Investments E-Book

Michael G. Mcmillian

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Serie: The CFA Institute Series
• Sprache: Englisch

Seitenzahl: 1217

Veröffentlichungsjahr: 2011

Beschreibung

A comprehensive guide to investment analysis and portfolio management by an expert team from the CFA Institute In a world of specialization, no other profession likely requires such broad, yet in-depth knowledge than that of financial analyst. Financial analysts must not only possess a broad understanding of the financial markets-including structure, organization, efficiency, portfolio management, risk and return, and planning and construction-but they must also have a strong sense of how to evaluate industries and companies prior to engaging in an analysis of a specific stock. Investments: Principles of Portfolio and Equity Analysis provides the broad-based knowledge professionals and students of the markets need to manage money and maximize return. The book * Details market structure and functions, market anomalies, secondary market basics, and regulation * Describes investment assets and asset classes, types of positions and orders, as well as forecasting methodologies * Discusses return and risk characteristics, portfolio diversification and management, the basics of both technical analysis and major technical indicators, and much more * A companion Workbook, which includes learning outcomes, summary overviews, and problems and solutions sections is available and sold separately Investments provides readers unparalleled access to the best in professional quality information on investment analysis and portfolio management.

Leseprobe

Contents

Foreword

Acknowledgments

Introduction

Chapter 1: Market Organization and Structure

Learning Outcomes

1. Introduction

2. The Functions of the Financial System

3. Assets and Contracts

4. Financial Intermediaries

5. Positions

6. Orders

7. Primary Security Markets

8. Secondary Security Market and Contract Market Structures

9. Well-Functioning Financial Systems

10. Market Regulation

11. Summary

Problems

Chapter 2: Security Market Indices

Learning Outcomes

1. Introduction

2. Index Definition and Calculations of Value and Returns

3. Index Construction and Management

4. Uses of Market Indices

5. Equity Indices

6. Fixed-Income Indices

7. Indices for Alternative Investments

8. Summary

Problems

Chapter 3: Market Efficiency

Learning Outcomes

1. Introduction

2. The Concept of Market Efficiency

3. Forms of Market Efficiency

4. Market Pricing Anomalies

5. Behavioral Finance

6. Summary

Problems

Chapter 4: Portfolio Management: An Overview

Learning Outcomes

1. Introduction

2. A Portfolio Perspective on Investing

3. Investment Clients

4. Steps in the Portfolio Management Process

5. Pooled Investments

6. Summary

Problems

Chapter 5: Portfolio Risk and Return: Part I

Learning Outcomes

1. Introduction

2. Investment Characteristics of Assets

3. Risk Aversion and Portfolio Selection

4. Portfolio Risk

5. Efficient Frontier and Investor’s Optimal Portfolio

6. Summary

Problems

Chapter 6: Portfolio Risk and Return: Part II

Learning Outcomes

1. Introduction

2. Capital Market Theory

3. Pricing of Risk and Computation of Expected Return

4. The Capital Asset Pricing Model

5. Beyond the Capital Asset Pricing Model

6. Summary

Problems

Chapter 7: Basics of Portfolio Planning and Construction

Learning Outcomes

1. Introduction

2. Portfolio Planning

3. Portfolio Construction

4. Summary

Problems

Chapter 8: Overview of Equity Securities

Learning Outcomes

1.Introduction

2. Equity Securities in Global Financial Markets

3. Types and Characteristics of Equity Securities

4. Private Versus Public Equity Securities

5. Investing in Nondomestic Equity Securities

6. Risk and Return Characteristics of Equity Securities

7. Equity Securities and Company Value

8. Summary

Problems

Chapter 9: Introduction to Industry and Company Analysis

Learning Outcomes

1. Introduction

2. Uses of Industry Analysis

3. Approaches to Identifying Similar Companies

4. Industry Classification Systems

5. Describing and Analyzing an Industry

6. Company Analysis

7. Summary

Problems

Chapter 10: Equity Valuation: Concepts and Basic Tools

Learning Outcomes

1. Introduction

2. Estimated Value and Market Price

3. Major Categories of Equity Valuation Models

4. Present Value Models: The Dividend Discount Model

5. Multiplier Models

6. Asset-Based Valuation

7. Summary

Problems

Chapter 11: Equity Market Valuation

Learning Outcomes

1. Introduction

2. Estimating a Justified P/E Ratio

3. Top-Down and Bottom-Up Forecasting

4. Relative Value Models

5. Summary

Problems

Chapter 12: Technical Analysis

Learning Outcomes

1. Introduction

2. Technical Analysis: Definition and Scope

3. Technical Analysis Tools

4. Elliott Wave Theory

5. Intermarket Analysis

6. Summary

Problems

Glossary

References

About the Authors

Index

CFA Institute is the premier association for investment professionals around the world, with over 101,000 members in 134 countries. Since 1963, the organization has developed and administered the renowned Chartered Financial Analyst® Program. With a rich history of leading the investment profession, CFA Institute has set the highest standards in ethics, education, and professional excellence within the global investment community, and is the foremost authority on investment profession conduct and practice.

