Transcript I_Ch01x

CHAPTER 1
Investments - Background
and Issues
The Goals of Chapter 1
This chapter takes an overview of what we will
learn in the text book
– Define an investment (投資)
– Investment targets: financial or real assets (金融資
產或實質資產)
– Introduce different classes of financial assets (Ch 2
and Parts 3, 4, and 5)
– Discuss the roles of financial markets (Ch 3)
– Something about corporate governance (公司治理)
– Introduce the investment process
– Risk-return trade-off and efficient markets (Part 2)
– Know players in financial markets (Ch 4)
– Financial crisis in 2008
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1.1 REAL ASSETS VERSUS
FINANCIAL ASSETS
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Financial Versus Real Assets
Real Assets (tangible (有形) or intangible (無形))
– Assets used to produce goods and services, e.g., land,
buildings, equipment, knowledge, or patents
– Can generate net income to the economy
Financial Assets
– Claims (所有權) on real assets or the income
generated by them, e.g., equity shares or debt of firms
Essence of investment
– Sacrifice something of value now, invest in real assets
or financial assets, and expect to benefit from that
sacrifice later
– The investment decision of individual investors is
associated with smoothing consumption
Invest in good time periods, and realize investments when
you need more consumption
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Balance Sheet (資產負債表) of U.S. Households 2014
※ The largest parts of assets and liabilities both come from the house owned
※ The position of deposits is usually maintained for liquidity of consumption
※ Pension reserves (退休準備) is the money or assets invested for future retired life
※ Equity in noncorporate business may come from the investment in sole
proprietorship (獨資) or partnership companies (合夥)
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Financial Versus Real Assets
Net wealth of the economy
– Banks account, corporate stock, or corporate
bonds are not only financial assets of households
but also the liabilities of the issuers
Banks use the proceeds of deposits to lend to firms or
households or to buy some financial asset issued by
firms
Firms issue financial assets (e.g., corporate stock or
bonds) to pay for the acquirement of real assets
– By aggregating balance sheets over all
households, firms, and banks, those financial
claims cancel out, leaving only real assets as the
net wealth of the economy
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Domestic Net Worth in the U.S. 2014
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1.2 A CLASSIFICATION OF FINANCIAL
ASSETS
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Major Classes of Financial Assets
Debt (fixed income securities) (part 3)
– Money market instruments (貨幣市場工具) (shorter
term, lower risk), e.g., Treasury bills (國庫券)
– Capital market instruments (資本市場工具) (longer
term, higher risk), e.g., Treasury or Corporate Bonds
(政府公債或公司債)
Equity (ownership share of a firm) (part 4)
– Shareholders may receive dividends (股利) and have
prorated ownership in the real assets of the firm
Derivative securities (part 5)
– Futures (期貨): an agreement (with both right and
obligation) to buy or sell an asset at a certain time
point in the future for an agreed price
– Options (選擇權): a right to buy or sell an asset at a
certain time point in the future for a specified price
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1.3 FINANCIAL MARKETS AND
THE ECONOMY
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Financial Markets
Provide price information
– Market prices reflect the consensus (共識) of
investing public (投資大眾)
– When market prices are determined, capital
resources are allocated (分配) efficiently
For firms with good (poor) prospects, the stock market
encourages (discourage) allocation of capital to those
firms, whose share prices are bidden up (down)
Shift consumption timing for individual investors
– Shift your purchasing power from high-earnings
periods to low-earnings periods of life
– The ultimate goal of investment for individual
investors is to smooth their consumption over
lifetime
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Financial Markets
Allocate risk (分配風險)
– Firms can transfer the project risk to investors who
buy stock shares or bonds issued by the firms
– Allow investors with the greatest taste for risk to
bear that risk
Stock shares for more risk-tolerant investors
Bonds for more conservative investors
– Another benefit for firms
When investors are able to select security types with the
risk-return characteristics that best fit their preference
from the financial markets, each security can be sold at
the best possible price
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Financial Markets
Separate ownership with management
– The invention of stock shares and stock markets
allows the separation of ownership and
management
– Meanwhile, shareholders elect a board of directors
(董事會) to supervise the management of the firm
– Advantages for this arrangement
Firms’ existence or performance is independent of the
status of their shareholders
Can hire professional managers to operate the firm
Shareholders can sell shares to others in financial
markets without affecting the management
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Financial Markets
– Agency problems (代理人問題): Conflicts of
interest between managers and stockholders
Empire building, avoid risky projects, or overconsume
luxuries
– All these suboptimal decisions hurt the interests of
shareholders
Solutions:
– Performance-based compensation plans (link the
manager’s income with the performance of the stock price)
– Penalty for the poor performance in stock price (force out
or fire the manager)
– Specialist monitoring (analysts, fund managers, or banks)
– Takeover (併購) by other firms (replace the poorperforming managers to enhance the value of the firm)
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Corporate Governance and Ethics
What is corporate governance (公司治理)?
