2021 - 2022
INVESTMENTS
SUMMARY
BM01FI
Laia Neira Quintanilla
, Laia Neira Quintanilla
Chapter 1: The Investment Environment
1.1 Real vs. Financial assets
Real asset: land, buildings, machines, and knowledge that can be used to produce goods and services.
Financial asset: bonds and stocks that do not contribute directly to the productive capacity of the economy but
instead are means by which individuals in well-developed economies hold their claims on real assets.
• While real assets generate net income to the economy, financial assets simply define the allocation of
income or wealth among investors.
1.2 Financial assets
Three broad types of financial assets: fixed income, equity, and derivatives.
Fixed-income or debt securities: promise either a fixed stream of income or a stream of income determined by a
specified formula.
• Money market refers to debt securities that are short term, highly marketable, and generally of very low
risk.
• Capital market includes long-term debt securities that range from very safe in terms of default risk (e.g.,
Treasury securities) to relatively risky (e.g., high-yield or “junk” bonds).
Equity: represents an ownership share in the corporation.
• Equity holders are not promised any particular payment.
• They receive any dividends the firm may pay and have prorated ownership in the real assets of the firm.
• If the firm is successful, the value of equity will increase; if not, it will decrease.
• The performance of equity investments, are therefore, tied directly to the success of the firm and its real
assets.
• For this reason, equity investments tend to be riskier than investments in debt securities.
Derivative securities such as options and futures contracts provide payoffs that are determined by the prices of
other assets such as bond, stock or commodity prices.
1.3 Financial markets (FM) and the economy
Real assets determine the wealth of an economy, while financial assets merely represent claims on real assets.
1.3.1 Informational roles of FM
Stock prices reflect investors’ collective assessment of a firm’s current performance and future prospects.
• When the market is more optimistic about the firm, its share price will rise.
• That higher price makes it easier for the firm to raise capital and therefore encourages investment.
• In this manner, stock prices play a major role in the allocation of capital in market economies, directing
capital to the firms and applications with the greatest perceived potential.
1
, Laia Neira Quintanilla
1.3.2 Timing aspects of FM
Investors can, in high-earnings periods, invest their savings in financial assets such as stocks and bonds and in low-
earnings periods, sell these assets to provide funds for their consumption needs.
By so doing, investors “shift” their consumption, thereby allocating their consumption to periods that provide the
greatest satisfaction.
1.3.3 Allocation of Risk in FM
Capital markets allow the risk that is inherent to all investments to be borne by the investors most willing to bear
it.
In other words, FM’s allow investors to partake in activities at the level of risk that they deem most appropriate for
their risk appetite.
1.3.4 Separation of ownership
Due to the separation of ownership between a firm’s managers and its investors potential conflicts of interest may
arise, called agency problems, because managers, who are hired as agents of the shareholders, may pursue their
own interests instead of what is best for their firm and its investors as a whole.
1.4 The Investment Process
An investor’s portfolio is simply a collection of its investment assets.
Once the portfolio is established, it is updated or “rebalanced” by:
i. selling existing securities and using the proceeds to buy new securities,
ii. by investing additional funds to increase the overall size of the portfolio,
iii. or by selling securities to decrease the size of the portfolio.
Investors make two types of decisions in constructing their portfolios:
i. The asset allocation decision: the choice among which broad asset classes like bonds, stocks, derivatives or
real estate to invest in
ii. The security selection decision: is the choice of which particular securities to hold within each asset class
“Top-down” portfolio construction starts with asset allocation.
• A top-down investor first makes crucial asset allocation decisions before turning to the decision of the
particular securities to be held in each asset class.
“Bottom-up” investors construct their portfolios from securities that seem attractively priced without as much
concern for the resultant asset allocation.
• Bottom-up techniques can result in unintended bets on one or other sectors of the economy.
• For example, it might turn out that the portfolio ends up with a very heavy representation of firms in one
industry, from one part of the country, or with exposure to one source of uncertainty. However, a bottom-up
strategy does focus the portfolio on the assets that seem to offer the most attractive investment
opportunities.
Security analysis: involves the valuation of particular securities that might be included in the portfolio.
2
, Laia Neira Quintanilla
1.5 FMs are competitive
There should be a risk–return trade-off in the securities markets, with higher-risk assets priced to offer higher
expected returns than lower-risk assets.
