Intermediate Asset Pricing – Lecture 1
Chapter 1
Investment: current commitment of money/other resources in the expectation of reaping future
benefits
à all investments have in common that you sacrifice something of value now, expecting to
benefit from that sacrifice later
Real assets vs financial assets
The material wealth of a society is determined by its productive capacity
à this depends on real assets; land, buildings, machinery, knowledge etc.
• These real assets contribute directly to the economy by producing goods and services
Financial assets, on the contrary, do not contribute directly to production
= represent claims on the income generated by real assets
• Financial assets allow individuals to invest in productive activities, without directly owning real
assets
- And deferring consumption and invest in future returns
• Primarily allocate wealth among investors, rather than creating new wealth
à companies in turn use the capital raised from selling financial assets to acquire real assets
for production
Important distinction: financial assets are liabilities for issuers and asset to investor
à when all BSs in an economy are aggregated, financial claims therefore cancel out
• Result: only real assets are the true measure of national wealth
3 main types of financial assets
I: Fixed-income securities (debt)
= assets that promise a fixed or formula-based income stream (ex. corporate bonds)
• Debt securities are generally less dependent on the financial health of the issuer (unless the
borrower defaults)
Vary in risk and duration
1. Money market instruments: ST, low-risk, and highly liquid (US Treasury bills)
2. Capital market instruments: longer maturities and range from low-risk (Treasuries) to high-risk
(junk bonds)
II: Equity (stocks)
= represents ownership in a corporation
• No fixed payments; investors receive dividends (if distributed) and have proportional
ownership of company assets
• Higher risk than debt securities as returns depend on the firm’s success
• If company performs well, stock values rises; if it fails; stockholders lose money
III: Derivative securities
= value is derived from other assets (e.g., stocks, bonds, commodities)
à ex. options, futures and swaps
à key functions:
• Hedging: reducing risk by transferring it to other parties; e.g., lock prices with futures contract
• Speculation: high-risk trading, sometimes leading to massive losses
à derivatives play a critical role in financial markets and portfolio management
(IV:) Other financial markets
• Currency markets: impacting international trade; trillions traded daily
• Commodity markets: investors can buy/sell real assets like oil, wheat
- Help firms manage risk: e.g., company hedging against raw material price fluctuations
,Financial markets and the economy
Financial assets and markets play a crucial role in supporting economic growth by enabling the
following:
I: Informational role of financial markets (efficient allocation)
• Stock prices reflect investors’ collective judgement of a firm’s value and future prospects
• Higher stock prices in turn make it easier for firms to raise capital and invest in productive
activities
BUT! markets are not perfect – they can misallocate resources
à despite that, remain the most efficient way to allocate capital compared to alternatives like
government planning
II: Consumption timing
Financial markets allow individuals to shift purchasing power over time
• Earning > consumption needed: invest in financial assets
• Earning < consumption needed: sell investments to fund their consumption
à this flexibility enables individuals to smooth consumption over their lifetime
III: Allocation of risk
Real assets involve risk, but financial markets help distribute that risk efficiently
• Investors with higher risk tolerance: buy stocks
• Risk-averse investors: buy bonds, which offer more stable returns
à helps businesses raise funds at better prices, supporting economic growth
IV: Separation of ownership and management
Large corporations have many shareholders who cannot directly manage the firm
Solution: elect board of directors to oversee management
• This system enables companies to grow beyond owner-operated businesses
• Problem: agency problem
- Managers may act in self-interest: e.g., avoiding risks to protect jobs
- Solutions:
o Performance-based compensation to align interests
o Board oversight to remove underperforming executives
o External monitoring by institutional investors/security analysts
o Threat of takeovers
V: Corporate governance and ethics
Market transparency is crucial for efficient capital allocation
• Corporate scandals involve fraudulent financial reporting that misleads investors
• Problems like: overstated profits, analysts using biased reports, auditors prioritising
consulting fees over accurate financial reporting
• Solution: Sarbanes-Oxley Act (2002) introduced reforms to strengthen CG
- More independent directors on corporate boards
- CFOs must personally certify financial statements
- Increased oversight of auditors to prevent conflicts of interest
The investment process
Investor’s portfolio: collection of investment assets that can include stocks, bonds, real estate,
commodities, and other asset classes
• Managing a portfolio involves making investment decisions and periodically rebalancing by
buying or selling securities
Key investment decisions
• Asset allocation: choosing how to distribute investments across different asset classes (e.g,
stocks, bonds, real estate)
• Security selection: choosing specific securities within each asset class (e.g., selecting Tesla
or Ford within the stock category)
,Top-down approach: begins with asset allocation before selecting individual securities (first
decides how much to invest in stocks etc. then select individual stock)
• This balances risk and return on a broad level
- Stocks have historically provided higher returns, but with high volatility
- Treasury bills are low-risk, but offer lower returns
Goals: manage risk while maximizing returns
Bottom-up approach: focuses on selecting securities that seem attractively prices
(undervalued), without as much concern for overall asset allocation
• Risk: can lead to over-concentration in a specific industry, region, etc.