Each book in the CFA Institute Investment Series is geared toward industry practitioners along with graduate-level finance students and covers the most important topics in the industry. The authors of these cutting-edge books are themselves industry professionals and academics and bring their wealth of knowledge and expertise to this series.

Copyright © 2011 by CFA Institute. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey

Published simultaneously in Canada

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Library of Congress Cataloging-in-Publication Data:

Investments : principles of portfolio and equity analysis / Michael G. McMillan.

p. cm. (CFA institute investment series)

Includes bibliographical references and index.

ISBN 978-0-470-91580-6 (cloth); ISBN 978-1-118-00114-1 (ebk);

ISBN 978-1-118-00115-8 (ebk); ISBN 978-1-118-00116-5 (ebk)

1. Portfolio management. 2. Investment analysis. I. McMillan, Michael G.

HG4529.5.I59 2011

332.6—dc22

2010032749

FOREWORD

As I read Investments: Principles of Portfolio and Equity Analysis, I was struck by how much the investment profession has evolved over the past 40 years. Although the changes have been mostly for the better, the market events of the past decade suggest that we still have more to learn in order to avoid repeating some of our recent mistakes. We witnessed the bursting of two bubbles—technology and housing/credit—which resulted in a lost decade for equities: The S&P 500 generated negative returns for the 10 years ended December 2009.

I remember learning modern portfolio theory as a student when it was indeed relatively modern. Although analytical techniques for managing portfolios have improved since the 1970s, the investment landscape has become much more complex. The number of markets, institutions, and securities has exploded alongside improvements in security selection/analysis, portfolio construction, and risk management. Aided by ever-increasing information and computing power, institutional investors have become bigger, more numerous, more global, and seemingly more sophisticated. They have attracted the best and brightest from the world’s leading universities. These growing armies of professional investors all compete to be the next Warren Buffett or top hedge fund manager.

New investment texts that keep up with the changing markets and analytical techniques are needed. Investments: Principles of Portfolio and Equity Analysis is a valuable addition to the bookshelves of all investment professionals and students of finance. It has kept pace with the changes in the institutional aspects of investing, as well as the advances in asset pricing and portfolio theory and the practical applications of such tools.

As chief investment officer of Georgetown University, I am responsible for investing its endowment. I also teach investment courses in the MBA program at Georgetown. I am a consumer of this book for both parts of my professional life. As an endowment manager, I know that our investment process involves asset allocation, investment manager selection, portfolio construction, and risk management. The governance for this process is set forth in our investment policy statement. Thoroughly covering all these topics, Investments: Principles of Portfolio and Equity Analysis discusses the theory and application of how endowments, pensions, and other institutions invest their sizable pools of capital. Although we are not directly involved with security selection at our endowment, it is important that we understand the best practices followed by investment managers (e.g., mutual funds, hedge funds, and other investment advisers) to help us in our selection of such managers. We must also be able to recognize opportunities for managers to add value relative to a passive index. Although many investors scoff at the notion of market efficiency, most managers fail to beat passive benchmarks. This book does a wonderful job of addressing not only market efficiency and whether and when active management can add value, but also the institutional details of investing—the mechanics of trading and custody; the array of institutions (e.g., endowments, pensions, and sovereign wealth funds); and the growing number of investment vehicles available to institutions (e.g., exchange-traded funds [ETFs] for passive implementation and hedge funds for active management).

As someone who spans both the academic and the real world of investing, I understand the challenge and importance of writing a book that is able to cover and meld both investment theory and implementation. I believe readers will find that Investments: Principles of Portfolio and Equity Analysis succeeds on both fronts. The book will help professional investors understand a broad body of investment theory. More importantly, it will help them apply this knowledge to the actual practice of investing.

Lawrence E. Kochard, CFA

Chief Investment Officer

Georgetown University

September 2010

ACKNOWLEDGMENTS

We would like to thank the many individuals who played important roles in producing this book.

Robert R. Johnson, CFA, Senior Managing Director of CFA Institute, originally saw the need for specialized curriculum materials and initiated their development. We appreciate his support. Robert E. Lamy, CFA, Head of CFA Program Content, initiated the project and oversaw its final development. The Education Advisory Committee, through the global practice analysis, provides valuable input in the development and review of the CFA Program curriculum.

