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Objectives

• A. Understand Investments• B. Understand differences between

financial and real assets in the economy• C. Understand types of financial markets

and trends in those markets• D. Understand the Investment Process

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BM410 – 3 Investments

• Issues in the Industry, Interships, and

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A. Understand Investments

• What is an Investment?• Current commitment of money or other

resources in the expectation of reaping future benefits.

• What is Sacrifice?• Current commitment of money or other

resources in the expectation of reaping future benefits.

• Is there a difference?• Interestingly, in the church we interchange

the two.

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Investments (continued)

• Are there priorities of Investments?• What are your most important investments?

• Your family and your testimony

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My Most Important Investments

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Investments (continued)

• What are your other key investments?• Education and Skills• Knowledge and Friendships• Food Storage and Emergency Funds• Real and Financial Investments

• Do not be too narrow in your view of investments

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Investments (continued)

• What investments will we be working with in this class?

• Generally financial investments:

• Stocks (equities), bonds, options, futures, etc, (with reference to other important investments as well)

• Will the analysis skills we will be learning be useful for other investments as well?

• Yes, they can be used in analyzing any type of investment, whether it’s a dental or medical office practice, a small business, a department of a larger business, or even a home.

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Questions?

• Do we understand investments?

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B. Understand the Differences between Financial and Real Assets

• What determines the wealth of a society?• The wealth of a society is determined by the

productive capacity of the economy

• The productive capacity is a function of the “real or productive assets” in the economy

• What are Real Assets?• Assets used to produce goods and services, e.g.,

land, machines, buildings, and knowledge• What are Financial Assets?

• Claims on real assets which define ownership of income streams, e.g., stocks, bonds, warrants, etc.

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Financial and Real Assets (continued)

• What are the three purposes of financial assets?• 1. Consumption timing

• Shift consumption to the most optimal time period

• 2. Allocation of Risk

• Shift risk to those most willing to bear it (at the expectation of higher return)

• 3. Separation of Ownership and Management• Separates functions and allows for large firms to

be managed professionally (hopefully)

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Questions

• Do you understand the difference between real and financial assets?

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Question 1-1

• Suppose you discover a treasure chest of $10 billion in cash.

• A. Is this a real or financial asset?• B. Is society any richer for the discovery?• C. Are you wealthier?• D. Can you reconcile your answers to (b)

and (c)? Is anyone worse off as a result?

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Answer 1-1

• A. Cash is a financial asset because it is a liability of the government.

• B. No. The cash does not directly add to the productive capacity of the economy.

• C. Yes.• D. Society as a whole is worse off, since

taxpayers as a whole will have to make up for the liability that you found, and before you found it they would not have had to make up for the liability

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D. Types of Financial Markets and Trends in those markets

What are the major types of financial market?• 1. Direct Search Markets

• Buyers/sellers seek each other out• Example: Classified ads

• 2. Brokered Markets• Brokers offer search services

• Example: Primary market, large block trades

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Types of Financial Markets (continued)

• 3. Dealer Markets• Dealers specialize in specific assets

• Example: OTC• 4. Auction Markets

• Traders converge on a single place• Example: NYSE

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Trends in Financial Markets

What are the major trends in financial markets? 1. Globalization 2. Securitization 3. Financial Engineering 4. Computer Networks (Technology and

delivery of service) The Future?

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Trends (continued)

1. Globalization Why is this trend coming about?

• International and Global Markets continue developing to meet the needs of global investors

• Managing foreign exchange is becoming critical to managing returns

• Diversification is becoming more important

• Instruments and vehicles continue to develop to meet the global needs of investors/businesses

• Information and analysis continues to improve• Examples: ADRs, WEBs, the Euro

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Trends (continued)

2. Securitization and Credit Enhancement Why is this trend coming about?

It offers more and better opportunities for investors and originators of loans

• It requires changes in financial institutions and regulation

• It seeks improvement in information capabilities and requirements

• It encourages credit enhancement and its role in capital formation

• Examples: GNMA, securitization of car loans, credit card loans, and home equity loans

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Trends (continued)

3. Financial Engineering Why is this trend coming about?

It allows repackaging of services of financial intermediaries to meet a specific need or objective

• It encourages bundling and unbundling of cash flows to meet investor needs for cash flow timing

• It provides new profit opportunities for those with the expertise to fill the needs

• Examples: strips, CMOs, dual purpose funds, principal/interest splits

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Trends (continued)

4. Computer Networks, i.e., Technology and Delivery of ServiceWhy is this trend coming about?

• Computer advancements reduce costs

• More complete and timely information is available (and needed)

• Competition is increasing as domestic firms compete globally and global firms compete in the US

• Trading hours have widened to meet investor needs

• Examples: online trading, internet, ECNs

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Trends (continued)

What will happen in the future? These trends are expected to continue

• Globalization continues and offers more opportunities for all who are prepared

• Securitization continues to develop, and increases dramatically in the Emerging Markets (less developed countries)

• Development of derivatives and exotics will continue to meet investor needs

• Technology will continue to develop and improve

• Greater integration of investments & corporate finance will lead to greater need for good analysts

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Questions?

• Do you understand the main financial markets and trends?

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Problem 1-7

• Why would you expect securitization to take place only in highly developed capital markets and countries, and not yet in many emerging markets such as Russia, Iran, and Pakistan?

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Answer 1-7

• Securitization requires access to a large number of potential investors. To attract them the capital market needs:

• A safe system of business laws and low probability of confiscatory taxation/regulation

• A well developed investment banking industry• A well developed system of brokerage and financial

transactions• A well developed media, particularly financial

reporting• These functions are found in and need a well developed

capital market.

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D. Understand the Investment Process

• Define the investment process?• The process by which decisions are made relating to

all aspects of investment including planning, analysis, implementation, and review

• It’s a process of determining your current financial state, your objectives, constraints, policy, investing, and then monitoring your investments with the intent of reaching your specific goals

• It is not as simple as it seems• There’s a whole industry set up to help you establish

a framework• Association for Investment Management and

Research (which sponsors the CFA program)

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The Investment Process (continued)

• What are the four major steps to the investment process?

• 1. Specifying Objectives• 2. Specifying Constraints• 3. Formulating Policies• 4. Monitoring and Updating the Portfolio

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Questions?

• Do we understand the investment process?

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Problem 1-13

• What are some advantages and disadvantages of top-down versus bottom-up investing styles?

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Answer 1-13

• Top Down• Under top-down investment strategy, you

focus on the asset allocation or broad composition of the entire portfolio, which is the greatest determinant of your performance. It is also a natural way to establish a portfolio with a risk level appropriate for you. The disadvantage is that you could give up potential high returns from individual securities that may be attractive.

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Answer 1-13

• Bottom Up• Under bottom-up investing, you try to

benefit from finding undervalued securities. The disadvantage is that you tend to overlook the overall composition of your portfolio, which may result in a non-diversified portfolio. It also tends to require more active management, hence higher costs.

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Review of Objectives

• Do you feel comfortable with:• A. Investments?• B. The differences in financial and real

assets in the economy?• C. The types of financial markets and trends

in those markets?• D. The Investment Process?