• Advantage: investors may capitalize on mispriced securities and max. returns
Security analysis: valuing individual securities to determine whether they are good
investments
• Stocks are harder to evaluate than bonds, as stock performance depends heavily on the
issuing company’s financial health
Markets are competitive
Financial markets are highly competitive, implying that finding undervalued securities (free-lunches) is
difficult, because professional analysts constantly search for profitable opportunities
à 2 key implications
I: The risk-return trade-off
Investors seek high returns, but all investments carry some risk – actual returns often deviate from
expectations
• No-free-lunch rule: higher returns come with higher risk
- If an asset offered high returns without high risk, investors would rush to buy it,
driving its price up and lowering future returns
- If high-risk assets had the same return as low-risk assets, investors would sell risky
assets, lowering their prices until they become attractive again
Thus: trade-off between risk and return
à higher-risk assets must offer higher expected returns to compensate investors
à the risk-return relationship is the foundation of the Modern Portfolio Theory (MPT)
Diversification: holding multiple assets, which helps reduce portfolio risk
II: Efficient markets
Market efficiency suggest that financial markets process all available information quickly and
accurately, meaning security prices reflect their fair value
• If markets are truly efficient: investors cannot consistently find undervalued/overvalued
stocks
Passive management strategy: investors hold diversified portfolios without actively picking stocks
• Assumes markets are efficient; trying to beat the market is a resources waste
Active management: investors try to identify mispriced securities or time the market to improve
performance
• Assumes that markets are not fully efficient, meaning there are still opportunities for skilled
investors
• If markets were perfectly efficient, this management would be pointless
- Markets are however only ‘near-efficient’ à so still some profit opportunities for
diligent investors
The players
There are 3 major players int the financial markets:
1. Firms/corporations: net demanders of capital
- Raise funds by issuing securities to finance investments in real assets
- Investors then purchase these securities in exchange for future returns
2. Households: net suppliers of capital
, -Invest in securities issued by firms and the government
-Households cannot easily lend directly à rely on financial intermediaries (banks,
mutual funds etc.)
3. Governments: borrowers or lenders dependent on tax revenue/spending
- Budget deficits: borrowing by issuing Treasury bills/notes/bonds
- Budget surpluses: paying off outstanding debt
Financial intermediaries
= connect investors and borrowers, providing benefits such as diversification, risk assessment, and
economies of scale
à types of financial intermediaries
• Banks: take deposits and lend money, earning profits from the interest spread
• Investment companies: pool investor funds to invest in diversified portfolios (e.g., mutual
funds)
• Insurance companies: manage risks and invest premiums collected from policyholders
• Credit unions: member-owned institutions providing loans and financial services
Benefits of financial intermediaries
1. Pooling resources of many small investors allows large-scale (sum) lending
2. By lending to multiple borrowers, significant diversification is achieved
3. Utilise expertise and economies of scale to assess and manage risk efficiently
Investment companies: pool and manage money of many investors, originated out of economies of
scale
Mutual funds vs. hedge funds
• Mutual funds: open to retail investors, diversified, lower risk, charge management fees
• Hedge funds: open to institutions/wealthy individuals, high-risk strategies, charge
performance-based fees
Investment bankers
= help corporations raise capital by issuing securities; act as underwriter
• Advise firms on pricing, interest rates, and marketing of new securities
• Underwriter: buy securities from firms and resell them to the public
- Securities are sold in the primary market à new issues
- The secondary market allows investors to trade existing securities
à 2008 Financial Crises led to major changes in investment banking, with many firms merging
with commercial banks
Venture capital and private equity
Venture capital: provides early-stage funding for start-ups in exchange for equity (ownership stake)
• VC firms are limited partnerships, pooling funds from wealthy investors and institutions
• Investors take an active role in management and provide strategic advice
Private equity: invests in distressed or undervalued companies, aiming to improve and resell them
for profit
à unlike VC, PE focuses on mature businesses rather than startups
The Financial Crisis of 2008
The 2008 financial crisis was one of the worst economic downturns since the Great Depression
à the causes of the crisis
I: Low interest rates and housing boom (early 2000s)
After the 2000-2002 dot-com crash, the Federal Reserve lowered interest rates to stimulate the
economy (spending, investing)
• These low interest rates fuelled a housing boom, leading to rapidly rising home prices
• Investors sought higher returns, increasing demand for mortgage-backed securities (MBS)
Chapter 1
Investment: current commitment of money/other resources in the expectation of reaping future
benefits
à all investments have in common that you sacrifice something of value now, expecting to
benefit from that sacrifice later
Real assets vs financial assets
The material wealth of a society is determined by its productive capacity
à this depends on real assets; land, buildings, machinery, knowledge etc.