We would especially like to thank James Bronson, CFA; Yves Courtois, CFA; Benoit Descourtieux, CFA; Doug Manz, CFA; George Troughton, CFA; and Philip Young, CFA, for their advice on the curriculum relevancy of each chapter.

Manuscript reviewers and authors of practice problems were as follows: William Akmentins, CFA; Christopher Anderson, CFA; Evan Ashcraft, CFA; Mark Bhasin, CFA; Michael J. Carr; David Cox, CFA; Lee Dunham, CFA; Philip Fanara Jr., CFA; Jane Farris, CFA; Thomas Franckowiak, CFA; Martha Freitag, CFA; Jacques Gagne, CFA; Bryan Gardiner, CFA; Gregory Gocek, CFA; Usman Hayat, CFA; Bradley Herndon, CFA; Glen Holden, CFA; C. Thomas Howard, PhD; Stephen Huffman, CFA; Muhammad Jawaid Iqbal, CFA; Frank Laatsch, CFA; David Landis, CFA; Dan Larocco, CFA; Sanford Leeds, CFA; Barbara MacLeod, CFA; Frank Magiera, CFA; John Maginn, CFA; Ronald Moy, CFA; Gregory Noronha, CFA; Edgar Norton, CFA; Michael Pompian, CFA; Murli Rajan, CFA; Raymond Rath, CFA; Victoria Rati, CFA; Joel Ray, CFA; Knut Reinertz, CFA; Karen O’Connor Rubsam, CFA; Sanjiv Sabherwal; Frank Smudde, CFA; Lavone Whitmer, CFA; and Pamela Yang, CFA.

Samuel Lum, CFA, Director of Private Wealth and Capital Markets in the Hong Kong office of CFA Institute, helpfully shared his expertise. Wanda Lauziere, Project Manager in Curriculum Development, expertly guided the reading manuscripts from planning through production. Tabitha Gore, Administrative Assistant in Curriculum Development, provided valuable assistance at various stages.

Thanks are due to the Editorial Services group at CFA Institute for their extraordinary support of the book’s copyediting needs.

INTRODUCTION

CFA Institute is pleased to provide you with this Investment Series covering major areas in the field of investments. These texts are thoroughly grounded in the highly regarded CFA Program Candidate Body of Knowledge that serves as the anchor for the three levels of the CFA Program. Currently, nearly 200,000 aspiring investment professionals from over 150 countries are devoting hundreds of hours each year to master this material, as well as other elements of the Candidate Body of Knowledge, to obtain the coveted CFA designation. We provide these materials for the same reason we have been chartering investment professionals for over 45 years: to lead the investment profession globally by setting the highest standards of ethics, education, and professional excellence.

HISTORY

This book series draws on the rich history and origins of CFA Institute. In the 1940s, several local societies for investment professionals developed around common interests in the evolving investment industry. At that time, the idea of purchasing common stock as an investment—as opposed to pure speculation—was still a relatively new concept for the general public. Just 10 years before, the U.S. Securities and Exchange Commission had been formed to help referee a playing field marked by robber barons and stock market panics.

In January 1945, a fundamental analysis–driven professor and practitioner from Columbia University and Graham-Newman Corporation wrote an article in the precursor of today’s CFA Institute Financial Analysts Journal, making the case that people who research and manage portfolios should have some sort of credential to demonstrate competence and ethical behavior. This person was none other than Benjamin Graham, the father of security analysis and future mentor to well-known modern investor Warren Buffett.

Creating such a credential took 16 years. By 1963, 284 brave souls—all over the age of 45—took an exam and successfully launched the CFA credential. What many do not fully understand is that this effort was driven by a desire to create professional standards for practitioners dedicated to serving individual investors. In so doing, a fairer and more productive capital market would result.

Most professions—including medicine, law, and accounting—have certain hallmark characteristics that help to attract serious individuals and motivate them to devote energy to their life’s work. First, there must be a body of knowledge. Second, entry requirements must exist, such as those required to achieve the CFA credential. Third, there must be a commitment to continuing education. Finally, a profession must serve a purpose beyond one’s individual interests. By properly conducting one’s affairs and putting client interests first, the investment professional encourages general participation in the incredibly productive global capital markets. This encourages the investing public to part with their hard-earned savings for redeployment in the fair and productive pursuit of appropriate returns.

As C. Stewart Sheppard, founding executive director of the Institute of Chartered Financial Analysts, said:

Society demands more from a profession and its members than it does from a professional craftsman in trade, arts, or business. In return for status, prestige, and autonomy, a profession extends a public warranty that it has established and maintains conditions of entry, standards of fair practice, disciplinary procedures, and continuing education for its particular constituency. Much is expected from members of a profession, but over time, more is given.

