Real assets create wealth. Financial assets represent claims to parts or all of that wealth. Financial assets determine how the ownership of real assets is distributed among investors. • Financial assets can be categorized as fixed-income (debt), equity, or derivative instru-ments. Top-down portfolio construction techniques start with the asset allocation decision—the allocation of funds across broad asset classes—and then progress to more specific security-selection decisions. • Competition in financial markets leads to a risk-return trade-off, in which securities that offer higher expected rates of return also impose greater risks on investors. The presence of risk, however, implies that actual returns can differ considerably from expected returns at the beginning of the investment period. Competition among security analysts also results in financial markets that are nearly informationally efficient, meaning that prices reflect all available information concerning the value of the security. Passive investment strategies may make sense in nearly efficient markets. Financial intermediaries pool investor funds and invest them. Their services are in demand because small investors cannot efficiently gather information, diversify, and monitor port-folios. The financial intermediary, in contrast, is a large investor that can take advantage of scale economies. • Investment banking brings efficiency to corporate fund raising. Investment bankers develop expertise in pricing new issues and in marketing them to investors. By the end of 2008, all the major stand-alone U.S. investment banks had been absorbed into commercial banks or had reorganized themselves into bank holding companies. In Europe, where uni- versal banking had never been prohibited, large banks had long maintained both commer-cial and investment banking divisions. • The financial crisis of 2008 showed the importance of systemic risk. Systemic risk can be limited by transparency that allows traders and investors to assess the risk of their counterparties, capital requirements to prevent trading participants from being brought down by potential losses, frequent settlement of gains or losses to prevent losses from accumulating beyond an institution’s ability to bear them, incentives to discourage exces-sive risk taking, and accurate and unbiased analysis by those charged with evaluating security risk.
Chapter 2 Summary
Money market securities are very short-term debt obligations. They are usually highly marketable and have relatively low credit risk. Their low maturities and low credit risk ensure minimal capital gains or losses. These securities often trade in large denominations, but they may be purchased indirectly through money market funds. • Much of U.S. government borrowing is in the form of Treasury bonds and notes. These are coupon-paying bonds usually issued at or near par value. Treasury bonds are similar in design to coupon-paying corporate bonds. • Municipal bonds are distinguished largely by their tax-exempt status. Interest payments (but not capital gains) on these securities are exempt from income taxes. Mortgage pass-through securities are pools of mortgages sold in one package. Owners of pass-throughs receive all principal and interest payments made by the borrower. The firm that originally issued the mortgage merely services the mortgage, simply “passing through” the payments to the purchasers of the mortgage. Payments of interest and principal on government agency pass-through securities are guaranteed, but payments on private-label mortgage pools are not. • Common stock is an ownership share in a corporation. Each share entitles its owner to one vote on matters of corporate governance and to a prorated share of the dividends paid to shareholders. Stock, or equity, owners are the residual claimants on the income earned by the firm. • Preferred stock usually pays a fixed stream of dividends for the life of the firm: It is a