– Corporate governance is the set of processes,
policies, or institutional systems affecting how a
corporation is directed, administered, or controlled
– It is associated with the interests among all the
stakeholders (利害關係人) in a company, including
shareholders, debtholders, and managers
Corporate governance arises from the
information asymmetry among stakeholders
– Without trust among stakeholders, additional laws
and regulations are required
They are in general designed to protect the investing public,
who possess less information and control power for firms
They can build the confidence of the investing public, which
is the essential pillar to support financial markets
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Corporate Governance and Ethics
Good corporate governance does matter:
McKinsey surveyed more than 200 institutional
investors as to the value they place on good
governance
※ The premium as the percentage of the stock price that institutional investors
would like to pay for companies with good governance in different countries
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Poor Corporate Governance
Accounting scandals (會計醜聞) (Enron,
WorldCom, Rite-Aid, HealthSouth, etc.)
– Enron in 2001
In late 2001, Enron was one of the world's leading
electricity, natural gas, communications and pulp and
paper companies, with claimed revenues of nearly $101
billion in 2000
Using special purpose entities (SPEs) (also known as
special purpose vehicle (SPV)) to hide debt which should
be in its own books (by selling non-performing assets to
SPEs)
– WorldCom in 2002
The U.S. second largest long distance phone company
(after AT&T)
Classify expenses as investments to enhance net income
or even hide losses
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Poor Corporate Governance
Misleading research reports by stock analysts
(Citibank, Merrill Lynch, etc.)
– Instead of providing fair reports, their favorable
reports are traded for the promise of future
investment banking business for the firm, e.g.,
participating the allocation of public offerings (公
開募資)
Auditors (查帳員): watchdogs or consultants
– Example of Arthur Andersen (AA) in Enron case:
due to the fact that the profit from consulting is
higher than that from auditing, AA, in order to
protect its consulting profits, had to weak its
function of auditing
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Reform of Corporate Governance
Sarbanes-Oxley Act in 2002 (tightening the
rules of corporate governance in the U.S.)
– More independent directors (獨立董監事) are
required in boards of directors
– CFOs (財務長) need to personally vouch for the
truth of corporate accounting statements
– A new quasi-public agency, Public Company
Accounting Oversight Board, is created to monitor
the accounting/auditing industry
– Prohibit auditors from providing various other
services to clients
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1.4 THE INVESTMENT PROCESS
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Investment Philosophies and Strategies
Asset allocation (資產配置)
– Choice among a broad classes of assets
– Decide the weight of various classes of assets
1. According to your return-risk preference (報酬風險偏好)
2. According to the portfolio theory: to construct a welldiversified (充分分散) portfolio to generate the desired
expected return but bear lower degree of risk (taking
the correlation into account)
Top down strategy (由上而下策略)
– The investment portfolio is constructed starting
with asset allocation
– For example, deposits vs. securities, stocks vs.