For more than 40 years, hundreds upon hundreds of practitioners and academics have served on CFA Institute curriculum committees, sifting through and winnowing out all the many investment concepts and ideas to create a body of investment knowledge and the CFA curriculum. One of the hallmarks of curriculum development at CFA Institute is its extensive use of practitioners in all phases of the process. CFA Institute has followed a formal practice analysis process since 1995. Most recently, the effort involves special practice analysis forums held at 20 locations around the world and surveys of 70,000 practicing CFA charterholders for verification and confirmation. In 2007, CFA Institute moved to implement an ongoing practice analysis to update the body of knowledge continuously, making use of a collaborative web-based site and wiki technology. In addition, CFA Institute has moved in recent years from using traditional academic textbooks in its curriculum to commissioning prominent practitioners and academics to create custom material based on this practice analysis. The result is practical, globally relevant material that is provided to CFA candidates in the CFA Program curriculum and published in this series for investment professionals and others.

What this means for the reader is that the concepts highlighted in these texts were selected by practitioners who fully understand the skills and knowledge necessary for success. We are pleased to put this extensive effort to work for the benefit of the readers of the Investment Series.

BENEFITS

This series will prove useful to those contemplating entry into the extremely competitive field of investment management, as well as those seeking a means of keeping one’s knowledge fresh and up to date. Regardless of its use, this series was designed to be both user friendly and highly relevant. Each chapter within the series includes extensive references for those who would like to further probe a given concept. I believe that the general public seriously underestimates the disciplined processes needed for the best investment firms and individuals to prosper. This material will help you better understand the investment field. For those new to the industry, the essential concepts that any investment professional needs to master are presented in a time-tested fashion. These volumes lay the basic groundwork for many of the processes that successful firms use on a day-to-day basis. Without this base level of understanding and an appreciation for how the capital markets operate, it becomes challenging to find competitive success. Furthermore, the concepts presented herein provide a true sense of the kind of work that is to be found managing portfolios, doing research, or pursuing related endeavors.

The investment profession, despite its relatively lucrative compensation, is not for everyone. It takes a special kind of individual to fundamentally understand and absorb the teachings from this body of work and then successfully apply them in practice. In fact, most individuals who enter the field do not survive in the long run. The aspiring professional should think long and hard about whether this is the right field. There is no better way to make such a critical decision than by reading and evaluating the classic works of the profession.

The more experienced professional understands that the nature of the capital markets requires a commitment to continuous learning. Markets evolve as quickly as smart minds can find new ways to create exposure, attract capital, or manage risk. A number of the concepts in these books did not exist a decade or two ago, when many were starting out in the business. In fact, as we talk to major employers about their training needs, we are often told that one of the biggest challenges they face is how to help the experienced professional keep up with the recent graduates. This series can be part of that answer.

As markets invent and reinvent themselves, a best-in-class foundation investment series is of great value. Investment professionals must continuously hone their skills and knowledge if they are to compete with the young talent that constantly emerges. Further, the best investment management firms are run by those who carefully form investment hypotheses and test them rigorously in the marketplace, whether it be in a quant strategy, comparative shopping for stocks within an industry, or hedge fund strategies. Their goal is to create investment processes that can be replicated with some statistical reliability. I believe those who embraced the so-called academic side of the learning equation have been much more successful as real-world investment managers.

THE TEXTS

One of the most prominent texts over the years in the investment management industry has been Maginn and Tuttle’s Managing Investment Portfolios: A Dynamic Process. The third edition updates key concepts from the 1990 second edition. Some of the more experienced members of our community own the prior two editions and will add the third edition to their libraries. Not only does this seminal work take the concepts from the other readings and put them in a portfolio context, but it also updates the concepts of alternative investments, performance presentation standards, portfolio execution, and, very importantly, managing individual investor portfolios. Focusing attention away from institutional portfolios and toward the individual investor makes this edition an important and timely work.

Quantitative Investment Analysis focuses on some key tools that are needed for today’s professional investor. In addition to classic time value of money, discounted cash flow applications, and probability material, there are two aspects that can be of value over traditional thinking.

The first involves the chapters dealing with correlation and regression that ultimately figure into the formation of hypotheses for purposes of testing. This gets to a critical skill that challenges many professionals: the ability to distinguish useful information from the overwhelming quantity of available data. For most investment researchers and managers, their analysis is not solely the result of newly created data and tests that they perform. Rather, they synthesize and analyze primary research done by others. Without a rigorous manner by which to understand quality research, you cannot understand good research, nor do you have a basis on which to evaluate less rigorous research.

