Investments Financial MARKETS and Instruments 1

Asst.Prof.Ph.D Julijana Angelovska

October 2012

Essentials of Investments

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Bodie • Kane • Marcus2 THE INVESTMENT PROCESS Saving, Investing, and Safe Investing

Saving means not spending all of your current income on consumption.

Investing, on the other hand, is choosing what assets to hold. You may choose to invest in safe assets, risky assets, or a combination of both. In common usage, however, the term saving is often taken to mean investing in safe assets such as an insured bank account. It is easy to confuse saving with safe investing.

Suppose you earn $100,000 a year from your job, and you spend $80,000 of it on consumption. You are saving $20,000. Suppose you decide to invest all $20,000 in risky assets. You are still saving $20,000, but you are not investing it safely.

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THE INVESTMENT PROCESSAn investor’s portfolio is simply his collection of investment assets.

Investment assets can be categorized into broad asset classes, such as stocks, bonds, real estate, commodities, and so on. Investors make two types of decisions in constructing their portfolios.

•The asset allocation decision is the choice among these broad asset classes-Allocation of an investment portfolio across broad asset classes.

•while the security selection decision is the choice of which particular securities to hold within each asset - Choice of specific securities within each asset class.

•Security analysis involves the valuation of particular securities that might be included in the portfolio-Analysis of the value of securities.

Market – any place or process that brings together buyers and sellers with a view to agreeing a price

The basis of how an economy operates – through production and subsequent exchange

The range of markets:• Organised markets – commodities e.g. rubber,

oil, sugar, wheat, gold, copper, etc.• Financial markets – stocks, shares, currencies,

financial instruments• Goods markets – the supply and demand

of goods and services in general, food, clothing, leisure, houses, cars, etc.

• Factor markets – the supply and demand of factors of production – land, labour and capital

A market does NOT have to be a physical place like a shop

The market place consists of all those who have items/services for sale and all those who are interested in buying those items/services

Many businesses have global markets because of the developments in technology – see www.amazon.com

Demand – the amount consumers desire to purchase at various alternative prices

Demand – reflects the degree of value consumers place on items – price and satisfaction gained from purchase (utility)

Supply – the amount producers are willing to offer for sale at various prices

Supply – reflects the cost of the resources used in production and the returns/profits required

Factors affecting the efficiency of markets• The amount of information about the markets held

by consumers and producers• The ease with which factors of production

can be put to alternative uses• The extent to which price is an accurate signal of the true utility

and true cost in determining the level of demand and supply (externalities)

• The degree to which firms hold monopoly power• The degree to which property rights are clearly defined• Whether the market can provide goods and services (public

goods)

Financial Markets are where financial claims are traded. It is a market for loanable funds. • The supply of funds comes from the savings of

households, the retained earnings of businesses, and the surplus funds of households, businesses, and governments.

• The demand for funds comes from businesses who need to raise funds to finance long-term and short-term capital purchases, households who need to finance the purchases of their houses, cars, and other consumer durables, and federal, state, and local governments who need to finance public projects and deficits.

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Financial markets

– Facilitate exchange by• Bringing opposite parties together• Establishing rates of exchange, i.e. prices

• Surplus units– Savers of funds available for lending

• Deficit units– Borrowers of funds for capital investment

and consumption

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• Financial instrument– Issued by a party raising funds,

acknowledging a financial commitment and entitling holder to specified future cash flows

• Flow of funds– Movement of funds through the financial

system between savers and borrowers giving rise to financial instruments

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• Financial system– Financial institutions, instruments and

markets facilitating transactions for goods and services and financial transactions

– Overcomes difficulty of• Double coincidence of wants

– Transaction between two parties meets their mutual needs

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Attributes of financial assets

– Return or yield• Total financial compensation received from an

investment expressed as a percentage of the amount invested

– Risk• Probability that actual return on an investment

will vary from the expected return

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• Liquidity– Ability to sell an asset within reasonable

time at current market prices and for reasonable transaction costs

• Time-pattern of the cash flows– When the expected cash flows from a

financial asset are to be received by the investor or lender

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Bodie • Kane • Marcus15 MARKETS AND MARKET STRUCTURE

• This is how financial markets evolved. Meeting places established for buyers and sellers of financial assets became a financial market. A pub in old London called Lloyd’s launched the maritime insurance industry. A Manhattan curb on Wall Street became synonymous with the financial world.

• Four types of markets: direct search markets, brokered markets, dealer markets, and auction markets.

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Direct Search Markets

• A direct search market is the least organized market. Buyers and sellers must seek each other out directly. An example of a transaction in such a market is the sale of a used refrigerator where the seller advertises for buyers in a local newspaper. Such markets are characterized by sporadic participation and low-priced and nonstandard goods. It does not pay most people or firms to seek profits by specializing in such an environment.