bonds, automobile industry vs. electronic industry,
Treasury bills vs. Treasury bonds, and so on
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Investment Philosophies and Strategies
Security selection (證券選擇)
– Perform the security analysis to evaluate
securities and find over- or under-valued ones
Bottom up strategy (由下而上策略)
– Find securities with over- or under-estimated
prices but ignore the resulting asset allocation
– In an efficient market (效率市場)
Price distortions exist for a short time period because
many investors try to benefit from selling overvalued
and buying undervalued securities
Theoretically, there are almost no distorted-price
securities and the bottom up strategy is difficult to make
profit
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1.5 MARKETS ARE COMPETITIVE
AND RISK-RETURN TRADE-OFF
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Financial Markets are Competitive
The performance in financial markets is
determined only by gains or losses in money
– This unique characteristic causes that the only
criteria for selecting securities are high expected
returns and low riskiness
– The pursuance for those securities makes financial
markets extremely competitive
Another source of competition:
– Many well-trained or knowledgeable investors
constantly survey the financial market for the best
buys (the most underpriced securities)
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Risk-Return Trade-Off (風險報酬抉擇)
Assets with higher expected returns have
greater risk (risk-return trade-off)
– The consequence of market competition
– If investors continuously buy the high-return-lowrisk assets, their prices will rise and the expected
returns (=profit/price) are lowered until the expected
returns are commensurate (相稱的) with risk
– As a result, if you want higher expected returns,
you need to bear higher investment risks
Stocks: high average annual return (12%) and high
degree of risk (min: –46% and max: 55% for one year)
Bonds: low average annual return (<6%) and low degree
of risk (never lose more than 13% in any one year)
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Risk-Return Trade-Off (風險報酬抉擇)
What role does diversification (分散投資) play
– Diversification means reducing risk by investing in
a variety of assets
– Diversification can reduce the risk of the portfolio
without hurting the expected return of the portfolio
– The effect of portfolio diversification, the proper
measurement of risk, and the risk-return
relationship are the topics in modern portfolio
theory and will be mentioned in Part 2
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Efficient Markets Theory
In an efficient market (效率市場), security
price should reflect all information available to
investors concerning the value of the security
– A market can be further classified as weak-form,
semistrong-form, and strong-form efficient market
(弱式、半強式、強式效率市場) (discussed in
Chapter 8)
– The price of the security in an efficient market
adjusts quickly to reflect the new information, i.e.,
there would be neither underpriced nor
overpriced securities in an efficient market
theoretically (discussed in Chapter 8)
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Active Versus Passive Management
Whether we believe markets are efficient affects
our choice of appropriate investment
management style
– Active management (主動管理) (in inefficient
markets)
Find undervalued securities by fundamental analysis
Market timing strategy: to develop strategies based on the
prediction of future market movement by technical analysis
– Passive management (被動管理) (in efficient
markets)
No attempt to find distorted-price securities
No attempt to time the market
Holding a well-diversified portfolio
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1.6 THE PLAYERS
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The Players
Five major players in the financial markets
– Business firms (公司) – net borrowers (raising
funds by issuing stocks or bonds)
– Households (家戶) – net savers
– Government (政府) – can be either net borrower
or net saver (depending on tax revenue and
government expenditures)
tax revenue > government expenditures  net saver
tax revenue < government expenditures  issuing
Treasury bonds to raise money  net borrower
– Financial institutions and financial intermediaries (金
融機構與金融中介機構)
– Investment banks (投資銀行)
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The Players
Financial institutions and financial intermediaries
– They both are institutions that “connect” borrowers
and lenders by accepting funds from lenders and
loaning funds to borrowers
– Their social function is to channel household savings
to business sectors
– For financial institutions (e.g., commercial and
investment banks, insurance companies), they can
make profit by taking risk and providing service
The next two slides show significant differences between the
balance sheets of nonfinancial business and financial institutions
– For financial intermediaries (e.g., investment
companies, mutual funds, pension funds, hedge
funds), they only provide service and thus earn fees
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Balance Sheet of Nonfinancial U.S.
