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Essentials of Investments
Eleventh Edition
Bodie, Kane, and Marcus
Chapter 1
Investments: Background and
Issues
© 2019 McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom. No reproduction
or further distribution permitted without the prior written consent of McGraw-Hill Education.
1.1 Real versus Financial Assets
Nature of Investment: Reduce current consumption for
greater future consumption
Financial Assets:
Claims on Real Assets or Real Asset Income
• Property, plants and equipment, human capital, etc.
• Productive Capacity
• Real Assets
© 2019 McGraw-Hill Education.
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Table 1.1 Balance Sheet, U.S. Households, 2017
Note: Column sums may differ from total because of rounding error.
SOURCE: Flow of Funds Accounts of the United States, Board of Governors of
the Federal Reserve System, March 2017.
© 2019 McGraw-Hill Education.
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1.1 Financial Assets = Financial Liabilities
Financial Assets and Liabilities must balance.
•
Financial Assets (Owner of the claim)
•
Financial Liability (Issues of the Claim)
Aggregated balance sheets → only real assets remain
Domestic Net Worth = Sum of real assets
© 2019 McGraw-Hill Education.
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Table 1.2 Domestic Net Worth, 2017
Assets
$ Billion
Commercial real estate
$18,335
Residential real estate
33,061
Equipment and IP
8,449
Inventories
2,523
Consumer durables
5,418
TOTAL
$67,786
Note: Column sums may differ from total because of rounding error.
SOURCE: Flow of Funds Accounts of the United States, Board of
Governors of the Federal Reserve System, March 2017.
© 2019 McGraw-Hill Education.
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1.2 Financial Assets
Asset Classes
• Common Stock
•
•
Fixed Income Securities
•
•
Ownership stake in entity, residual cash flow
Money market instruments, Bonds, Preferred stock
Derivative Securities
•
Contract, value derived from underlying market
condition
© 2019 McGraw-Hill Education.
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1.3 Financial Markets and the Economy (1 of 7)
Informational Role of Financial Markets
• Capital flow to companies with best prospects
• Market Price = Fair Value?
Do markets allocate capital to best uses?
• Other mechanisms to allocate capital?
• Advantages/disadvantages of other systems?
© 2019 McGraw-Hill Education.
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1.3 Financial Markets and the Economy (2 of 7)
Consumption Timing
• Use securities to store wealth
• Transfer consumption to the future
Jump to long description
© 2019 McGraw-Hill Education.
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1.3 Financial Markets and the Economy (3 of 7)
Risk Allocation
•
•
Investors select desired risk level
•
Bond vs. stock
•
Bank CD vs. company bond
Is there always a Risk/Expected Return trade-off?
© 2019 McGraw-Hill Education.
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1.3 Financial Markets and the Economy (4 of 7)
Separation of Ownership and Management
Separation → Agency Problems
Mitigating Factors
•
Performance-based compensation
•
Boards of directors may fire managers
•
Threat of takeovers
© 2019 McGraw-Hill Education.
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1.3 Financial Markets and the Economy (5 of 7)
Corporate Governance and Corporate Ethics
• Businesses and markets require trust
•
•
No trust → additional costly laws and regulations
Governance and ethics failures cost the economy
•
Erodes public support and confidence
© 2019 McGraw-Hill Education.
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1.3 Financial Markets and the Economy (6 of 7)
Corporate Governance and Corporate Ethics
• Accounting scandals
•
•
Misleading research reports
•
•
Enron, WorldCom, Rite-Aid, HealthSouth, Global
Crossing, Qwest
Citicorp, Merrill Lynch, others
Auditors: Watchdogs or consultants?
•
Arthur Andersen and Enron
© 2019 McGraw-Hill Education.
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1.3 Financial Markets and the Economy (7 of 7)
Corporate Governance and Corporate Ethics
•
Sarbanes-Oxley Act:
•
Requires more independent directors on
•
CFO to personally verifies the financial statements
•
Oversight board for the accounting/audit industry
•
Charged board with maintaining a culture of high
ethical standards
© 2019 McGraw-Hill Education.
