Summary Test Bank for Investments

The Investment Environment CHAPTER 1PART I (continued) 2 (concluded) the setting in which they act. Finally, we discuss the financial crisis that began playing out in 2007 and peaked in 2008. The crisis dramatically illustrated the connections between the financial system and the “real” side of the economy. We look at the origins of the crisis and the lessons that may be drawn about systemic risk. We close the chapter with an overview of the remainder of the text. The material wealth of a society is ultimately determined by the productive capacity of its economy, that is, the goods and services its members can create. This capacity is a function of the real assets of the economy: the land, buildings, machines, and knowledge that can be used to produce goods and services. In contrast to real assets are financial assets such as stocks and bonds. Such securities are no more than sheets of paper or, more likely, computer entries, and they do not contribute directly to the productive capacity of the economy. Instead, these assets are the means by which individuals in well-developed economies hold their claims on real assets. Financial assets are claims to the income generated by real assets (or claims on income from the government). If we cannot own our own auto plant (a real asset), we can still buy shares in Ford or Toyota (financial assets) and thereby share in the income derived from the production of automobiles. While real assets generate net income to the economy, financial assets simply define the allocation of income or wealth among investors. Individuals can choose between consuming their wealth today or investing for the future. If they choose to invest, they may place their wealth in financial assets by purchasing various securities. When investors buy these securi- ties from companies, the firms use the money so raised to pay for real assets, such as plant, equipment, technology, or inventory. So investors’ returns on securities ultimately come from the income produced by the real assets that were financed by the issuance of those securities. The distinction between real and financial assets is appar- ent when we compare the balance sheet of U.S. households, shown in Table 1.1, with the composition of national wealth in the United States, shown in Table 1.2. Household wealth includes financial assets such as bank accounts, corporate stock, or bonds. However, these securities, which are finan- cial assets of households, are liabilities of the issuers of the securities. For example, a bond that you treat as an asset because it gives you a claim on interest income and repay- ment of principal from Toyota is a liability of Toyota, which is obligated to make these payments to you. Your asset is Toyota’s liability. Therefore, when we aggregate over all balance sheets, these claims can- cel out, leaving only real assets as the net wealth of the economy. National wealth consists of structures, equipment, inventories of goods, and land.1 1.1 Real Assets versus Financial Assets 1You might wonder why real assets held by households in Table 1.1 amount to $30,979 billion, while total real assets in the domestic economy (Table 1.2) are far larger, at $64,747 billion. A big part of the difference reflects the fact that real assets held by firms, for example, property, plant, and equipment, are included as financial assets of the household sector, specifically through the value of corporate equity and other stock market investments. Similarly, Table 1.2 includes assets of noncorporate businesses. Finally, there are some differences in valuation methods. For example, equity and stock investments in Table 1.1 are measured by market value, whereas plant and equipment in Table 1.2 are valued at replacement cost. Are the following assets real or financial? a. Patents b. Lease obligations c. Customer goodwill d. A college education e. A $5 bill Concept Check 1.1 C H A P T E R 1 The Investment Environment 3 Table 1.1 Balance sheet of U.S. households Note: Column sums may differ from total because of rounding error. Source: Flow of Funds Accounts of the United States, Board of Governors of the Federal Reserve System, March 2016. Assets $ Billion % Total Liabilities and Net Worth $ Billion % Total Real assets Liabilities Real estate $ 25,276 25.0% Mortgages $ 9,711 9.6% Consumer durables 5,241 5.2 Consumer credit 3,533 3.5 Other 463 0.5 Bank and other loans 975 1.0 Total real assets $ 30,979 30.6% Other 291 0.3 Total liabilities $ 14,510 14.3% Financial assets Deposits $ 10,693 10.6% Life insurance reserves 1,331 1.3 Pension reserves 20,972 20.7 Corporate equity 13,311 13.1 Equity in noncorporate business 10,739 10.6 Mutual fund shares 8,119 8.0 Debt securities 4,200 4.1 Other 962 0.9 Total financial assets $ 70,327 69.4 Net worth 86,796 85.7 Total $101,306 100.0% $101,306 100.0% We will focus almost exclusively on financial assets. But you shouldn’t lose sight of the fact that the successes or failures of the financial assets we choose to purchase ultimately depend on the performance of the underlying real assets. 