Business Firms
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Balance Sheet of Commercial Banks (商業銀行)
※ Financial institutions earn interest rate spread at the expense of suffering
default risk (違約風險) of business firms
※ Financial institutions are usually with a high percentage level of liability, which
can increase the profitability for shareholders substantially
※ The risk for financial institutions is high, so they need rigorous risk
management systems
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The Players
– The reason for the existence of financial institutions
or intermediaries
1. It is comparatively inefficient for the small-size
households to make direct investment
– Higher transaction cost
– No economic scale (經濟規模) to manage portfolios or survey
markets
– Difficult to achieve diversification for small-size portfolios
2. For households (net savers), it is also difficult to find
borrowers by themselves
3. An individual lender is not equipped with the ability to
estimate and monitor the default risk (違約風險) of
borrowers
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The Players
– Advantages of the roles of financial institutions or
intermediaries
1. Pool sources of small investors and lend considerable
amount to firms or conduct large-scale trading
2. By lending to many borrowers to achieve the
diversification and reduce the risk they bear
3. Due to economies of scale, financial institutions and
intermediaries can build expertise to manage portfolios or
to estimate and monitor risk
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The Players
Investment banks (投資銀行) (introduced in Ch. 3)
– Financial institutions specializing in the sale of new
securities to the public, typically by underwriting (承
銷) the issue
– Firms do not directly market their securities to the
public. Instead, they hire investment bankers to
represent them to the investing public
– Primary market (初級市場): a market in which new
issues of securities are offered to the public
Players: business firms, investment bankers, and
institutional or individual investors
– Secondary market (次級市場): previously issued
securities are traded among investors
Players: institutional and individual investors
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The Players
– Commercial and investment banks’ functions were
separated by laws in the U.S. from 1933 to 1999
Glass-Steagall Act in 1933: Prohibited banks from both
accepting retail deposits (零售存款) and underwriting
securities (承銷證券)
– Commercial banks accept deposits
– Investment banks neither accept deposits nor undertake the
business of retail loans (零售貸款)
– Investment banks raise funds through issuing corporate bonds
(公司債) or borrowing money from other financial institutions
Gramm-Leach-Bliley Act (Financial Services Modernization
Act) in 1999: allowed commercial banks, investment banks,
securities firms, and insurance companies to consolidate to
form financial holding companies (金控公司)
– Large investment banks still operated independently from
commercial banks, but many large commercial banks
increased their investment banking activities, pressuring profit
margins of traditional investment banks
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The Players
Money invested to finance a new firm is called
venture capital (創投)
– A start-up company relies on bank loans and
investors who are willing to stake (押注) on the
future of this small and young companies
Note that smaller and younger companies do not have
options to issue publicly-traded securities for raising funds
– Two sources of venture capital: venture capital
funds (創投基金) or wealthy individuals known as
angel investors (天使投資人)
– Venture capital funds and angel investors usually
engage in the operation of the invested company,
e.g., help to recruit managers or provides business
advice
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The Players
– In practice, there are a lot of fails for venture capital
investments, but a successful case can bring million
profits
– These investments in firms that do not trade on
public stock exchanges are known as private equity
investment (私募股權投資)
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1.7 Financial Crisis in 2008
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Securitization (證券化)
Pooling loans and backed by those loans,
issue standardized securities, which can then
be traded like any other security
– Payments from borrowers of loans will pass to
holders of securitization securities, rather than the
initiating bank (發起銀行)
Holders of securitization securities can earn the average
lending rate minus the fee paid to the initiating bank
– Note that the ownership of loans and the default
risk of borrowers are also transferred to holders of
securitization securities
– Instead of selling securitization securities to other
investors, initiating banks sometimes purchase part
of securitization securities back for themselves
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Securitization (證券化)
Increase the liquidity (流動性) of the asset of the bank by
replacing the illiquid loan assets with liquid securitization
securities
Securitization securities vs. original loans
Securitization securities
Original loans
Small, standard size
Large, nonstandard size
Credit risk (信用風險) is transferred to
holders of the securitization securities
 Holders of the securitization securities
can earn the lending rate
The bank which lends the loan bears the
credit risk
 The bank can earn the spread between
the lending and deposit rates
Predicted default rates for portfolios of
loans (due to the diversification effect)
 Perceivable degree of the credit risk for
holders of securitization securities
Uncertain default rate for each loan
 Potential investors cannot estimate
accurately the credit risk they bear
Liquid assets: tradable in public markets
Illiquid assets: almost impossible to resale
the loan assets to others (The moral
hazard (道德風險) problem is also a major