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1.4 The Investment Process: Asset Allocation
Asset Allocation
• Primary determinant of a portfolio’s return
• Percentage of fund in asset classes, for example:
• Top Down Investment Strategies starts with Asset
Allocation
© 2019 McGraw-Hill Education.
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1.4 The Investment Process: Security Selection
Security Selection
• Choice of particular securities within asset class
• Security Analysis
•
•
Analysis of the value of securities.
Bottom Up Investment Strategies starts with Security
Selection
© 2019 McGraw-Hill Education.
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1.5 Markets Are Competitive (1 of 4)
Risk-Return Trade-Off
• Assets with higher expected returns have higher risk
Stocks
Average Annual Return
Minimum (1931)
Maximum (1933)
About 12%
−46%
55%
• Stock portfolios lose money an average of 25%
• Bonds
• Lower average rates of return (under 6%)
• Not lost more than 13% of value in any one year
© 2019 McGraw-Hill Education.
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1.5 Markets Are Competitive (2 of 4)
Risk-Return Trade-Off
• How do we measure risk?
• How does diversification affect risk?
© 2019 McGraw-Hill Education.
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1.5 Markets Are Competitive (3 of 4)
In Efficient Markets Securities should
• be neither underpriced nor overpriced on average
• reflect all information available to investors
•
•
Your Belief in Market Efficiency
Choice of Investment-Management Style
© 2019 McGraw-Hill Education.
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1.5 Markets Are Competitive (4 of 4)
Active
Management
Passive
Management
Inefficient
Efficient
Security Selection:
Actively Seek
Undervalued
Stocks
No Attempt to
Find Undervalued
Securities
Asset Allocation
Market Timing
No Attempt to
Time Market
Markets are…
© 2019 McGraw-Hill Education.
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1.6 The Players (1 of 6)
Business Firms (net borrowers)
Households (net savers)
Governments (can be both borrowers and savers)
Financial Intermediaries (connectors of borrowers and
lenders)
• Commercial banks
• Investment companies
• Insurance companies
• Pension funds
• Hedge funds
© 2019 McGraw-Hill Education.
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1.6 The Players (2 of 6)
Roll of Government?
Roll of Intermediaries?
Jump to long description
© 2019 McGraw-Hill Education.
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1.6 The Players (3 of 6)
Investment Bankers
• Specialize in primary market transactions
• Primary market
•
•
•
Newly issued securities offered to public
Investment banker “underwrites” issue
Secondary market
•
Preexisting securities traded among investors
© 2019 McGraw-Hill Education.
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1.6 The Players (4 of 6)
Investment Bankers
• Separate from commercial banks’ functions by law
(1933-1999)
•
Post-1999: Large commercial banks increased
investment-banking activities, pressuring investment
banks’ profit margins
•
September 2008: Mortgage-market collapse
•
Major investment banks bankrupt;
purchased/reorganized
© 2019 McGraw-Hill Education.
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1.6 The Players (5 of 6)
Investment Bankers
•
•
Investment banks may become commercial banks
•
Obtain deposit funding
•
Have access to government assistance
Major banks now under stricter regulations
© 2019 McGraw-Hill Education.
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Table 1.3 Balance Sheet of Commercial Banks,
2017
Note: Column sums may differ from total because of rounding error.
SOURCE: Federal Deposit Insurance Corporation, www.fdic.gov, March 2017.
© 2019 McGraw-Hill Education.
1-25
Table 1.4 Balance Sheet of Nonfinancial U.S.
Business, 2017
Note: Column sums may differ from total because of rounding error.
SOURCE: Flow of Funds Accounts of the United States, Board of Governors
of the Federal Reserve System, March, 2017.
© 2019 McGraw-Hill Education.
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1.6 The Players (6 of 6)
Venture Capital and Private Equity
•
Venture capital
•
•
Equity Investment to finance new firm
Private equity
•
Investments in privately-held companies
© 2019 McGraw-Hill Education.
