This document provides an overview of investments and financial markets. It discusses key concepts like financial intermediation, different types of financial markets and securities, interest rates, and the relationship between risk and return. The purpose of the financial system is to connect individuals and entities with surplus funds to those that need funds. Financial intermediaries like banks facilitate the flow of funds between these groups.

1. Investments and Financial Markets
Introduction

2. Master Objectives
 Investment and Opportunity Cost
 Debt Cycle
 Financial Institutions and Intermediation
 Financial Instruments
 Portfolio Theory
 Active Investment Management
 Financial Crises

3. Financial System
 Purpose: bring together individuals, businesses, and
government entities (economic units) that generate
and spend funds.
 Surplus economic units have funds left
over after spending all they wish to spend.
 Deficit economic units need to acquire
additional funds to sustain their
operations.

4. Financial Markets
 Classified according to characteristics of participants
and securities
 Primary Market: deficit economic units sell securities to
raise funds.
 Secondary market is where investors trade previously
issued securities with each other.
 Other types of Markets, e.g. Money and Capital
Markets

5. Financial Markets
 Money Market
 Trade short term (1 year or less) debt
instruments (e.g. T-Bills, Commercial Paper)
 Major money centers in Tokyo, London and
New York
 Capital Market
 Trades long term securities (Bonds, Stocks)
 NYSE, ASE, LSE, over-the-counter (NASDAQ
and other OTC)

6. Financial Markets
 Intermediaries, such as commercial and investment
banks and insurance companies facilitate the flow of
funds in the financial marketplace. This called
“Financial Intermediation”.
$$ Securities
Securities $$

7. Market Efficiency
 Market efficiency refers to the ease, speed, and
cost of trading securities.
 The market for the securities of large
companies is generally efficient: Trades can
be executed in a matter of seconds and
commissions are very low. Somewhat true: rule
generally is still T+3.
 The real estate market is not generally efficient:
It can take months to sell a house and the
commission is 6-7% of the price.

8. Market Efficiency
 Why is market efficiency important?
 The more efficient the market, the easier it
is to transfer idle funds to those parties that need the
funds.
 If funds remain idle, this results in lower growth for the
economy and higher unemployment.
 Investors can adjust their portfolios easily
and at low cost as their needs and preferences change.

9. Securities in the Financial Market
 Money Market Securities
 Highly liquid, low risk
 Treasury Bills (T-Bills)
 Certificates of Deposit (CDs)
 Commercial Paper
 Eurodollars
 Banker’s Acceptances

10. Treasury Bills
 T-Bills are short term securities issued by the
Federal Government [USA].
 After initial sale, there is an active secondary market.
 They are bought at discount and at maturity face
value is paid.

11. Negotiable Certificate of Deposit
 Interest bearing securities issued by financial
institutions.
 Maturities of one year or less.

12. Commercial Paper
 Unsecured debt issued by large corporations with
good credit ratings.
 Usually bought only by large institutions.

13. Eurodollars
 They are dollar denominated deposits located in
non-US banks.
 Buyers and sellers are large institutions.

14. Banker’s Acceptances
 Debt securities guaranteed by a bank.
 Used primarily to facilitate international
transactions, e.g. International trade.

15. Bonds
 They are “IOUs” issued by the borrower and sold to
investors.
 Issuer promises to pay the face amount of the bond
on the maturity date, plus pay interest each year in
the amount of the coupon rate times the face value.
 How many “cash flow” streams does a bond have?
 Other types
 Treasury bonds issued by Federal Government
 Municipal bonds issued by state and local governments
 Corporate bonds

16. Common Stock
 Shareholders own a portion of the company and
have right to vote on major decisions
 Return on investment: dividends [if paid by company]
and capital gain, if any.

17. Preferred Stock
 Hybrid instrument between bond and common stock.
 Accounting purposes, it is equity, not debt.
 Dollar value is guaranteed
 Dividends paid to preferred shareholders first under
contract
 Rarely have voting rights
 In event of insolvency, paid off after bondholders but
before common shareholders

18. Interest Rates
 Interest Rates Determined by
 Real Rate of Interest
 Expected Inflation
 Default Risk
 Maturity Risk
 Liquidity Risk

19. Real rate of interest
 Compensation for lender’s lost opportunity to
consume.

20. Default Risk
 For most securities, there is some risk that the
borrower will not repay the interest and/or principal
on time, or at all.
 The greater the chance of default, the greater the
interest rate the investor demands and the issuer
must pay.

21. Expected Inflation
 Inflation erodes the purchasing power of money.
 Example: If you loan someone $1,000 and they pay it
back one year later with 10% interest, you will have
$1,100. But if prices have increased by 5%, then
something that would have cost $1,000 at the outset of
the loan will now cost $1,000(1.05) = $1,050.

22. Maturity Risk
 If interest rates rise, lenders may find that their
loans are earning rates that are lower than what
they could get on new loans.
 The risk of this occurring is higher for longer
maturity loans.
 Lenders will adjust the premium they charge for this risk
depending on whether they believe rates will go up or
down.

23. Liquidity Risk
 Investments that are easy to sell without losing
value are more liquid.
 Illiquid securities have a higher interest rate to
compensate the lender for the inconvenience of
being “stuck.”

24. Determination of Rates
k = k* + IRP + DRP + MP + LP
k = the nominal, or
observed rate
on security
k* = real rate of
interest
IRP = Inflation Risk
Premium
DRP = Default Risk
Premium
MP = Maturity Premium
LP = Liquidity Premium

25. Term Structure
 Relationship between long and short
term interest rates
 Yield curve

26. Treasury Yield Curve
8.00
%
7.50 3 month
% T-Bill
7.00
%
6.50
%
6.00
%
5.50
%
5.00
%
4.50
%
4.00
%
3.50
% 3 6 1 2 3 5 7 1 2
mos yr. maturities 0
0
.

27. Treasury Yield Curve
8.00%
7.50%
7.00%
6.50%
6.00%
5.50%
5.00%
4.50%
4.00%
3.50%
3 6 1 2 3 5 7 10 20
mos. yr. maturities

28. Financial versus Real Assets
 Essential nature
 Reduced current consumption
 Planned later consumption
 Real Assets
 Assets used to produce goods and services
 Financial Assets
 Claims on real assets

29. Investment Process
 Asset Allocation
 Security selection
 Risk-return trade-off
 Market efficiency
 Active vs. passive management

30. Active versus Passive Management
Active Management
 Finding undervalued securities
 Timing the market
Passive Management
 No attempt to find undervalued securities
 No attempt to time
 Holding an efficient portfolio

31. Financial Engineering
Repackaging Services of Financial Intermediaries
 Bundling and unbundling of cash flows
 Slicing and dicing of cash flows
 Examples: strips, CMOs, dual purpose
funds, principal/interest splits