chap 001 portfolio management
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INVESTMENTS (ASIA GLOBAL EDITION) | BODIE, KANE, MARCUS, JAINCopyright © 2011 by The McGraw-Hill Companies, Inc. ll rights reser!e". McGraw-Hill#Irwin
Chapter 1
The Investment Environment
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Real Aet Ver! "#$a$%#alAet
• Real Assets
– Determine the productive capacity andnet income of the economy
– Examples: Land, buildings, machines,no!ledge used to produce goods andservices
• "inancial Assets
– #laims on real assets
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"#$a$%#al Aet
• $hree types:
%& "ixed income or debt
'& #ommon stoc or e(uity)& Derivative securities
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"#&e' I$%e
• *ayments fixed or determined by aformula
• +oney maret debt: short term, highlymaretable, usually lo! credit ris
• #apital maret debt: long term bonds,can be safe or risy
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C$ St%* a$' Der#+at#+e
• #ommon toc is e(uity or o!nershipin a corporation&
– *ayments to stocholders are not fixed,
but depend on the success of the firm• Derivatives
– -alue derives from prices of other
securities, such as stocs and bonds
– .sed to transfer ris
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"#$a$%#al Mar*et a$' theE%$
• /nformation Role: #apital flo!s to
companies !ith best prospects
• #onsumption $iming: .se securities
to store !ealth and transfer
consumption to the future
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"#$a$%#al Mar*et a$' theE%$ (Ct'-)
• Allocation of Ris: /nvestors can select
securities consistent !ith their tastes
for ris
• eparation of 0!nership and
+anagement: 1ith stability comes
agency problems
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"#$a$%#al Mar*et a$' theE%$ (Ct'-)
• #orporate 2overnance and #orporate Ethics
– Accounting candals
• atyam 3/ndia4, 0lympus 35apan4, Longtop
"inancial $echnologies 3#hina4 – Auditors – !atchdogs of the firms
• Arthur Andersen 3Enron4
– toc Analysts – optimistic research reports
– arbanes60xley Act
• $ighten the rules of corporate governance
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The I$+ete$t .r%e
• Asset allocation
– #hoice among broad asset classes
• ecurity selection – #hoice of !hich securities to hold within
asset class
– ecurity analysis to value securities anddetermine investment attractiveness
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Mar*et are Cpet#t#+e
• Ris6Return $rade60ff
• Efficient +arets – Active +anagement
• "inding mispriced securities
• $iming the maret
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Mar*et are Cpet#t#+e (Ct'-)
– *assive +anagement
• 7o attempt to find undervalued
securities
• 7o attempt to time the maret
• 8olding a highly diversified portfolio
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The .laer
• 9usiness "irms – net borro!ers
• 8ouseholds – net savers
• 2overnments – can be both borro!ers
and savers
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The .laer (Ct'-)
• "inancial /ntermediaries: *ool and invest
funds
– /nvestment #ompanies
– 9ans
– /nsurance companies
– #redit unions
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U$#+eral Ba$* A%t#+#t#e
Investment Banking• .nder!rite ne! stoc
and bond issues
• ell ne!ly issued
securities to public in theprimary maret
• /nvestors trade previously
issued securities among
themselves in thesecondary marets
Commercial Banking
• $ae deposits and
mae loans
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"#$a$%#al Cr## / 02
• Antecedents of the #risis:
– $he 2reat +oderation;: a time in !hich the
.&& had a stable economy !ith lo! interest
rates and a tame business cycle !ith onlymild recessions
– 8istoric boom in housing maret
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"#3!re 1-4 The Cae5Sh#ller I$'e& /U-S- 6!#$3 .r#%e
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Cha$3e #$ 6!#$3 "#$a$%e
Old Way
• Local thrift institution
made mortgage loans to
homeo!ners
• $hrift
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"#3!re 1-7 Cah "l8 #$ aMrt3a3e .a5Thr!3h Se%!r#t
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Cha$3e #$ 6!#$3 "#$a$%e(Ct'-)
• At first, "annie +ae and "reddie +acsecuriti>ed conforming mortgages, !hich!ere lo!er ris and properly documented&
• Later, private firms began securiti>ingnonconforming subprime; loans !ithhigher default ris&
– Little due diligence – *laced higher default ris on investors
– 2reater use of AR+s and piggybac; loans
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Mrt3a3e Der#+at#+e
• #ollaterali>ed debt obligations 3#D0s4
– +ortgage pool divided into slices or tranches
to concentrate default ris
– enior tranches: Lo!er ris, highest rating
– 5unior tranches: 8igh ris, lo! or =un rating
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Mrt3a3e Der#+at#+e
• *roblem: Ratings !ere !rong? Ris !as
much higher than anticipated, even for the
senior tranches
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9h 8a Cre'#t R#*U$'eret#ate':
• 7o one expected the entire housing
maret to collapse all at once
• 2eographic diversification did not
reduce ris as much as anticipated
• Agency problems !ith rating agencies
• #redit Default !aps 3#D4 did notreduce ris as anticipated
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Cre'#t De/a!lt S8ap (CDS)
• A #D is an insurance contract against
the default of the borro!er
• /nvestors bought sub6prime loans and
used #D to insure their safety
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Cre'#t De/a!lt S8ap (CDS)
• ome big s!ap issuers did not have
enough capital to bac their #D !hen
the maret collapsed&
• #onse(uence: #D0 insurance failed
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R#e / Ste#% R#*
• ystemic Ris: a potential breado!n of the
financial system in !hich problems in one
maret spill over and disrupt others&
– 0ne default may set off a chain of furtherdefaults
– 1aves of selling may occur in a do!n!ard
spiral as asset prices drop
– *otential contagion from institution to
institution, and from maret to maret
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R#e / Ste#% R#* (Ct'-)
• 9ans had a mismatch bet!een thematurity and li(uidity of their assets and
liabilities&
– Liabilities !ere short and li(uid – Assets !ere long and illi(uid
– #onstant need to refinance the asset portfolio
• 9ans !ere very highly levered, givingthem almost no margin of safety&
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R#e / Ste#% R#* (Ct'-)
• /nvestors relied too much on credit
enhancement; through structured
products lie #D
• #D traded mostly over the counter;,
so less transparent, no posted margin
re(uirements
• 0pa(ue linages bet!een financial
instruments and institutions
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The She Drp
• '@@@6'@@: harp increase in housing prices
caused many investors to believe that
continually rising home prices !ould bail out
poorly performing loans
• '@@B: /nterest rates began rising
• '@@: 8ome prices peaed
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The She Drp
• '@@C: 8ousing defaults and losses on
mortgage6baced securities surged
• '@@C: 9ear tearns announces trouble at
its subprime mortgage–related hedge
funds
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The She Drp
• '@@: $roubled firms include 9ear
tearns, "annie +ae, "reddie +ac, +errill
Lynch, Lehman 9rothers, and A/2
– +oney maret breas do!n
– #redit marets free>e up
– "ederal bailout to stabili>e financial system
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Ste#% R#* a$' the RealE%$
• Add li(uidity to reduce insolvency ris and
brea a vicious circle of valuation
riscounterparty risli(uidity ris
• /ncrease transparency of structured
products lie #D contracts
• #hange incentives to discourage
excessive ris6taing and to reduce
agency problems at rating agencies