Chapter 1

Investment: Commitment of current resources in the expectation of deriving greater resources in thefuture

1.1: Real Assets versus Financial Assets:

real assets: Assets used to produce goods and services

financial assets: Claims on real assets or the income generated by them

1.2 A Taxonomy of Financial Assets:

three broad types of financial assets: debt, equity, and derivatives

fixed-income (debt) securities:Pay a specified cash flow over a specific period.

equity:An ownership share in a corporation.

derivative securities:Securities providing payoffs that depend on the values of other assets.

1.3 Financial Markets and the Economy:

Informational Role of Financial Markets

             Consumption Timing:

o   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.

            Allocation of Risk:

                        Investors can choose a desired risk level

                        Bonds versus stock of a given company

                        Bank CD versus company bond

                        Tradeoff between risk and return?

          Separation of Ownership and Management

                  Large size of firms requires separation of ownership and management

In 2008 GE had over $800 billion in assets and over 650,000 stockholders

Owners (principals) ≠ Managers (agents)

Agency costs: Owners’ interests may not align with managers’ interests

       Mitigating factors:

•         Performance based compensation

•         Boards of Directors may fire managers

•         Threat of takeovers

         Corporate Governance and Corporate Ethics:

          Business and market require trust to operate efficiently

                      Without trust additional laws and regulations are required

                      All laws and regulations are costly

         Governance and ethics failures have cost our economy billions if not trillions of            dollars.

Eroding public support and confidence in market based systems

1.4  The Investment Process:

asset allocation: Allocation of an investment portfolio across broad asset classes.

security selection:Choice of specific securities within each asset class.

security analysis:Analysis of the value of securities

1.5  Markets Are Competitive:

o        Risk-return trade-off:Assets with higher expected returns have higher risk.

o        passive management:Buying and holding a diversified portfolio without attempting to identify mispricedsecurities.

o        active management:Attempting to identify mispriced securities or to forecast broad market trends

1.6  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 companies

o   Insurance companies

o   Pension funds

o   Hedge funds

•         Investment Bankers: Firms specializing in the sale of new securities to the public, typically by underwriting the issue.

•         Primary market: A market in which new issues of securities are offered to the public

•         Secondary market: Previously issued securities are traded among investors.

1.7 Recent Trends:

Globalization: Tendency toward a worldwide   investment environment, and the integration of international capital markets.

Pass - through securities: Pools of loans (such as home mortgage loans) sold in one package. Owners of pass- throughs   receive all of the principal and interest payments made by the borrowers.

Securitization: Pooling loans into standardized securities backed by those loans, which can then be traded like any other security.

Bundling , unbundling: Creation of new securities either by combining primitive and derivative securities into one composite hybrid or by separating returns on an asset into classes.

Financial engineering:The process of creating and designing securities with custom-tailored characteristics.

Chapter 3

3.1: How Firms Issue Securities

Primary  market : Market for new issues of securities.

Secondary  market :Market for already-existing securities.

Initial  public offering (IPO): First sale of stock by a formerly private company.

Underwriters : Underwriters purchase securities from the issuing company and resell them.

Prospectus : A description of the firm and the security it is issuing.

Private  placement: Primary offerings in which shares are sold directly to a small group of institutional orwealthy investors.

3.2: How Securities are Traded:

Types of Markets:

four types of markets: direct search markets, brokered markets, dealer markets, andauction markets.

Direct search markets: A direct search market is the least organized market. Buyers and sellers must seek each other out directly.

Brokered markets: The next level of organization is a brokered market.

In markets where trading in a good is active, brokers find it profitable to offer search services to buyers and sellers.

Dealer markets : Markets in which traders specializing in particular assets buy and sell for their own accounts

Auction  market : A market where all traders meet at one place to buy or sell an asset.

Types of Orders:

-Market orders:

   Bid  price: The price at which a dealer or other trader is willing to purchase a security.

   Ask  price: The price at which a dealer or other trader will sell a security.

  bid–ask spread :The difference between a dealer’s bid and asked price.

            - Price-contingent orders

              limit buy (sell) order: An order specifying a price at which an investor is willing to buy   or sell a security.

             Stop  order:Trade is not to be executed unless stock hits a price limit.

            Trading  Mechanisms:

              Over -the-counter (OTC) market: An informal network of brokers and dealers who negotiate sales of securities.

Electronic communication networks (ECNs): Computer networks that allow direct trading without the need for market makers.

Specialist :A trader who makes a market in the shares of one or more firms and who maintains a“fair and orderly market” by dealing personally in the market.

3.3: U.S. Securities Markets:

NASDAQ Stock Market:The computer-linked priced quotation system for the OTC market.

stock exchanges :Secondary markets where already-issued securities are bought and sold by members.

block transactions : Large transactions in which at least 10,000 shares of stock are bought or sold.

program trade :Coordinated sale or purchase of a portfolio of stocks.

Margin :Describes securities purchased with money borrowed in part from a broker. The margin is thenet worth of the investor’s account.

Short sale: The sale of shares not owned by the investor but borrowed through a broker and laterpurchased to replace the loan.

inside information:Nonpublic knowledge about a corporation possessed by corporate officers, major owners,or other individuals with privileged access to information about the firm.