Second, the last chapter of Quantitative Investment Analysis covers portfolio concepts and takes the reader beyond the traditional capital asset pricing model (CAPM) type of tools and into the more practical world of multifactor models and arbitrage pricing theory.

Equity Asset Valuation is a particularly cogent and important resource for anyone involved in estimating the value of securities and understanding security pricing. A well-informed professional knows that the common forms of equity valuation—dividend discount modeling, free cash flow modeling, price/earnings models, and residual income models—can all be reconciled with one another under certain assumptions. With a deep understanding of the underlying assumptions, the professional investor can better understand what other investors assume when calculating their valuation estimates. This volume has a global orientation, including emerging markets. The second edition provides new coverage of private company valuation and expanded coverage on required rate of return estimation.

Fixed Income Analysis has been at the forefront of new concepts in recent years, and this particular book offers some of the most recent material for the seasoned professional who is not a fixed income specialist. The application of option and derivative technology to the once-staid province of fixed income has helped contribute to an explosion of thought in this area. Not only have professionals been challenged to stay up to speed with credit derivatives, swaptions, collateralized mortgage securities, mortgage-backed securities, and other vehicles, but this explosion of products strained the world’s financial markets and challenged central banks to provide sufficient oversight. Armed with a thorough grasp of the new exposures, the professional investor is much better able to anticipate and understand the challenges our central bankers and markets face.

Corporate Finance: A Practical Approach is a solid foundation for those looking to achieve lasting business growth. In today’s competitive business environment, companies must find innovative ways to enable rapid and sustainable growth. This volume equips readers with the foundational knowledge and tools for making smart business decisions and formulating strategies to maximize company value. It covers everything from managing relationships between stakeholders to evaluating mergers and acquisitions bids, as well as the companies behind them.

Through extensive use of real-world examples, readers will gain critical perspective into interpreting corporate financial data, evaluating projects, and allocating funds in ways that increase corporate value. Readers will gain insights into the tools and strategies used in modern corporate financial management.

International Financial Statement Analysis is designed to address the ever-increasing need for investment professionals and students to think about financial statement analysis from a global perspective. The work is a practically oriented introduction to financial statement analysis that is distinguished by its combination of a true international orientation, a structured presentation style, and abundant illustrations and tools covering concepts as they are introduced in the text. The authors cover this discipline comprehensively and with an eye to ensuring the reader’s success at all levels in the complex world of financial statement analysis.

Investments: Principles of Portfolio and Equity Analysis provides an accessible yet rigorous introduction to portfolio and equity analysis. Portfolio planning and portfolio management are presented within a context of up-to-date, global coverage of security markets, trading, and market-related concepts and products. The essentials of equity analysis and valuation are explained in detail and profusely illustrated. The book includes coverage of practitioner-important but often neglected topics such as industry analysis. Throughout, the focus is on the practical application of key concepts with examples drawn from both emerging and developed markets. Each chapter affords the reader many opportunities to self-check his or her understanding of topics. In contrast to other texts, the chapters are collaborations of respected senior investment practitioners and leading business school teachers from around the globe. By virtue of its well-rounded, expert, and global perspectives, the book should be of interest to anyone who is looking for an introduction to portfolio and equity analysis.

I hope you find this new series helpful in your efforts to grow your investment knowledge, whether you are a relatively new entrant or an experienced veteran ethically bound to keep up to date in the ever-changing market environment. CFA Institute, as a long-term, committed participant in the investment profession and a not-for-profit global membership association, is pleased to provide you with this opportunity.

Robert R. Johnson, PhD, CFA

Senior Managing Director

CFA Institute

September 2010

CHAPTER 1

MARKET ORGANIZATION AND STRUCTURE

Larry Harris

Los Angeles, CA, U.S.A.

LEARNING OUTCOMES

After completing this chapter, you will be able to do the following:

Explain and illustrate the main functions of the financial system.Describe classifications of assets and markets.Describe the major types of securities, currencies, contracts, commodities, and real assets that trade in organized markets, including their distinguishing characteristics and major subtypes.Describe the types of financial intermediaries and the services that they provide.Compare and contrast the positions an investor can take in an asset.Calculate and interpret the leverage ratio, the rate of return on a margin transaction, and the security price at which the investor would receive a margin call.Compare and contrast execution, validity, and clearing instructions.Compare and contrast market orders with limit orders.Describe the primary and secondary markets and explain how secondary markets support primary markets.Describe how securities, contracts, and currencies are traded in quote-driven markets, order-driven markets, and brokered markets.Describe the characteristics of a well-functioning financial system.Describe the objectives of market regulation.