Diversification: means that many assets are held in a portfolio so that the exposure to any particular asset is limited.
Passive management calls for holding highly diversified portfolios without spending effort or other resources
attempting to improve investment performance through security analysis.
Active management is the attempt to improve performance either by identifying mispriced securities or by timing
the performance of broad asset classes—for example, increasing one’s commitment to stocks when one is bullish
on the stock market.
If markets are efficient and prices reflect all relevant information, perhaps it is better to follow passive strategies
instead of spending resources in a futile attempt to outguess your competitors in the financial markets.
1.6 Players in FMs and some other important aspects of FMs
i. Firms are net demanders of capital.
ii. Households typically are net suppliers of capital.
iii. Governments can be borrowers or lenders, depending on the relationship between tax revenue and
government expenditures
Financial intermediaries bring the suppliers of capital (investors) together with the demanders of capital (primarily
corporations and the federal government).
Mutual funds [FOR SMALL INVESTORS] have the advantage of large-scale trading and portfolio management, while
participating investors are assigned a prorated share of the total funds according to the size of their investment. This
system gives small investors advantages they are willing to pay for via a management fee to the mutual fund
operator.
Hedge funds [FOR LARGE INVESTORS] also pool and invest the money of many clients. But they are open only to
institutional investors such as pension funds, endowment funds, or wealthy individuals. They are more likely to
pursue complex and higher-risk strategies. They typically keep a portion of trading profits as part of their fees,
whereas mutual funds charge a fixed percentage of assets under management.
Investment banks -> underwriters in IPO’s
Primary market: where new issues of securities are offered to the public.
Secondary market: where investors can trade previously issued securities among themselves
A credit default swap, or CDS, is in essence an insurance contract against the default of one or more borrowers. The
purchaser of the swap pays an annual premium (like an insurance premium) for protection from credit risk.
SYSTEMATIC VS. UNSYSTEMATIC RISK
Ask price is the price you would have to pay to buy [INVESTORS PERSPECTIVE]
Bid price is the slightly lower price you would receive if you wanted to sell a bill to a dealer. [INVESTORS
PERSPECTIVE]
Bid–ask spread is the difference in these prices, which is the dealer’s source of profit.
3
INVESTMENTS
SUMMARY
BM01FI
Laia Neira Quintanilla
, Laia Neira Quintanilla
Chapter 1: The Investment Environment
1.1 Real vs. Financial assets
Real asset: land, buildings, machines, and knowledge that can be used to produce goods and services.
Financial asset: bonds and stocks that do not contribute directly to the productive capacity of the economy but
instead are means by which individuals in well-developed economies hold their claims on real assets.
• While real assets generate net income to the economy, financial assets simply define the allocation of
income or wealth among investors.
1.2 Financial assets
Three broad types of financial assets: fixed income, equity, and derivatives.
Fixed-income or debt securities: promise either a fixed stream of income or a stream of income determined by a
specified formula.
• Money market refers to debt securities that are short term, highly marketable, and generally of very low
risk.
• Capital market includes long-term debt securities that range from very safe in terms of default risk (e.g.,
Treasury securities) to relatively risky (e.g., high-yield or “junk” bonds).
Equity: represents an ownership share in the corporation.
• Equity holders are not promised any particular payment.
• They receive any dividends the firm may pay and have prorated ownership in the real assets of the firm.
• If the firm is successful, the value of equity will increase; if not, it will decrease.
• The performance of equity investments, are therefore, tied directly to the success of the firm and its real
assets.
• For this reason, equity investments tend to be riskier than investments in debt securities.
Derivative securities such as options and futures contracts provide payoffs that are determined by the prices of
other assets such as bond, stock or commodity prices.
1.3 Financial markets (FM) and the economy
Real assets determine the wealth of an economy, while financial assets merely represent claims on real assets.
1.3.1 Informational roles of FM
Stock prices reflect investors’ collective assessment of a firm’s current performance and future prospects.
• When the market is more optimistic about the firm, its share price will rise.
• That higher price makes it easier for the firm to raise capital and therefore encourages investment.
• In this manner, stock prices play a major role in the allocation of capital in market economies, directing
capital to the firms and applications with the greatest perceived potential.
1
, Laia Neira Quintanilla
1.3.2 Timing aspects of FM
Investors can, in high-earnings periods, invest their savings in financial assets such as stocks and bonds and in low-
earnings periods, sell these assets to provide funds for their consumption needs.