• These real assets contribute directly to the economy by producing goods and services
Financial assets, on the contrary, do not contribute directly to production
= represent claims on the income generated by real assets
• Financial assets allow individuals to invest in productive activities, without directly owning real
assets
- And deferring consumption and invest in future returns
• Primarily allocate wealth among investors, rather than creating new wealth
à companies in turn use the capital raised from selling financial assets to acquire real assets
for production
Important distinction: financial assets are liabilities for issuers and asset to investor
à when all BSs in an economy are aggregated, financial claims therefore cancel out
• Result: only real assets are the true measure of national wealth
3 main types of financial assets
I: Fixed-income securities (debt)
= assets that promise a fixed or formula-based income stream (ex. corporate bonds)
• Debt securities are generally less dependent on the financial health of the issuer (unless the
borrower defaults)
Vary in risk and duration
1. Money market instruments: ST, low-risk, and highly liquid (US Treasury bills)
2. Capital market instruments: longer maturities and range from low-risk (Treasuries) to high-risk
(junk bonds)
II: Equity (stocks)
= represents ownership in a corporation
• No fixed payments; investors receive dividends (if distributed) and have proportional
ownership of company assets
• Higher risk than debt securities as returns depend on the firm’s success
• If company performs well, stock values rises; if it fails; stockholders lose money
III: Derivative securities
= value is derived from other assets (e.g., stocks, bonds, commodities)
à ex. options, futures and swaps
à key functions:
• Hedging: reducing risk by transferring it to other parties; e.g., lock prices with futures contract
• Speculation: high-risk trading, sometimes leading to massive losses
à derivatives play a critical role in financial markets and portfolio management
(IV:) Other financial markets
• Currency markets: impacting international trade; trillions traded daily
• Commodity markets: investors can buy/sell real assets like oil, wheat
- Help firms manage risk: e.g., company hedging against raw material price fluctuations
,Financial markets and the economy
Financial assets and markets play a crucial role in supporting economic growth by enabling the
following:
I: Informational role of financial markets (efficient allocation)
• Stock prices reflect investors’ collective judgement of a firm’s value and future prospects
• Higher stock prices in turn make it easier for firms to raise capital and invest in productive
activities
BUT! markets are not perfect – they can misallocate resources
à despite that, remain the most efficient way to allocate capital compared to alternatives like
government planning
II: Consumption timing
Financial markets allow individuals to shift purchasing power over time
• Earning > consumption needed: invest in financial assets
• Earning < consumption needed: sell investments to fund their consumption
à this flexibility enables individuals to smooth consumption over their lifetime
III: Allocation of risk
Real assets involve risk, but financial markets help distribute that risk efficiently
• Investors with higher risk tolerance: buy stocks
• Risk-averse investors: buy bonds, which offer more stable returns
à helps businesses raise funds at better prices, supporting economic growth
IV: Separation of ownership and management
Large corporations have many shareholders who cannot directly manage the firm
Solution: elect board of directors to oversee management
• This system enables companies to grow beyond owner-operated businesses
• Problem: agency problem
- Managers may act in self-interest: e.g., avoiding risks to protect jobs
- Solutions:
o Performance-based compensation to align interests
o Board oversight to remove underperforming executives
o External monitoring by institutional investors/security analysts
o Threat of takeovers
V: Corporate governance and ethics
Market transparency is crucial for efficient capital allocation
• Corporate scandals involve fraudulent financial reporting that misleads investors
• Problems like: overstated profits, analysts using biased reports, auditors prioritising
consulting fees over accurate financial reporting
• Solution: Sarbanes-Oxley Act (2002) introduced reforms to strengthen CG
- More independent directors on corporate boards
- CFOs must personally certify financial statements
- Increased oversight of auditors to prevent conflicts of interest
The investment process
Investor’s portfolio: collection of investment assets that can include stocks, bonds, real estate,
commodities, and other asset classes
• Managing a portfolio involves making investment decisions and periodically rebalancing by
buying or selling securities
Key investment decisions
• Asset allocation: choosing how to distribute investments across different asset classes (e.g,
stocks, bonds, real estate)
• Security selection: choosing specific securities within each asset class (e.g., selecting Tesla
or Ford within the stock category)
,Top-down approach: begins with asset allocation before selecting individual securities (first
decides how much to invest in stocks etc. then select individual stock)
• This balances risk and return on a broad level
- Stocks have historically provided higher returns, but with high volatility
- Treasury bills are low-risk, but offer lower returns
Goals: manage risk while maximizing returns
Bottom-up approach: focuses on selecting securities that seem attractively prices
(undervalued), without as much concern for overall asset allocation
• Risk: can lead to over-concentration in a specific industry, region, etc.