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1.7 The Financial Crisis of 2008 (1 of 6)
Changes in Housing Finance
Old Way
• Local thrift institution
made mortgage loans to
homeowners
• Thrift’s possessed a
portfolio of long-term
mortgage loans
• Thrift’s main liability:
Deposits
New Way
• Securitization: Fannie Mae
and Freddie Mac bought
mortgage loans and
bundled them into large
pools
• Mortgage-backed securities
are tradable claims against
the underlying mortgage
pool
•
•
“Originate to hold”
“Originate to distribute”
© 2019 McGraw-Hill Education.
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1.7 Changes in Housing Finance (1 of 2)
Securitization:
FIGURE 1.4
Cash flows in a mortgage pass-through security
Jump to long description
© 2019 McGraw-Hill Education.
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1.7 Changes in Housing Finance (2 of 2)
Inclusion of nonconforming “subprime” loans
Low/No-documentation loans
Rising loan-to-value ratio
Adjustable-Rate Mortgages
© 2019 McGraw-Hill Education.
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Figure 1.3 Case-Shiller Index of U.S. Housing
Prices
© 2019 McGraw-Hill Education.
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1.7 The Financial Crisis of 2008 (2 of 6)
Mortgage Derivatives
•
CDOs: Consolidated default risk of loans onto one
class of investor, divided payment into tranches
•
Ratings agencies paid by issuers; pressured to give
high ratings
© 2019 McGraw-Hill Education.
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1.7 The Financial Crisis of 2008 (3 of 6)
Credit Default Swaps
•
Insurance contract against the default of borrowers
•
Issuers ramped up risk to unsupportable levels
•
AIG sold $400 billion in CDS contracts
© 2019 McGraw-Hill Education.
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1.7 The Financial Crisis of 2008 (4 of 6)
Systemic Risk
•
Risk of breakdown in financial system — spillover
effects from one market into others
•
Banks highly leveraged; assets less liquid
•
Formal exchange trading replaced by over-thecounter markets — no margin for insolvency
protection
© 2019 McGraw-Hill Education.
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1.7 The Financial Crisis of 2008 (5 of 6)
The Shoe Drops
•
September 7: Fannie Mae and Freddie Mac put into
conservatorship
•
Lehman Brothers and Merrill Lynch verged on
bankruptcy
•
September 17: Government lends $85 billion to AIG
•
Money market panic freezes short-term financing
market
© 2019 McGraw-Hill Education.
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Figure 1.1 LIBOR, T-Bill Rates and the TED
Spread
Jump to long description
© 2019 McGraw-Hill Education.
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1.7 The Financial Crisis of 2008 (6 of 6)
Dodd-Frank Reform Act
•
Stricter rules for bank capital, liquidity, risk
management
•
Mandated increased transparency
•
Clarified regulatory system
•
Volcker Rule
© 2019 McGraw-Hill Education.
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Figure 1.2 Cumulative Returns
Cumulative returns on a $1 investment in the S&P 500
index
Jump to long description
© 2019 McGraw-Hill Education.
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1.8 Text Outline
Part One: Introduction to Financial Markets, Securities,
and Trading Methods
Part Two: Modern Portfolio Theory
Part Three: Debt Securities
Part Four: Equity Security Analysis
Part Five: Derivative Markets
Part Six: Active Investment Management Strategies
© 2019 McGraw-Hill Education.
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Appendix of Image Long Descriptions
@2019 McGraw Hill Education.
© 2019 McGraw-Hill Education.
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1.3 Financial Markets and the Economy (2 of 7)
Long Description
A straight horizontal line representing consumption extends
midway point on the graph. A bell-shaped curve for income
is shown and where it starts and ends, below the
consumption line, is labeled Dissavings. Savings is above
the consumption line.
Jump to image
© 2019 McGraw-Hill Education.
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1.6 The Players (2 of 6) Long Description
Upward sloping diagonal line represents who supplies
capital, or households. Downward sloping diagonal line
represents what demands capital, or firms.
Jump to image
© 2019 McGraw-Hill Education.
