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Boğaziçi University

Investment Analysis and Portfolio Management

Attila Odabaşı

Textbook: Investments, Bodie, Kane and Marcus (BKM)

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OUTLINE

• Real vs Financial Assets• Clients of Financial System• Financial Institutions & Innovation• Markets and Market Structure• Trends

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Investments and Financial Assets

Real Assets:Assets used in the production of goods and services

– Land, buildings, machines, knowledge, etc.

– Add to productive capacity– Appear on left-hand side of balance

sheet– Destroyed by physical damage or wear

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Investments and Financial Assets

Financial Assets:Claims on cash flows from real assetsAppear on both sides of balance sheet Real versus Financial Assets:• All financial assets (owner of the claim) are offset

by a financial liability (issuer of the claim). • When we aggregate over all balance sheets, only

real assets remain. • Hence the net wealth of an economy is the sum

of its real assets.

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Essential nature of investment

• Reduce current consumption in hopes of greater future consumption

• Hence, we invest our surplus funds in various financial assets

• Financial assets are issued by firms (among others) because the timing of their income stream typically does not match desired timing of physical investments.

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Major Classes of Financial Assets or Securities

• Debto Money market instruments

• Bank certificates of deposit, T-bills, commercial paper, etc.

o Bondso Preferred stock

• Common stocko Ownership stake in the entity, residual cash

flow• Derivative securities

o A contract whose value is derived from some underlying market condition.

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Components of a Financial System

Pool of Funds

Financial Intermediaries,Comm Banks, Broker Houses,Mutual Funds,

etc

Households,Pension F, Insurance

Co’s:Supply funds,

Demand financial assets,

Firms,Govnmt: Demand funds, supply

fin assets

Cash

Fin Instr

Cash

Fin Instr

Cash + Interest

Cash + Interest

Judicial and Admin

Regulations

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The Players• Business Firms – net borrowers• Households – net savers• Governments – can be both borrowers and

savers• Financial Intermediaries “Connectors of

borrowers and lenders”o Commercial Banks

• Traditional line of business: Make loans funded by deposits

o Investment companieso Investment Bankers,o Mutual Funds,o Etc.,

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The Players Cont.

• Investment Bankerso Firms that specialize in primary market

transactions

o Primary market:• A market where newly issued securities are offered to

the public. • The investment banker typically ‘underwrites’ the

issue.

o Secondary market• A market where pre-existing securities are traded

among investors.

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Investment Bankers

o Commercial and investment banks’ functions and organizations were separated by law from 1933 to 1999.

o Post 1999 large investment banks, collectively known as “Wall Street,” operated independently from commercial banks, although many of the large commercial banks increased their investment banking activities, pressuring profit margins of investment banks.

o In September 2008 major investment banks either went bankrupt, reorganized as commercial banks or were purchased by commercial banks as a result of the collapse of the mortgage markets.

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• Investment Bankers

o Some investment banks chose to become commercial banks to obtain deposit funding and government assistance

o All of the major investment banks are now under the much stricter commercial bank regulations. • What are the implications for innovation and capital

issuance resulting from these changes?

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Financial Markets: Institutions & Innovations

• Financial system addresses market participants’ needs– Through intermediaries (e.g., banks

collect savings and hand out loans)– By creating suitable securities (e.g.,

stocks, bonds, derivatives)

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Financial Markets

• Informational Role of Financial Marketso Do market prices equal the fair value estimate

of a security’s expected future risky cash flows?

o Can we rely on markets to allocate capital to the best uses?• What other mechanism could we use to

allocate capital? • What would be the advantages and

disadvantages of another system?

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Financial Markets

• They allow consumption timingo People tend to smooth consumption over time.

o If one has more than enough cash to meet their basic needs in the current time period one might shift consumption through time by investing the surplus.

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Financial Markets

o They enable allocation of risko Investors can choose a desired risk level

• Bonds versus stock of a given company

• Bank CD versus company bond

• Tradeoff between risk and return?

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Corporate Governance and Corporate Ethics

• Businesses and markets require trust to operate efficientlyo Without trust additional laws and regulations

are requiredo All laws and regulations are costly

• Governance and ethics failures o Erode public support and confidence in market

based systemso Cost the economy billions of dollars

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Corporate Governance and Corporate Ethics

• Some examples:• Accounting Scandals

o Enron, WorldCom, Rite-Aid, HealthSouth, Global Crossing, Qwest,

• Misleading Research Reportso Citicorp, Merrill Lynch, others

• Auditors: Watchdogs or Consultants?o Arthur Andersen and Enron

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Corporate Governance and Corporate Ethics

• Preventie actions:• Sarbanes-Oxley Act

o Increases the number of independent directors on company boards

o Requires the CFO to personally verify the financial statements

o Creates a new oversight board for the accounting/audit industry

o Charges the board with maintaining a culture of high ethical standards

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The Investment Management Process

1. Setting investment objectives2. Establishing an investment policy3. Selecting an investment strategy4. Constructing a portfolio5. Measuring and evaluating investment

performance

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Setting Investment Objectives

• Analysis of the investment objectives of the entity whose funds are being managed.– Individual investors– Institutional investors

• Pension funds, depository institutions, insurance companies, regulated investment companies (mutual funds,..), endowments and foundations, and treasury department of corporations, government agencies.

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Establishing an Investment Policy

• Starts with the asset allocation decision– How the funds to be invested should be

distributed among the major classes of assets• Return vs risk

• Take into account any investment constraints or restrictions– Client constraints, regularity

constraints,..