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Brokered Markets• In markets where trading in a good is active, brokers find it

profitable to offer search services to buyers and sellers. A good example is the real estate market, where economies of scale in searches for available homes and for prospective buyers make it worthwhile for participants to pay brokers to conduct the searches. Brokers in particular markets develop specialized knowledge on valuing assets traded in that market.

• An important brokered investment market is the so-called primary market, where new issues of securities are offered to the public.

• Another brokered market is that for large block transactions, in which very large blocks of stock are bought or sold.

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Dealer Markets• When trading activity in a particular type of asset

increases, dealer markets arise. Dealers specialize in various assets, purchase these assets for their own accounts, and later sell them for a profit from their inventory. The spreads between dealers’ buy (or “bid”) prices and sell (or “ask”) prices are a source of profit. Dealer markets save traders on search costs because market participants can easily look up the prices at which they can buy from or sell to dealers.

• A fair amount of market activity is required before dealing in a market is an attractive source of income. The over-the-counter (OTC) market is one example of a dealer market.

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Over-the-Counter Market

• The Over-the-Counter Market (OTC) is an informal exchange for the trading of over 70,000 stocks, many corporate and municipal bonds, the equity shares of mutual funds, mortgage-backed securities, shares in limited partnerships, and Treasury and federal agency securities.

• OTC market can be described as a market of brokers and dealers linked to each other by a computer, telephone and telex communications system.

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Auction Markets• The most integrated market is an auction market, in

which all traders converge at one place to buy or sell an asset. The New York Stock Exchange (NYSE) is an example of an auction market. An advantage of auction markets over dealer markets is that one need not search across dealers to find the best price for a good. If all participants converge, they can arrive at mutually agreeable prices and save the bid-ask spread.

• The organized stock exchanges are also secondary markets. They are organized for investors to trade existing securities among themselves.

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Bodie • Kane • Marcus21 DEBT VERSUS EQUITY INSTRUMENTS

• Financial instruments can be classified by the type of claim that the holder has on the issuer. When the claim is for a fixed dollar amount, the financial instrument is said to be a debt instrument. In contrast to a debt obligation, an equity instrument obligates the issuer of the financial instrument to pay the holder an amount based on earnings, if any, after the holders of debt instruments have been paid.

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CHARACTERISTICS OF DEBT INSTRUMENTS

• Debt instruments include loans, money market instruments, bonds, mortgage-backed securities, and asset-backed securities.

• the “term to maturity”

• as simply its “maturity” or “term.”

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Questions?Discuss about Saving, Investing, and Safe Investing.

Define investor’s portfolio, asset allocation, security selection, security analyses.

Identify the 4 types of markets.

Explain the attributes of Financial assets.

Homework

Search the interest rates offered in the banks for deposits.

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Asset allocation refers to ____________. 

A. choosing which securities to hold based on their valuationB. investing only in "safe" securitiesC. the allocation of assets into broad asset classesD. bottom-up analysisE. top-down analysis

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Bodie • Kane • Marcus25 The ____________ refers to the potential conflict between management and shareholders.

•  A. agency problemB. diversification problemC. liquidity problemD. solvency problemE. regulatory problem

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Financial assets can permit all of the following except ____________. 

•A. consumption timingB. allocation of riskC. separation of ownership and controlD. elimination of riskE. easy transfer of ownership

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Financial assets ______. A. directly contribute to the country's productive capacityB. indirectly contribute to the country's productive capacityC. contribute to the country's productive capacity both directly and indirectlyD. do not contribute to the country's productive capacity either directly or indirectlyE. are of no value to anyone

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Bodie • Kane • Marcus28 The means by which individuals hold their claims on real assets in a well-developed economy are 

•A. Investment assets.B. Depository assets.C. Derivative assets.D. Financial assets.E. Exchange-driven assets.

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_______ is/are a real asset(s). 

A. Only landB. Only machinesC. Only stocks and bondsD. Only knowledgeE. Land, machines and knowledge are real assets

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Security selection refers to ____________. 

A. choosing which securities to hold based on their valuationB. investing only in "safe" securitiesC. the allocation of assets into broad asset classesD. top-down analysisE. moving assets between stocks and bonds

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• Commercial banks differ from other businesses in that both their assets and their liabilities are mostly A. illiquid.B. financial.C. real.D. owned by the government.E. regulated.

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Bodie • Kane • Marcus32 Which of the following are mechanisms that have evolved to mitigate potential agency problems? I) Compensation in the form of the firm's stock optionsII) Hiring bickering family members as corporate spiesIII) Underperforming management teams being forced out by boards of directorsIV) Security analysts monitoring the firm closelyV) Takeover threats A. II and VB. I, III, and IVC. I, III, IV, and VD. III, IV, and VE. I, III, and V

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Bodie • Kane • Marcus33 Financial intermediaries exist because small investors cannot efficiently ________.

•  A. diversify their portfoliosB. assess credit risk of borrowersC. advertise for needed investmentsD. diversify their portfolios, assess credit risk of borrowers, or advertise for needed investmentsE. diversify their portfolios or assess credit risk of borrowers.