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Figure 1.1 LIBOR, T-Bill Rates and the TED
Spread Long Description
Percent is on the vertical axis, and the years 2000 to 2018, marked for
January of each year, are on the horizontal axis. TED spread begins at 0.05
percent and trends between 0.05 percent and 1 percent until going into
January 2008. Between roughly July 2007 and January 2008, it trends
between 1 percent and 2 percent. At January 2009, it spikes to 3.5 percent,
dropping to almost zero by January 2010. It trends under 0.05 percent for the
remainder of the period. The 3-month T-Bill start at 5.5 percent, spikes to 6
percent at January 2001, and then drops to 1 percent around July 2003. It
then climbs to 5 percent in January 2006 and trends there until roughly July
2007, where it drops to 1.25 percent in January 2008 and zero in January
2009. It trends between 0 percent and 0.25 percent for the remainder of the
period. The 3-month LIBOR trends with the 3-month T-Bill, but half a percent
higher over the period. All values are approximations.
Jump to image
© 2019 McGraw-Hill Education.
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Figure 1.2 Cumulative Returns Long Description
Cumulative Value of a $1 Investment is on the vertical axis
and the years 1980 to 2018 are on the horizontal axis. The
S and P index climbs from 1 in 1980 to 30 by 2000, drops
to 20 in 2003, up to 30 again in late 2007, dropping to 15 in
2009, and then climbing steadily to end at 50 in 2016. All
values are approximations.
Jump to image
© 2019 McGraw-Hill Education.
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FIGURE 1.4 Case flows in a mortgage
pass-through security Long Description
Four rectangles are arrayed horizontally and labeled, left to
right: homeowner, originator, agency, and investor. Under the
boxes, arrows indicate a left to right flow: principle and interest
(P and I) to P and I minus servicing fee to P and I minus
servicing minus guarantee fee. Above the boxes, arrows
indicate a right to left flow of $100,000 between each box.
Jump to image
© 2019 McGraw-Hill Education.
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Essentials of Investments
Eleventh Edition
Bodie, Kane, and Marcus
Chapter 2
Asset Classes and Financial Instruments
© 2019 McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom. No reproduction
or further distribution permitted without the prior written consent of McGraw-Hill Education.
2.1 Asset Classes
Asset Classes
• Fixed Income
• Equity
• Derivatives
© 2019 McGraw-Hill Education.
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2.1 Fixed Income: Money Markets
Asset Classes
• Fixed Income
•
•
•
•
Money Markets
Capital Markets
Equity
Derivatives
© 2019 McGraw-Hill Education.
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2.1 The Money Market
Subsector of the fixed-income market
• Short-term
• Liquid
• Low risk
• Often have large denominations
© 2019 McGraw-Hill Education.
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2.1 The Money Market: Treasury Bills (1 of 3)
Treasury Bills
Issuer: Federal Government
Denomination: Commonly $10,000; $1,000
Maturity: 4, 13, 26 or 52 Weeks
Liquidity: High
Default Risk: None
Interest Type: Discount
Taxation: Owed: Federal; Exempt: State, Local
© 2019 McGraw-Hill Education.
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2.1 The Money Market: Treasury Bills (2 of 3)
FIGURE 2.1 Treasury bill listings
Source: Wall Street Journal Online, April 18, 2017.
DAYS TO
MATURITY
BID
ASKED
CHG
ASKED
YIELD
June 8, 2017
51
0.730
0.720
unch.
0.731
August 17, 2017
121
0.793
0.783
−0.010
0.795
October 12, 2017
177
0.905
0.895
−0.028
0.911
December 7, 2017
233
0.928
0.918
−0.023
0.936
March 29, 2018
345
0.988
0.978
−0.020
1.000
MATURITY
© 2019 McGraw-Hill Education.
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2.1 The Money Market: Treasury Bills (3 of 3)
Bank Discount Rate (T-bill quotes)
$10,000 − P 360
rBD =
×
$10,000 = Par
$10,000
n
rBD = bank discount rate
P = market priceof the T – bill
n = number of days tomaturity
Example: 90-day T-bill, P = $9,875
$10,000 − $9,875 360
rBD =
×
= 5%
$10,000
90
© 2019 McGraw-Hill Education.
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2.1 The Money Market: Certificates of Deposit
(CDs)
Certificates of Deposit
Issuer: Depository Institutions
Denomination: Any, $100,000 or more marketable
Maturity: Varies, Typically 14-day Minimum
Liquidity: High for CDs
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