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Investment/Portfolio Strategy

• Active portfolio strategy:– Seek a better performance than a

simply diversified portfolio viaFinding undervalued securities (Security Selection)Timing the market (Asset allocation)

• Passive portfolio strategy:– Relies on diversification to match the

performance of some market index• Which would you select? Why?

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Efficient Marketso What we mean by Market efficiency?

o Securities should be neither underpriced nor overpriced on average

o Security prices should reflect all information available to investors

o Markets should be competitive.

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Constructing the Portfolio

• Select the specific assets to be included in the portfolio

• Aim to construct an efficient portfolio– One that provides the greatest expected

return for a given level of risk, or equivalently, the lowest risk for a given expected return

– Need to quantify (measure) risk!• How diversification reduces risk?

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Measuring and Evaluating Performance

• Calculating return over the evaluation period and comparing with a benchmark (index)– Different return measures

• Arithmetic average• Geometric average• Time-weighted rate of return

– Single-index performance measures• Sharpe ratio, etc.

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The Investment Management Process

• The above mentioned process is a top-down approach

• Starts with asset allocation• Then Security selection

• Alternative approach is Bottom-up• Security selection first

• Reminder: Asset allocation decision is the primary determinant of a portfolio’s return

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Recent Trends

• Globalization

• Securitization

• Financial Engineering

• Information and Computer Networks

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Globalization

• Domestic firms compete in global markets

• Performance in one country or region depends on other regions

• Internationl Opportunities for better returns & implications for risko International diversification reduces risko Instruments and vehicles continue to develop

(ADRs and WEBs)o Information and analysis improveso Managing foreign exchange

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Securitization

• Loans of a given type such as mortgages are placed into a ‘pool’ and new securities are issued that use the loan payments as collateral.

• The new securities are marketable and are purchased by many institutions.

• Credit enhancement provided by pool issuers has improved marketability.

• End result is more investment opportunities for purchasers, and spreading loan credit risk among more institutions

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Financial Engineering

• Repackaging cash flows of a security to enhance marketability

• Bundling and unbundling of cash flowsoBundling:

Combining more than one asset into a composite security, for example securities sold backed by a pool of mortgages.

oUnbundlingSelling separate claims to the cash flows of one security, for example a CMO

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Computer Networks

• Online low cost trading• Information made cheaply and widely available• Direct trading among investors via electronic

communication networks

• What have been the effects on Wall Street firms’ profit margins? o How has Wall Street responded?

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The Future

• Globalization will continue and investors will have far more investment opportunities than in the past

• Securitization will continue to grow after the crisis

• Continued development of derivatives and exotics, more regulation for “over the counter” derivatives

• Strong fundamental foundation of understanding is critical

• Understanding corporate finance requires understanding investments

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The Financial Crisis of 2008• http

://www.youtube.com/watch?v=bx_LWm6_6tA• Showed intimate links between real and

financial economies.• Antecedents of the crisis:

– High-tech bubble, 2000-2002– Low interest rates to prevent recession– That leads to a boom in housing market,– Changes in Housing Finance:

• 1970’s, Fannie Mae, Freddie Mac, started Securitization,• Mortgage-backed securities, pass throughs...

– Securitization by private firms of nonconfirming ‘subprime’ loans with higher default risk / high leverage home loans

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The Financial Crisis of 2008• Adjustable-rate mortgages also grew in popularity

– Low initial or teaser rates– These rates were reset to current market rates later

• Starting by 2004 interest rates started to increase• This put pressure on payments • House prices peaked in 2006 and started to

decline in 2007• Housing default rates began to surge in 2007

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The Financial Crisis of 2008• Mortgage derivatives

– CDO’s (Collateralized debt obligations):• Innovation,• Based on: Securitization, restructuring, and

credit enhancement• Output: AAA-rated securities from original-

issue ‘junk’ loans.– Credit rating agencies were wrong.

• Why? Default probabilities were based on historical data from recession-free economy

• Geographical diversification proved excessive optimism

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The Financial Crisis of 2008

– Credit Default Swaps (CDS) market also exploded in the same period:• In essence an insurance contract against the

default of one or more borrowers.• Swap purchaser pays an annual premium for

protection from credit risk.• Credit enhancement method: Buy subprime

loans and insure their safety.• Some swap issuers took unsupportable

credit risk without sufficient capital to back those obligations (eg AIG sold $400 bio of CDS) .

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The Rise of Systemic Risk• By 2007 some financial institutions used

to:– Borrow short-term at low rates to finance

holdings in higher yielding long-term illiquid assets.• High leverage (up to 30:1), • Constant Refinancing needs due to

mismatch• They had little capital

• This made these institutions vulnerable to crises of confidence

• High reliance on CDO products created other problems– By Aug 2008, $63 trillion CDS outstanding (US

GDP $14 trillion)• All these increased the systemic risk!

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The Financial Crisis of 2008• The Shoe Drops: First signs, summer of 2007

• Bear Stearns announce huge losses on subprime,

• Fall ‘07: housing prices decline, stock market too

• March ‘08: Bearn Stearns acquired by JPMorgan Chase with some gov. guarantee,

• Sep ‘08: Fannie Mae and Freddie Mac put into conservatorship,

• Sep 14, ‘08: Merrill Lynch sold to Bank of America,

• Sept 15: LehmanBrothers filed for bankcruptcy,

• Sep 17: US Gov lent $85 billion to AIG,• Sep 18: Treasury unveiled the proposal to

spend $700 bio to purchase ‘toxic’ mortgage-backed securities.

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Reading assignment:

• The first four chapters in Investments, BKM.