1. INTRODUCTION

Financial analysts gather and process information to make investment decisions, including those related to buying and selling assets. Generally, the decisions involve trading securities, currencies, contracts, commodities, and real assets such as real estate. Consider several examples:

Fixed-income analysts evaluate issuer creditworthiness and macroeconomic prospects to determine which bonds and notes to buy or sell to preserve capital while obtaining a fair rate of return.Stock analysts study corporate values to determine which stocks to buy or sell to maximize the value of their stock portfolios.Corporate treasurers analyze exchange rates, interest rates, and credit conditions to determine which currencies to trade and which notes to buy or sell to have funds available in a needed currency.Risk managers work for producers or users of commodities to calculate how many commodity futures contracts to buy or sell to manage inventory risks.

Financial analysts must understand the characteristics of the markets in which their decisions will be executed. This chapter, by examining those markets from the analyst’s perspective, provides that understanding.

This chapter is organized as follows. Section 2 examines the functions of the financial system. Section 3 introduces assets that investors, information-motivated traders, and risk managers use to advance their financial objectives and presents ways practitioners classify these assets into markets. These assets include such financial instruments as securities, currencies, and some contracts; certain commodities; and real assets. Financial analysts must know the distinctive characteristics of these trading assets.

Section 4 is an overview of financial intermediaries (entities that facilitate the functioning of the financial system). Section 5 discusses the positions that can be obtained while trading assets. You will learn about the benefits and risks of long and short positions, how these positions can be financed, and how the financing affects their risks. Section 6 discusses how market participants order trades and how markets process those orders. These processes must be understood to achieve trading objectives while controlling transaction costs.

Section 7 focuses on describing primary markets. Section 8 describes the structures of secondary markets in securities. Sections 9 and 10 close the chapter with discussions of the characteristics of a well-functioning financial system and of how regulation helps make financial markets function better. A conclusions and summary section reviews the chapter’s major ideas and points, and practice problems conclude.

2. THE FUNCTIONS OF THE FINANCIAL SYSTEM

The financial system includes markets and various financial intermediaries that help transfer financial assets, real assets, and financial risks in various forms from one entity to another, from one place to another, and from one point in time to another. These transfers take place whenever someone exchanges one asset or financial contract for another. The assets and contracts that people (people act on behalf of themselves, companies, charities, governments, etc., so the term “people” has a broad definition in this chapter) trade include notes, bonds, stocks, exchange-traded funds, currencies, forward contracts, futures contracts, option contracts, swap contracts, and certain commodities. When the buyer and seller voluntarily arrange their trades, as is usually the case, the buyer and the seller both expect to be better off.

People use the financial system for six main purposes:

1. To save money for the future.

2. To borrow money for current use.

3. To raise equity capital.

4. To manage risks.

5. To exchange assets for immediate and future deliveries.

6. To trade on information.

The main functions of the financial system are to facilitate:

1. The achievement of the purposes for which people use the financial system.

2. The discovery of the rates of return that equate aggregate savings with aggregate borrowings.

3. The allocation of capital to the best uses.

These functions are extremely important to economic welfare. In a well-functioning financial system, transaction costs are low, analysts can value savings and investments, and scarce capital resources are used well.

Sections 2.1 through 2.3 expand on these three functions. The subsections of Section 2.1 cover the six main purposes for which people use the financial system and how the financial system facilitates the achievement of those purposes. Sections 2.2 and 2.3 discuss determining rates of return and capital allocation efficiency, respectively.

2.1. Helping People Achieve Their Purposes in Using the Financial System

People often arrange transactions to achieve more than one purpose when using the financial system. For example, an investor who buys the stock of an oil producer may do so to move her wealth from the present to the future, to hedge the risk that she will have to pay more for energy in the future, and to exploit insightful research that she conducted that suggests the company’s stock is undervalued in the marketplace. If the investment proves to be successful, she will have saved money for the future, managed her energy risk exposure, and obtained a return on her research.

The separate discussions of each of the six main uses of the financial system by people will help you better identify the reasons why people trade. Your ability to identify the various uses of the financial system will help you avoid confusion that often leads to poor financial decisions. The financial intermediaries that are mentioned in these discussions are explained further in Section 4.

2.1.1. Saving

People often have money that they choose not to spend now and that they want available in the future. For example, workers who save for their retirements need to move some of their current earnings into the future. When they retire, they will use their savings to replace the wages that they will no longer be earning. Similarly, companies save money from their sales revenue so that they can pay vendors when their bills come due, repay debt, or acquire assets (for example, other companies or machinery) in the future.

To move money from the present to the future, savers buy notes, certificates of deposit, bonds, stocks, mutual funds, or real assets such as real estate. These alternatives generally provide a better expected rate of return than simply storing money. Savers then sell these assets in the future to fund their future expenditures. When savers commit money to earn a financial return, they commonly are called investors. They invest when they purchase assets, and they divest when they sell them.

