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 eleventh 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.
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.
Nicholas Racculia, PhD, SSC
Associate Professor of Finance
McKenna School of Business, Economics and Government
Saint Vincent College
Chapter 01 – Investments: Background and Issues
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 1 through
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
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 70% of total assets in 2017. Domestic net worth has risen over the years,
totaling $67,786 billion in 2017 (compared to $57,873 billion in 2014).
Chapter 01 – Investments: Background and Issues
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 through 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 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 1-13
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).
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.
Chapter 01 – Investments: Background and Issues
The large size of firms requires separation of ownership and management in today’s corporate
world. The text states that in 2016 GE had over $350 billion in assets and over 500,000
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
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
4. The Investment Process
PPT 1-14 through 1-16
The two major components of the investment process are described in PPT 1-14/15, namely asset
allocation and security selection. Asset allocation is the primary determinant of a portfolio’s
return. Security selection is 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.
Chapter 01 – Investments: Background and Issues
6. The Players
PPT 1-20 through PPT 1-27
Some of the major participants in the financial markets are listed in PPT 1-20. Governments,
households and businesses can be issuers and investors in securities. PPT 1-21 shows the the
economic equilibrium of capital. Investment bankers bring issuers and investors together. The
primary and secondary markets are defined in PPT 1-22 and the underwriting function is
introduced. PPT 1-23 and PPT 1-24 discuss some of the history of the separation of commercial
and investment banking, the changes resulting from regulatory changes, and the collapse of the
major investment banks in the recent crisis. In 1933 the Glass-Steagall act strictly limited the
activities of commercial banks. An institution could not accept deposits and underwrite
Summary statistics for commercial banks’ and non–finance U.S. business’ balance sheets for
2017 are displayed in PPT 1-25 and in PPT 1-26.
7. The Financial Crisis of 2008
PPT 1-28 through PPT 1-38
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
credit risk, was around .25%, which is low.
Changes in Housing Finance
Low interest rates and a stable economy created a boom in the housing market, and drove
investors to find higher-yield investments. In the 1970s Fannie Mae and Freddie Mac bundled
mortgage loans into tradable pools by a process called securitization. The securitization model
led 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 to current-market interest yields.
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Credit Default Swaps
Credit Default Swaps also contributed to the financial crisis. Credit default swaps are insurance
contracts against the default of borrowers. However, many CDS issuers ramped-up their risk
exposure to unsupportable levels without sufficient capital to back their obligations. AIG sold
$400 Billion in CDS contracts on subprime mortgages.
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, which did not require any margin to protect against insolvency.
The Shoe Drops
On September 7, 2008 Fannie Mae and Freddie Mac were put into conservatorship. By the
second week of September both Lehman Brothers and Merrill Lynch verged on bankruptcy. On
September 17, The U.S. Government lent $85 Billion to AIG. The potential insolvency of these
banks led to a panic in the money markets, which in turn froze the short-term financing market.