy. If you
believe that the markets are efficient then a passive-investment-strategy is appropriate for you. If
markets are efficient, markets and prices reflect all relevant information. In an efficient market, an
active management strategy will not consistently outperform a passive investment strategy from a
risk-return standpoint. Active strategies assume that trading will result in an improvement in the
risk-return tradeoff of a passive strategy after subtracting trading costs.
The two major elements of active management are security selection and timing. Material in later
chapters can be previewed in terms of emphasis on elements of active management. The essential
element of passive management is related to holding an efficient portfolio. The elements are not
limited to pure diversification concepts. Efficiency also is related to appropriate risk level, the
cash flow characteristics and the administration costs.
6. The Players
PPT 1-20 through PPT 1-26
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7. The Financial Crisis of 2008
PPT 1-27 through PPT 1-35
Antecedents of the Crisis
From 2001 to 2004 the Federal Reserve aggressively lowered interest rates. In 2007 the TED
Spread, which measures the spread between LIBOR and Treasury-bill rate, common measure of
to the development of subprime loans (loans above 80% of home value, with no underwriting
criteria, and higher default risk). These loans were traded in private-label pools in which investors
bore the risk of default. By 2006, a majority of subprime borrowers purchased houses by
borrowing the entire purchase price. Another factor which led to the crisis was the prevalence of
Adjustable Rate Mortgages (ARMs), which offered low initial interest rates, but eventually reset
into “tranches”. Senior tranches paid out first, junior tranches later. Ratings agencies
dramatically underestimated the credit risk in these securities because they were paid to provide
ratings by the issuer of the securities, and thus pressured to rate securities generously.
Credit Default Swaps
Credit Default Swaps also contributed to the financial crisis. Credit default swaps are insurance
Chapter 01 – Investments: Background and Issues
The Rise of Systemic Risk
Systemic Risk is the risk of breakdown in the financial system, particularly due to spillover effects
from one market into others. By 2007, banks were highly leveraged, with increasingly illiquid
assets. In addition, formal exchange trading was being replaced by over-the-counter markets,
banks led to a panic in the money markets, which in turn froze the short-term financing market.
Dodd-Frank Reform Act
The Dodd-Frank Reform Act imposes stricter rules for bank capital, liquidity, and risk
management. It also mandates increased transparency, and clarifies the regulatory system. In
addition the Volcker Rule limits a bank’s ability to trade for its own account.
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