1. Chapter 1 – The Investment Environment
1. History of Investing
2. The Economic System and Investment
Buyers think value is higher than share price, sellers think opposite
Market Price  used by corporation when it needs to issue new shares
Corporation is only involved when issuing shares, or repurchasing
Companies raise capital from investing public by issuing new shares
Bonds  acknowledge indebtedness, specify terms of repayment
Stocks  Convey ownership rights, no guarantee of return. Allow investor to
participate in business activities while being protected from individual
ownership. They are relatively liquid, and offer limited liability. Greatest loss
is the investment itself
a) Real Investment Vs Financial Investment
i) Financial Investment – investment in stocks and bonds. Cash is
exchanged between investors, no new capital reaches the company
ii) Real Investment – when corporation takes capital and invests in
productive assets
iii) Real Assets – determine productive capacity of the economy. Land,
buildings, machines, even knowledge, necessary to produce goods and
services.
iv) Financial Assets – stocks and bonds. Do not represent society’s wealth.
Stocks only represent ownership rights. Contribute to productive
capacity of the economy indirectly, allow for separation of ownership and
management and transfer funds.
 When real assets generate income, income allocated first to bond holders
and creditors, remainder goes to stockholders. Values of the financial
assets are derived from and depend on values of the underlying assets of
the firm
 Real assets are income generating assets, financial assets define
allocation of income
 Financial assets are the means by which individuals hold their claims on
real assets
 Information Role – efficient allocation of investment capital to companies
with promise
 Consumption Timing – allow individuals to separate decisions
concerning current consumption from constraints that would be
imposed by current earning. Buy financial assets when you are working,
sell them when retiring
 Separation of Ownership and Management – if stockholders no longer
want to participate in ownership, they can sell stocks to other investors.
No disruption occurs.
3. The Participants
a) Individuals and Financial Objectives

2. o Attitudes shift towards risk aversion as people age. When you are young
you have more time to earn money to make up for financial loss, as you
age you have less time to earn income to make up for a loss
b) Investment Process
o Asset allocation – choice among broad asset classes – stocks, bonds etc
o Security allocation – choice of securities within each asset class
o Top down construction – begins with asset allocation.
o Security Analysis – valuation of securities that might be included in the
portfolio  difficult with stocks due to sensitivity to the condition of the
issuing firm
o Bottom-up construction – choose attractive securities, without care for
asset allocation. May end up heavily weighted
c) Financial Intermediaries
o Bring lenders and borrowers together
o Investment companies – pool resources and lend large sums to
borrowers. Achieve significant diversification, so they can accept loans
that would be too risky on their own. Also build knowledge through the
large volume of transactions. Investment firm can perform the same
service for many clients, and charge for it
o Investment Bankers – advise corporation on the prices it can charge for
securities issued, interest rates, etc. Handles marketing in the primary
market (new issue). Also trade securities in secondary market. Bankers
own best interest to protect its reputation for honesty.
o
4. Recent Trends
a) Globalization
o Purchase foreign securities using American Depository Receipts
(domestically traded but represent claims to foreign shares)
o Purchase foreign securities sold in dollars
o Buy mutual funds or exchange traded funds that participate
internationally
o Derivative securities with payoffs that depend on prices in foreign
security markets
b) Financial Engineering
o Use of mathematical models and computer-based trading technologies to
create new financial products
o Unbundling – breaking up and allocating the cash flows from one
security to create several new securities
o Bundling – combining more than one security into a composite security
o Allows for custom tailored risk attributes
c) Securitization
o Converts non-marketable assets, such as receivables, into traded
securities by issuing claims against the firm back by original assets
o Mortgage Backed Security – insures and guarantees pools of
mortgages issued by banks. Securities grant an interest in the
payments on the mortgages to their holders. Breakthrough, since

3. mortgage funds can flow from any region to where they are
demanded
o
d) Information and Computer Networks
o Online trading – connects investor directly to a brokerage firm.
Process is cheaper and charge lower commission.
o Online information dissemination – data, investment tools, analysts
reports are available
o Automated trade crossing – Allow direct trading among investors.
Members post buy/sell orders, automatically matched up
5. The Agency Problem: Executives, Analysts, and Auditors
o Managers failed to disclose their own investment or disinvestment in
company shares through incentive plans based on stock options
o Investment dealers who failed to disclose the conflict of interest
between their banking divisions and their analyst sections, despite the
potential for biased recommendations
o Accounting audits that failed to disclose enough information about the
cash flows, the risky assets, and the alternative definitions of income
6. Lessons to Learn
a) Free Lunches
b) Diversification, Information, and Patience
7. Outline of the Text