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fixed-income securities

Pay a specified cash flow over a specific period.

Part ONE Elements of Investments equity

An ownership share in a corporation.

derivative securities

Securities providing payoffs that depend on the values of other assets.

of income that is determined according to a specified formula. For example, a corporate 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 two 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 fixed-income 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 fixed-income securities that are short term, highly marketable, and generally of very low risk. Examples of money market securities are 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 (for example, Treasury securities) to relatively risky (for example, high yield or "junk" bonds). They also are designed with extremely diverse provisions regarding payments 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 fixed-income market in Part Three.

Unlike fixed-income securities, common stock, or equity, in a firm 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, 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 fixed-income securities. Equity markets and equity valuation are the topics of Part Four.

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.1 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 Five.

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.

In addition to these financial assets, individuals might invest directly in some real assets. For example, real estate or commodities such as precious metals or agricultural products are real assets that might form part of an investment portfolio.

'A call option is the right to buy a share of stock at a given exercise price on or before the option's maturity 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 matures, however, the option can be exercised to obtain the share for only $30.

1 Investments: Background and Issues 7

1.3: FINANCIAL MARKETS AND THE ECONOMY

We stated earlier that real assets determine the wealth of an economy, while financial assets merely represent claims on real assets. Nevertheless, financial assets and the markets in which they are traded play several crucial roles in developed economies. Financial assets allow us to make the most of the economy's real assets.

Consumption Timing

Some individuals in an economy are earning more than they currently wish to spend. Others, for example, retirees, spend more than they currently earn. How can you shift your purchasing power from high-earnings periods to low-earnings periods of life? One way is to "store" your wealth in financial assets. In high-earnings periods, you can invest your savings in financial assets such as stocks and bonds. In low-earnings periods, you can sell these assets to provide funds for your consumption needs. By so doing, you can "shift" your consumption over the course of your lifetime, thereby allocating your consumption to periods that provide the greatest satisfaction. Thus, financial markets allow individuals to separate decisions concerning current consumption from constraints that otherwise would be imposed by current earnings.

Allocation of Risk

Virtually all real assets involve some risk. When GM builds its auto plants, for example, it cannot know for sure what cash flows those plants will generate. Financial markets and the diverse financial instruments traded in those markets allow investors with the greatest taste for risk to bear that risk, while other, less risk-tolerant individuals can, to a greater extent, stay on the sidelines. For example, if GM raises the funds to build its auto plant by selling both stocks and bonds to the public, the more optimistic or risk-tolerant investors can buy shares of stock in GM, while the more conservative ones can buy GM bonds. Because the bonds promise to provide a fixed payment, the stockholders bear most of the business risk. Thus, capital markets allow the risk that is inherent to all investments to be borne by the investors most willing to bear that risk.

This allocation of risk also benefits the firms that need to raise capital to finance their investments. When investors are able to select security types with the risk-return characteristics that best suit their preferences, each security can be sold for the best possible price. This facilitates the process of building the economy's stock of real assets.

Separation of Ownership and Management

Many businesses are owned and managed by the same individual. This simple organization is well-suited to small businesses and, in fact, was the most common form of business organization before the Industrial Revolution. Today, however, with global markets and large-scale production, the size and capital requirements of firms have skyrocketed. For example, General Electric has property, plant, and equipment worth over $40 billion, and total assets in excess of $400 billion. Corporations of such size simply cannot exist as owner-operated firms. GE actually has over one-half million stockholders with an ownership stake in the firm proportional to their holdings of shares.

Such a large group of individuals obviously cannot actively participate in the day-to-day management of the firm. Instead, they elect a board of directors which in turn hires and supervises the management of the firm. This structure means that the owners and managers of

Part ONE Elements of Investments agency problem

Conflicts of interest between managers and stockholders.

the firm are different parties. This gives the firm a stability that the owner-managed firm cannot achieve. For example, if some stockholders decide they no longer wish to hold shares in the firm, they can sell their shares to another investor, with no impact on the management of the firm. Thus, financial assets and the ability to buy and sell those assets in the financial markets allow for easy separation of ownership and management.

How can all of the disparate owners of the firm, ranging from large pension funds holding hundreds of thousands of shares to small investors who may hold only a single share, agree on the objectives of the firm? Again, the financial markets provide some guidance. All may agree that the firm's management should pursue strategies that enhance the value of their shares. Such policies will make all shareholders wealthier and allow them all to better pursue their personal goals, whatever those goals might be.

Do managers really attempt to maximize firm value? It is easy to see how they might be tempted to engage in activities not in the best interest of shareholders. For example, they might engage in empire building or avoid risky projects to protect their own jobs or overconsume luxuries such as corporate jets, reasoning that the cost of such perquisites is largely borne by the shareholders. These potential conflicts of interest are called agency problems because managers, who are hired as agents of the shareholders, may pursue their own interests instead.

Several mechanisms have evolved to mitigate potential agency problems. First, compensation plans tie the income of managers to the success of the firm. A major part of the total compensation of top executives is typically in the form of stock options, which means that the managers will not do well unless the stock price increases, benefiting shareholders. (Of course, we've learned more recently that overuse of options can create its own agency problem. Options can create an incentive for managers to manipulate information to prop up a stock price temporarily, giving them a chance to cash out before the price returns to a level reflective of the firm's true prospects.) Second, while boards of directors are sometimes portrayed as defenders of top management, they can, and in recent years increasingly do, force out management teams that are underperforming. Third, outsiders such as security analysts and large institutional investors such as pension funds monitor the firm closely and make the life of poor performers at the least uncomfortable.

Finally, bad performers are subject to the threat of takeover. If the board of directors is lax in monitoring management, unhappy shareholders in principle can elect a different board. They can do this by launching a proxy contest in which they seek to obtain enough proxies (i.e., rights to vote the shares of other shareholders) to take control of the firm and vote in another board. However, this threat is usually minimal. Shareholders who attempt such a fight have to use their own funds, while management can defend itself using corporate coffers. Most proxy fights fail. The real takeover threat is from other firms. If one firm observes another underperforming, it can acquire the underperforming business and replace management with its own team.

asset allocation

Allocation of an investment portfolio across broad asset classes.

security selection

Choice of specific securities within each asset class.

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