• Advantage: investors may capitalize on mispriced securities and max. returns
Security analysis: valuing individual securities to determine whether they are good
investments
• Stocks are harder to evaluate than bonds, as stock performance depends heavily on the
issuing company’s financial health
Markets are competitive
Financial markets are highly competitive, implying that finding undervalued securities (free-lunches) is
difficult, because professional analysts constantly search for profitable opportunities
à 2 key implications
I: The risk-return trade-off
Investors seek high returns, but all investments carry some risk – actual returns often deviate from
expectations
• No-free-lunch rule: higher returns come with higher risk
- If an asset offered high returns without high risk, investors would rush to buy it,
driving its price up and lowering future returns
- If high-risk assets had the same return as low-risk assets, investors would sell risky
assets, lowering their prices until they become attractive again
Thus: trade-off between risk and return
à higher-risk assets must offer higher expected returns to compensate investors
à the risk-return relationship is the foundation of the Modern Portfolio Theory (MPT)
Diversification: holding multiple assets, which helps reduce portfolio risk
II: Efficient markets
Market efficiency suggest that financial markets process all available information quickly and
accurately, meaning security prices reflect their fair value
• If markets are truly efficient: investors cannot consistently find undervalued/overvalued
stocks
Passive management strategy: investors hold diversified portfolios without actively picking stocks
• Assumes markets are efficient; trying to beat the market is a resources waste
Active management: investors try to identify mispriced securities or time the market to improve
performance
• Assumes that markets are not fully efficient, meaning there are still opportunities for skilled
investors
• If markets were perfectly efficient, this management would be pointless
- Markets are however only ‘near-efficient’ à so still some profit opportunities for
diligent investors
The players
There are 3 major players int the financial markets:
1. Firms/corporations: net demanders of capital
- Raise funds by issuing securities to finance investments in real assets
- Investors then purchase these securities in exchange for future returns
2. Households: net suppliers of capital
, -Invest in securities issued by firms and the government
-Households cannot easily lend directly à rely on financial intermediaries (banks,
mutual funds etc.)
3. Governments: borrowers or lenders dependent on tax revenue/spending
- Budget deficits: borrowing by issuing Treasury bills/notes/bonds
- Budget surpluses: paying off outstanding debt
Financial intermediaries
= connect investors and borrowers, providing benefits such as diversification, risk assessment, and
economies of scale
à types of financial intermediaries
• Banks: take deposits and lend money, earning profits from the interest spread
• Investment companies: pool investor funds to invest in diversified portfolios (e.g., mutual
funds)
• Insurance companies: manage risks and invest premiums collected from policyholders
• Credit unions: member-owned institutions providing loans and financial services
Benefits of financial intermediaries
1. Pooling resources of many small investors allows large-scale (sum) lending
2. By lending to multiple borrowers, significant diversification is achieved
3. Utilise expertise and economies of scale to assess and manage risk efficiently
Investment companies: pool and manage money of many investors, originated out of economies of
scale
Mutual funds vs. hedge funds
• Mutual funds: open to retail investors, diversified, lower risk, charge management fees
• Hedge funds: open to institutions/wealthy individuals, high-risk strategies, charge
performance-based fees
Investment bankers
= help corporations raise capital by issuing securities; act as underwriter
• Advise firms on pricing, interest rates, and marketing of new securities
• Underwriter: buy securities from firms and resell them to the public
- Securities are sold in the primary market à new issues
- The secondary market allows investors to trade existing securities
à 2008 Financial Crises led to major changes in investment banking, with many firms merging
with commercial banks
Venture capital and private equity
Venture capital: provides early-stage funding for start-ups in exchange for equity (ownership stake)
• VC firms are limited partnerships, pooling funds from wealthy investors and institutions
• Investors take an active role in management and provide strategic advice
Private equity: invests in distressed or undervalued companies, aiming to improve and resell them
for profit
à unlike VC, PE focuses on mature businesses rather than startups
The Financial Crisis of 2008
The 2008 financial crisis was one of the worst economic downturns since the Great Depression
à the causes of the crisis
I: Low interest rates and housing boom (early 2000s)
After the 2000-2002 dot-com crash, the Federal Reserve lowered interest rates to stimulate the
economy (spending, investing)
• These low interest rates fuelled a housing boom, leading to rapidly rising home prices
• Investors sought higher returns, increasing demand for mortgage-backed securities (MBS)