Investors require a fair rate of return while their money is invested. The required fair rate of return compensates them for the use of their money and for the risk that they may lose money if the investment fails or if inflation reduces the real value of their investments.

The financial system facilitates savings when institutions create investment vehicles, such as bank deposits, notes, stocks, and mutual funds, that investors can acquire and sell without paying substantial transaction costs. When these instruments are fairly priced and easy to trade, investors will use them to save more.

2.1.2. Borrowing

People, companies, and governments often want to spend money now that they do not have. They can obtain money to fund projects that they wish to undertake now by borrowing it. Companies can also obtain funds by selling ownership or equity interests (covered in Section 2.1.3). Banks and other investors provide those requiring funds with money because they expect to be repaid with interest or because they expect to be compensated with future disbursements, such as dividends and capital gains, as the ownership interest appreciates in value.

People may borrow to pay for such items as vacations, homes, cars, or education. They generally borrow through mortgages and personal loans, or by using credit cards. People typically repay these loans with money they earn later.

Companies often require money to fund current operations or to engage in new capital projects. They may borrow the needed funds in a variety of ways, such as arranging a loan or a line of credit with a bank, or selling fixed-income securities to investors. Companies typically repay their borrowing with income generated in the future. In addition to borrowing, companies may raise funds by selling ownership interests.

Governments may borrow money to pay salaries and other expenses, to fund projects, to provide welfare benefits to their citizens and residents, and to subsidize various activities. Governments borrow by selling bills, notes, or bonds. Governments repay their debt using future revenues from taxes and in some instances from the projects funded by these debts.

Borrowers can borrow from lenders only if the lenders believe that they will be repaid. If the lenders believe, however, that repayment in full with interest may not occur, they will demand higher rates of interest to cover their expected losses and to compensate them for the discomfit they experience wondering whether they will lose their money. To lower the costs of borrowing, borrowers often pledge assets as collateral for their loans. The assets pledged as collateral often include those that will be purchased by the proceeds of the loan. If the borrowers do not repay their loans, the lenders can sell the collateral and use the proceeds to settle the loans.

Lenders often will not loan to borrowers who intend to invest in risky projects, especially if the borrowers cannot pledge other collateral. Investors may still be willing to supply capital for these risky projects if they believe that the projects will likely produce valuable future cash flows. Rather than lending money, however, they will contribute capital in exchange for equity in the projects.

The financial system facilitates borrowing. Lenders aggregate from savers the funds that borrowers require. Borrowers must convince lenders that they can repay their loans, and that, in the event they cannot, lenders can recover most of the funds lent. Credit bureaus, credit rating agencies, and governments promote borrowing; credit bureaus and credit rating agencies do so by collecting and disseminating information that lenders need to analyze credit prospects and governments do so by establishing bankruptcy codes and courts that define and enforce the rights of borrowers and lenders. When the transaction costs of loans (i.e., the costs of arranging, monitoring, and collecting them) are low, borrowers can borrow more to fund current expenditures with credible promises to return the money in the future.

2.1.3. Raising Equity Capital

Companies often raise money for projects by selling (issuing) ownership interests (e.g., corporate common stock or partnership interests). Although these equity instruments legally represent ownership in companies rather than loans to the companies, selling equity to raise capital is simply another mechanism for moving money from the future to the present. When shareholders or partners contribute capital to a company, the company obtains money in the present in exchange for equity instruments that will be entitled to distributions in the future. Although the repayment of the money is not scheduled as it would be for loans, equity instruments also represent potential claims on money in the future.

The financial system facilitates raising equity capital. Investment banks help companies issue equities, analysts value the securities that companies sell, and regulatory reporting requirements and accounting standards attempt to ensure the production of meaningful financial disclosures. The financial system helps promote capital formation by producing the financial information needed to determine fair prices for equity. Liquid markets help companies raise capital. In these markets, shareholders can easily divest their equities as desired. When investors can easily value and trade equities, they are more willing to fund reasonable projects that companies wish to undertake.

EXAMPLE 1-1 Financing Capital Projects

As a chief financial officer (CFO) of a large industrial firm, you need to raise cash within a few months to pay for a project to expand existing and acquire new manufacturing facilities. What are the primary options available to you?

Solution: Your primary options are to borrow the funds or to raise the funds by selling ownership interests. If the company borrows the funds, you may have the company pledge some or all of the project as collateral to reduce the cost of borrowing.

2.1.4. Managing Risks

Many people, companies, and governments face financial risks that concern them. These risks include default risk and the risk of changes in interest rates, exchange rates, raw material prices, and sale prices, among many other risks. These risks are often managed by trading contracts that serve as hedges for the risks.

