Financial Economics Bocconi Lecture1

INVESTMENTS | BODIE, KANE, MARCUS

Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

Class 30055 Financial Economics

Bocconi University, Spring 2013

Prof. Daniela Kolusheva, Office 2-E2-02

Office Hours: Tue, Thu 13:00 – 14:00


1-2

The Investment Environment

• Real assets vs. financial assets

• Financial markets – broad overview

• The investment process

• Concept of market competitiveness

• Major participants in financial markets

• The financial crisis of 2008


1-3

Real Assets Versus Financial Assets

• Real Assets

– Determine the productive capacity and net income of the economy

– Examples: Land, buildings, machines, knowledge used to produce goods and services

• Financial Assets

– Claims on real assets

– Determine the allocation of income


1-4

Real Assets Versus Financial Assets: Quick Quiz

• Are the following assets real or financial?

a. Patents

b. Lease obligations

c. Customer goodwill

d. A college education

e. A $5 bill


1-5

Financial Assets

1. Fixed income or debt

2. Common stock or equity

3. Derivative securities


1-6

Fixed Income

• Payments fixed or determined by a formula

• Money market debt: short term, highly marketable, usually low credit risk

• Capital market debt: long term bonds, can be safe or risky in terms of default risk


1-7

Common Stock and Derivatives

• Common Stock is equity or ownership

in a corporation.

– Payments to stockholders are not fixed,

but depend on the success of the firm

• Derivatives (options, futures, swaps)

– Value derives from prices of other

securities, such as stocks and bonds

– Used to transfer risk


1-8

Financial Markets and the Economy

• Information Role: Capital flows to

companies with best prospects

• Consumption Timing: Use securities

to store wealth and transfer

consumption to the future


1-9

Financial Markets and the Economy (Ctd.)

• Allocation of Risk: Investors can select

securities consistent with their tastes

for risk

• Separation of Ownership and

Management: due to the size and

complexity of today’s firms. May lead to

agency problems


1-10

Mechanisms to Mitigate the Principal-Agent Problem

• Compensation schemes for top

executives tied to the performance of

the firm

• Board of directors

• Key outsiders: security analysts, large

institutional investors

• Threat of takeover (M&A, proxy

contest)


1-11

Corporate Governance and Corporate Ethics

– Accounting Scandals

• Examples – WorldCom, Enron, Rite Aid, etc.

– Auditors – watchdogs of the firms

– Analyst Scandals

– Sarbanes-Oxley Act

• Tighten the rules of corporate governance

• Independent directors, rules for auditors,

mgmt has to vouch for accounting statements


1-12

The Investment Process

• Asset allocation

– Choice among broad asset classes

• Security selection

– Choice of which securities to hold within

asset class

– Security analysis to value securities and

determine investment attractiveness


1-13

Markets are Competitive

• Risk-Return Trade-Off: higher-risk assets

priced to offer higher expected returns

than lower-risk assets

• Type of risk that matters: volatility of

individual asset vs. covariance with other

assets in a well-diversified portfolio

• Modern Portfolio Theory (Markowitz and

Sharpe)


1-14

Markets are Competitive

• Efficient Markets

– Financial markets process all relevant info

about securities quickly and efficiently

– As new information about a security becomes

available, its price quickly adjusts so that at

any time, the security price equals the market

consensus estimate of the value of the

security


1-15

Markets are Competitive (Ctd.)

– Active Management

• Finding mispriced securities

• Timing the market

– Passive Management

• No attempt to find undervalued

securities or to time the market

• Holding a highly diversified portfolio


1-16

The Players

• Business Firms– net borrowers

• Households – net savers

• Governments – can be both borrowers

and savers


1-17

The Players (Ctd.)