1.2 Financial Assets It is common to distinguish among 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. For example, a corporate Assets $ Billion Commercial real estate $17,269 Residential real estate 31,643 Equipment and intellectual property 8,104 Inventories 2,492 Consumer durables 5,240 Total $64,747 Table 1.2 Domestic net worth Note: Column sums may differ from total because of rounding error. Source: Flow of Funds Accounts of the United States, Board of Governors of the Federal Reserve System, March 2016. 4 P A R T I Introduction bond typically would promise that the bondholder will receive a fixed amount of interest each year. Other so-called floating-rate bonds promise payments that depend on current interest rates. For example, a bond may pay an interest rate that is fixed at 2 percentage points above the rate paid on U.S. Treasury bills. Unless the borrower is declared bankrupt, the payments on these securities are either fixed or determined by formula. For this reason, the investment performance of debt securities typically is least closely tied to the financial condition of the issuer. Nevertheless, fixed-income securities come in a tremendous variety of maturities and payment provisions. At one extreme, the money market refers to debt securities that are short term, highly marketable, and generally of very low risk, for example, U.S. Treasury bills or bank certificates of deposit (CDs). In contrast, the fixed-income capital market includes long-term securities such as Treasury bonds, as well as bonds issued by federal agencies, state and local municipalities, and corporations. These bonds range from very safe in terms of default risk (e.g., Treasury securities) to relatively risky (e.g., high-yield or “junk” bonds). They also are designed with extremely diverse provisions regarding pay- ments provided to the investor and protection against the bankruptcy of the issuer. We will take a first look at these securities in Chapter 2 and undertake a more detailed analysis of the debt market in Part Four. Unlike debt securities, common stock, or equity, in a firm represents an ownership share in the corporation. Equityholders 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, therefore, is 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. Equity markets and equity valuation are the topics of Part Five. Finally, derivative securities such as options and futures contracts provide payoffs that are determined by the prices of other assets such as bond or stock prices. For example, a call option on a share of Intel stock might turn out to be worthless if Intel’s share price remains below a threshold or “exercise” price such as $30 a share, but it can be quite valuable if the stock price rises above that level.2 Derivative securities are so named because their values derive from the prices of other assets. For example, the value of the call option will depend on the price of Intel stock. Other important derivative securities are futures and swap contracts. We will treat these in Part Six. Derivatives have become an integral part of the investment environment. One use of derivatives, perhaps the primary use, is to hedge risks or transfer them to other parties. This is done successfully every day, and the use of these securities for risk management is so commonplace that the multitrillion-dollar market in derivative assets is routinely taken for granted. Derivatives also can be used to take highly speculative positions, however. Every so often, one of these positions blows up, resulting in well-publicized losses of hundreds of millions of dollars. While these losses attract considerable attention, they are in fact the exception to the more common use of such securities as risk management tools. Derivatives will continue to play an important role in portfolio construction and the financial system. We will return to this topic later in the text. Investors and corporations regularly encounter other financial markets as well. Firms engaged in international trade regularly transfer money back and forth between dollars and other currencies. In London alone, nearly $2 trillion dollars of currency is traded each day. 2A call option is the right to buy a share of stock at a given exercise price on or before the option’s expiration date. If the market price of Intel remains below $30 a share, the right to buy for $30 will turn out to be valueless. If the share price rises above $30 before the option expires, however, the option can be exercised to obtain the share for only $30. C H A P T E R 1 The Investment Environment 5 Investors also might invest directly in some real assets. For example, dozens of commodities are traded on exchanges such as the New York Mercantile Exchange or the Chicago Board of Trade. You can buy or sell corn, wheat, natural gas, gold, silver, and so on. Commodity and derivative markets allow firms to adjust their exposure to various business risks. For example, a construction firm may lock in the price of copper by buying copper futures contracts, thus eliminating the risk of a sudden jump in the price of its raw materials. Wherever there is uncertainty, investors may be interested in trading, either to speculate or to lay off their risks, and a market may arise to meet that demand. 1.3 Financial Markets and the Economy