reason for the illiquidity)
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Outstanding amount (在外流通餘額) of Assetbacked Securities (ABS, 資產擔保證券)
※ Securitization has grown rapidly
due to
• Turning illiquid loan assets into
a liquid and saleable asset
• Changes in financial regulation
permitting its growth,
particularly lower capital
requirements on securitization
securities
• The development of credit
enhancement techniques, e.g.,
over collateralization (超額抵
押), which can increases
prices and marketability of
ABSs
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Mortgage-Backed Securities
– Mortgage Loan (不動產抵押借款) and MortgageBacked Security (MBS, 不動產抵押擔保證券)
A mortgage loan (不動產抵押借款) is a loan with the real
properties (房地產) as the collateral (抵押品)
A MBS, which is the security generated from the
securitization process, represents the ownership of a pool
of mortgages loans
– In 1970s, Fannie Mae (FNMA) and Freddie Mac (FHLMC)
guarantee the timely payment of principal and interest (即時
償付本息) even if the borrowers default and then issue
MBSs based on portfolios of these loans
– The simplest type of the mortgage-backed securities is the
pass-through (過手) MBSs
The intermediaries (banks and FNMA or FHLMC) collects the
monthly payments from the household borrower, and after
deducting a fee, passes the cash flows through to the holders
of the pass-through security
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Financial Crisis in 2008
Traditionally all MBSs were based on conforming mortgage
loans (符合條件不動產抵押債款) , but since 2006, Alt-A
and subprime mortgage loans (次級不動產抵押債款) were
included in pools
– A-prime mortgages are conforming or conventional loans,
meaning it would meet the guarantee requirement and can
be resale to government-sponsored institutions (like FNMA
and FHLMC)
– The Alt-A loans are still with low risk, but for some reasons
are not initially conforming, e.g., the size is too large or the
required documents are not complete
– Subprime mortgage loans reflect borrowers who do not meet
the underwriting criteria (e.g., loans above 80% of house
value or the income of the borrower is not stable) and have a
high perceived risk of default
(Note that subprime mortgage loans are commonly arranged
as adjustable-rate mortgages (ARM) (浮動利率房貸))
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Financial Crisis in 2008
The reasons for the growth of the subprime mortgage loans
– The growing house prices
– The low interest rate to aid the U.S. economy in its recovery
from the 2000-2001 recession reduces the overall interest rate
paid by the subprime borrowers
– Political encouragement to spur affordable housing led to
increase in subprime lending
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Financial Crisis in 2008
Subprime crisis (次貸危機):
– Financial institutions assumed housing prices would
continue to rise, but they began to fall rapidly since the
middle of 2006
– The interest rate rises from 2004 to 2007, which increases
the payment burden of subprime borrowers
– Consequently, MBSs backed with subprime mortgage loans,
widely held by financial institutions, lost most of their value
– The result has been a large loss in the capital of many banks
worldwide and U.S. government sponsored institutions (like
FNMA and FHLMC)
※Note that MBSs are the transmission media to spread this
crisis worldwide  spill-over effects (外溢效果) from one
market into others  This is also the reason for the name of
“financial tsunami” (金融海嘯)
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Financial Crisis in 2008
Collateralized debt obligation (CDO, 擔保債務憑
證)
– CDO is a type of structured asset-backed security,
which concentrate the default risk of loans onto one
or two tranches (源自法文slices之意) of investors
– CDOs create high rating securities from the pools
even with a high degree of default risk (However, it
does not work in a widespread downturn)
Credit default swaps (CDS, 信用違約交換)
– The CDS is an insurance contract against the default
of the reference entity
– AIG sold $400 billion in CDS contracts and it is one
of the reason to result in its default crisis
(Both CDO and CDS will be introduced in Ch. 10)
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Financial Crisis in 2008
The failure of financial institutions froze the lending business
of banks and caused the following credit crisis (信用危機)
– In 03/2008, Bear Stearns failed, and the Federal Reserve
System (美國聯邦儲備系統) arranged the sale of Bear Stearns
to JPMorgan Chase
– On 07/09/2008, the U.S. government took over FNMA (房利美)
and FHLMC (房地美)
– On 14/09/2008, Merrill Lynch was sold to Bank of America
– On 15/09/2008, Lehman Brothers (LB), one of the oldest
investment banks, filed for the largest bankruptcy in U.S.
LB borrowed considerable funds by issuing commercial
paper (商業票據) (CP) (borrowing at short-term rate and
investing at long-term rate is common by 2007)
The CP market (short-term financing market) was
essentially shut down after the default of Lehman Brothers
– On 17/09/2008, the U.S. government lends $85 billion to AIG
(American International Group, a multinational insurance
corporation)
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Financial Crisis in 2008
Dodd-Frank Wall Street Reform and Consumer
Protection Act passed in 2010:
– Call for stricter rules for bank capital, liquidity, risk
management practices (especially for large banks)
– Mandate increased transparency, especially in
derivative markets (e.g., suggest to standardize
CDS contracts and trade them on exchanges)
– Unify regulatory authority and clarify responsibility in
one or a smaller number of government agencies
– Volcker rule: Limited banks’ ability to trade for their
own accounts (if it does not benefit their customers)
and to invest in speculative hedge funds or private
equity funds
Named after a former chairman of the Federal Reserve
Board (美國聯邦儲備委員會), Paul Volcker
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