• Financial Intermediaries: Pool and invest

funds

– Investment Companies

– Banks

– Insurance companies

– Credit unions


1-18

Universal Bank ActivitiesInvestment Banking

• Underwrite new stock

and bond issues

• Sell newly issued

securities to public in

the primary market

• Investors trade

previously issued

securities among

themselves in the

secondary markets

Commercial Banking

• Take deposits and

make loans


1-19

Financial Crisis of 2008

• Antecedents of the Crisis:

– “The Great Moderation”: a time in which the

U.S. had a stable economy with low interest

rates and a tame business cycle with only

mild recessions

– Historic boom in housing market


1-20

Figure 1.3 The Case-Shiller Index of U.S. Housing Prices


1-21

Changes in Housing FinanceOld Way

• Local thrift institution

made mortgage loans to

homeowners

• Thrift’s major asset: a

portfolio of long-term

mortgage loans

• Thrift’s main liability:

deposits

• “Originate to hold”

New Way

• Securitization: Fannie

Mae and Freddie Mac

bought mortgage loans

and bundled them into

large pools

• Mortgage-backed

securities are tradable

claims against the

underlying mortgage pool

• “Originate to distribute”


1-22

Figure 1.4 Cash Flows in a Mortgage Pass-Through Security


1-23

Changes in Housing Finance(Ctd.)

• At first, Fannie Mae and Freddie Mac securitized conforming mortgages, which were lower risk and properly documented.

• Later, private firms began securitizing nonconforming “subprime” loans with higher default risk.

– Little due diligence

– Placed higher default risk on investors

– Greater use of ARMs and “piggyback” loans


1-24

Mortgage Derivatives

• Collateralized debt obligations (CDOs)

– Mortgage pool divided into slices or tranches

to concentrate default risk

– Senior tranches: Lower risk, highest rating

– Junior tranches: High risk, low or junk rating


1-25

Mortgage Derivatives

• Problem: Ratings were wrong! Risk was

much higher than anticipated, even for the

senior tranches


1-26

Why was Credit Risk Underestimated?

• No one expected the entire housing

market to collapse all at once

• Geographic diversification did not

reduce risk as much as anticipated

• Agency problems with rating agencies

• Credit Default Swaps (CDS) did not

reduce risk as anticipated


1-27

Credit Default Swap (CDS)

• A CDS is an insurance contract against

the default of the borrower

• Investors bought sub-prime loans and

used CDS to insure their safety


1-28

Credit Default Swap (CDS)

• Some big swap issuers did not have

enough capital to back their CDS when the

market collapsed.

• Consequence: CDO insurance failed


1-29

Rise of Systemic Risk

• Systemic Risk: a potential breakdown of the

financial system in which problems in one

market spill over and disrupt others.

– One default may set off a chain of further

defaults

– Waves of selling may occur in a downward

spiral as asset prices drop

– Potential contagion from institution to

institution, and from market to market


1-30

Rise of Systemic Risk (Ctd.)

• Banks had a mismatch between the

maturity and liquidity of their assets and

liabilities.

– Liabilities were short and liquid

– Assets were long and illiquid

– Constant need to refinance the asset portfolio

• Banks were very highly levered, giving

them almost no margin of safety.


1-31

Rise of Systemic Risk (Ctd.)

• Investors relied too much on “credit

enhancement” through structured

products like CDS

• CDS traded mostly “over the counter”,

so less transparent, no posted margin

requirements

• Opaque linkages between financial

instruments and institutions


1-32

The Shoe Drops

• 2000-2006: Sharp increase in housing

prices caused many investors to believe

that continually rising home prices would

bail out poorly performing loans

• 2004: Interest rates began rising

• 2006: Home prices peaked


1-33

The Shoe Drops

• 2007: Housing defaults and losses on

mortgage-backed securities surged

• 2007: Bear Stearns announces trouble at

its subprime mortgage–related hedge

funds


1-34

The Shoe Drops

• 2008: Troubled firms include Bear

Stearns, Fannie Mae, Freddie Mac, Merrill

Lynch, Lehman Brothers, and AIG

– Money market breaks down

– Credit markets freeze up

– Federal bailout to stabilize financial system


1-35

Systemic Risk and the Real Economy

• Add liquidity to reduce insolvency risk and

break a vicious circle of valuation

risk/counterparty risk/liquidity risk

• Increase transparency of structured

products like CDS contracts

• Change incentives to discourage

excessive risk-taking and to reduce

agency problems at rating agencies

Financial Economics Bocconi Lecture1

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