By so doing, investors “shift” their consumption, thereby allocating their consumption to periods that provide the
greatest satisfaction.
1.3.3 Allocation of Risk in FM
Capital markets allow the risk that is inherent to all investments to be borne by the investors most willing to bear
it.
In other words, FM’s allow investors to partake in activities at the level of risk that they deem most appropriate for
their risk appetite.
1.3.4 Separation of ownership
Due to the separation of ownership between a firm’s managers and its investors potential conflicts of interest may
arise, called agency problems, because managers, who are hired as agents of the shareholders, may pursue their
own interests instead of what is best for their firm and its investors as a whole.
1.4 The Investment Process
An investor’s portfolio is simply a collection of its investment assets.
Once the portfolio is established, it is updated or “rebalanced” by:
i. selling existing securities and using the proceeds to buy new securities,
ii. by investing additional funds to increase the overall size of the portfolio,
iii. or by selling securities to decrease the size of the portfolio.
Investors make two types of decisions in constructing their portfolios:
i. The asset allocation decision: the choice among which broad asset classes like bonds, stocks, derivatives or
real estate to invest in
ii. The security selection decision: is the choice of which particular securities to hold within each asset class
“Top-down” portfolio construction starts with asset allocation.
• A top-down investor first makes crucial asset allocation decisions before turning to the decision of the
particular securities to be held in each asset class.
“Bottom-up” investors construct their portfolios from securities that seem attractively priced without as much
concern for the resultant asset allocation.
• Bottom-up techniques can result in unintended bets on one or other sectors of the economy.
• For example, it might turn out that the portfolio ends up with a very heavy representation of firms in one
industry, from one part of the country, or with exposure to one source of uncertainty. However, a bottom-up
strategy does focus the portfolio on the assets that seem to offer the most attractive investment
opportunities.
Security analysis: involves the valuation of particular securities that might be included in the portfolio.
2
, Laia Neira Quintanilla
1.5 FMs are competitive
There should be a risk–return trade-off in the securities markets, with higher-risk assets priced to offer higher
expected returns than lower-risk assets.
Diversification: means that many assets are held in a portfolio so that the exposure to any particular asset is limited.
Passive management calls for holding highly diversified portfolios without spending effort or other resources
attempting to improve investment performance through security analysis.
Active management is the attempt to improve performance either by identifying mispriced securities or by timing
the performance of broad asset classes—for example, increasing one’s commitment to stocks when one is bullish
on the stock market.
If markets are efficient and prices reflect all relevant information, perhaps it is better to follow passive strategies
instead of spending resources in a futile attempt to outguess your competitors in the financial markets.
1.6 Players in FMs and some other important aspects of FMs
i. Firms are net demanders of capital.
ii. Households typically are net suppliers of capital.
iii. Governments can be borrowers or lenders, depending on the relationship between tax revenue and
government expenditures
Financial intermediaries bring the suppliers of capital (investors) together with the demanders of capital (primarily
corporations and the federal government).
Mutual funds [FOR SMALL INVESTORS] have the advantage of large-scale trading and portfolio management, while
participating investors are assigned a prorated share of the total funds according to the size of their investment. This
system gives small investors advantages they are willing to pay for via a management fee to the mutual fund
operator.
Hedge funds [FOR LARGE INVESTORS] also pool and invest the money of many clients. But they are open only to
institutional investors such as pension funds, endowment funds, or wealthy individuals. They are more likely to
pursue complex and higher-risk strategies. They typically keep a portion of trading profits as part of their fees,
whereas mutual funds charge a fixed percentage of assets under management.
Investment banks -> underwriters in IPO’s
Primary market: where new issues of securities are offered to the public.
Secondary market: where investors can trade previously issued securities among themselves
A credit default swap, or CDS, is in essence an insurance contract against the default of one or more borrowers. The
purchaser of the swap pays an annual premium (like an insurance premium) for protection from credit risk.
SYSTEMATIC VS. UNSYSTEMATIC RISK
Ask price is the price you would have to pay to buy [INVESTORS PERSPECTIVE]
Bid price is the slightly lower price you would receive if you wanted to sell a bill to a dealer. [INVESTORS
PERSPECTIVE]
Bid–ask spread is the difference in these prices, which is the dealer’s source of profit.
3
