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CHAPTER ONE

THE INVESTMENT ENVIRONMENT

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MBA 543 ON1

MINI-LECTURE NOTES

CHAPTER ONE: THE INVESTMENT ENVIRONMENT

CHAPTER OVERVIEW

You are introduced to the general concept of investingto forego spending cash today in the hopes ofincreasing wealth in the future. Real assets are differentiated from financial assets, and the major

categories of financial assets are defined. The risk/return tradeoff and the reality that most assets areefficiently priced most of the time are introduced. The role of financial intermediaries is discussed. The

chapter concludes with a presentation of the financial crisis of 2008, its causes and its implications.

LEARNING OBJECTIVES

After studying this chapter, you should have an understanding of the overall investment process and

understand some key elements involved in the investment process. You should understand differences infinancial and real assets and be able to identify the major components of the investment process. You

should be able to describe a derivative security and understand how it is used. Finally, you shouldunderstand the causes and effects of the financial crisis of 2008.

PRESENTATION OF CHAPTER MATERIAL (Th e textbook pr ovides more in -depth cover age)

1.1 Real Assets versus Financial Assets (PowerPoint Slide 1-2)

The main elements of the chapter are presented here. The concept of giving up current consumption to

invest in assets that allow greater consumption in the future is the key notion to start discussion of the

chapter material. The discussion of real and financial assets presents key differences in the assets andtheir appropriateness as investment vehicles.

1.2 Financial Assets (PowerPoint Slide 1-3 through 1-5)

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 areassociated with these securities. Common stock that features residual payments to the owners can becontrasted with the relatively certain debt claims. A derivative security is a security whose performanceis based on or tied to another asset or financial security. The discussion of derivative securities presentedhere is brief (more details later on) and used to highlight the discussion of innovation in our markets.

You may find interest in key elements of each derivative and how these elements relate the properties todebt and equity securities.

1.3 Financial Markets and the Economy (PowerPoint Slide 1-6 through 1-8)

Section 1.3 exposits the crucial role played by the markets in the economy. Markets encourage allocationof capital to firms that have the best prospects in the view of the market participants. Markets allow

participants to adjust consumption and to choose levels of risk that are appropriate. Financial markets

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CHAPTER ONE

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also allow for separation of management and ownership. Current issues related to corporate governanceand ethics issues are presented here.

1.4 The Investment Process (PowerPoint Slide 1-9)

Section 1.4 describes the major components of the investment process. Two of the major elements in theinvestment process, asset allocation and security selection, are central to the content and coverage in the

course. Understanding the concept of risk-return trade-off is important for the development of portfoliotheory and many other concepts developed in the course later on. The discussion of active and passivemanagement styles is related to the concept of market efficiency.

1.5 Markets are Competitive (PowerPoint Slide 1-10 through 1-11)

The two major elements of active management are security selection and timing. Material in laterchapters will emphasize more on elements of active management. On the other hand the essentialelement related to passive management is holding an efficient portfolio. Here, efficiency means not only

diversification, but also appropriate risk levels, cash flow characteristics and administration costs.

1.6 The Players (PowerPoint Slide 1-12 through 1-14)

The major participants in the financial markets are discussed here. Governments, households and

businesses can be issuers and investors in securities. Financial intermediaries include many groups whobring issuers and investors together. Investment bankers perform many specialized services for

businesses and operate in the primary market.

1.7 The Financial Crisis of 2008 (PowerPoint Slide 1-15 through 1-31)

Section 1.7 presents the Financial Crisis of 2008, with emphasis on its antecedents and its significance in

the future of the financial world. It begins with events leading up to the crisis and introduces theimportant Case-Shiller Index of U.S. housing prices (of which you should be familiar). The discussion

turns to the mechanics of the mortgage pass-through security (note that the generalized idea ofsecuritization is presented here as well). The cash flow for these securities is depicted graphically inFigure 1.4. The discussion then turns to the role government sponsored entities Fannie Mae and Freddie

Mac played in the crisis.

This section also introduces mortgage derivatives, focusing on collateralized debt obligations (CDOs) and

credit default swaps (CDS). This section ties these derivatives with the all important concept of systemicrisk (where problems in one financial sector spill over to other sectors). You will need to tie togetherseveral disparate concepts here for a better understanding of how this crisis occurred. (Note: it is naturalthat these derivatives and their impacts are not quite clear to you at this point, the begging of the course.)

This section then describes the sub-prime housing meltdown, the subsequent credit freeze and the impact

these events had on the real economy. The governments response is presented. There are significantimplications on the effectiveness of the various fiscal and monetary actions during this time.