For example, a farmer and a food processor both face risks related to the price of grain. The farmer fears that prices will be lower than expected when his grain is ready for sale whereas the food processor fears that prices will be higher than expected when she has to buy grain in the future. They both can eliminate their exposures to these risks if they enter into a binding forward contract for the farmer to sell a specified quantity of grain to the food processor at a future date at a mutually agreed upon price. By entering into a forward contract that sets the future trade price, they both eliminate their exposure to changing grain prices.

In general, hedgers trade to offset or insure against risks that concern them. In addition to forward contracts, they may use futures contracts, option contracts, or insurance contracts to transfer risk to other entities more willing to bear the risks (these contracts will be covered in Section 3.4). Often the hedger and the other entity face exactly the opposite risks, so the transfer makes both more secure, as in the grain example.

The financial system facilitates risk management when liquid markets exist in which risk managers can trade instruments that are correlated (or inversely correlated) with the risks that concern them without incurring substantial transaction costs. Investment banks, exchanges, and insurance companies devote substantial resources to designing such contracts and to ensuring that they will trade in liquid markets. When such markets exist, people are better able to manage the risks that they face and often are more willing to undertake risky activities that they expect will be profitable.

2.1.5. Exchanging Assets for Immediate Delivery (Spot Market Trading)

People and companies often trade one asset for another that they rate more highly or, equivalently, that is more useful to them. They may trade one currency for another currency, or money for a needed commodity or right. Following are some examples that illustrate these trades:

Volkswagen pays its German workers in euros, but the company receives dollars when it sells cars in the United States. To convert money from dollars to euros, Volkswagen trades in the foreign exchange markets.A Mexican investor who is worried about the prospects for peso inflation or a potential devaluation of the peso may buy gold in the spot gold market. (This transaction may hedge against the risk of devaluation of the peso because the value of gold may increase with inflation.)A plastic producer must buy carbon credits to emit carbon dioxide when burning fuel to comply with environmental regulations. The carbon credit is a legal right that the producer must have to engage in activities that emit carbon dioxide.

In each of these cases, the trades are considered spot market trades because the instruments trade for immediate delivery. The financial system facilitates these exchanges when liquid spot markets exist in which people can arrange and settle trades without substantial transaction costs.

2.1.6. Information-Motivated Trading

Information-motivated traders trade to profit from information that they believe allows them to predict future prices. Like all other traders, they hope to buy at low prices and sell at higher prices. Unlike pure investors, however, they expect to earn a return on their information in addition to the normal return expected for bearing risk through time.

Active investment managers are information-motivated traders who collect and analyze information to identify securities, contracts, and other assets that their analyses indicate are under- or overvalued. They then buy those that they consider undervalued and sell those that they consider overvalued. If successful, they obtain a greater return than the unconditional return that would be expected for bearing the risk in their positions. The return that they expect to obtain is a conditional return earned on the basis of the information in their analyses. Practitioners often call this process active portfolio management.

Note that the distinction between pure investors and information-motivated traders depends on their motives for trading and not on the risks that they take or their expected holding periods. Investors trade to move wealth from the present to the future whereas information-motivated traders trade to profit from superior information about future values. When trading to move wealth forward, the time period may be short or long. For example, a bank treasurer may only need to move money overnight and might use money market instruments trading in an interbank funds market to accomplish that. A pension fund, however, may need to move money 30 years forward and might do that by using shares trading in a stock market. Both are investors although their expected holding periods and the risks in the instruments that they trade are vastly different.

In contrast, information-motivated traders trade because their information-based analyses suggest to them that prices of various instruments will increase or decrease in the future at a rate faster than others without their information or analytical models would expect. After establishing their positions, they hope that prices will change quickly in their favor so that they can close their positions, realize their profits, and redeploy their capital. These price changes may occur almost instantaneously, or they may take years to occur if information about the mispricing is difficult to obtain or understand.

The two categories of traders are not mutually exclusive. Investors also are often information-motivated traders. Many investors who want to move wealth forward through time collect and analyze information to select securities that will allow them to obtain conditional returns that are greater than the unconditional returns expected for securities in their assets classes. If they have rational reasons to expect that their efforts will indeed produce superior returns, they are information-motivated traders. If they consistently fail to produce such returns, their efforts will be futile, and they would have been better off simply buying and holding well-diversified portfolios.

EXAMPLE 1-2 Investing versus Information-Motivated Trading

The head of a large labor union with a pension fund asks you, a pension consultant, to distinguish between investing and information-motivated trading. You are expected to provide an explanation that addresses the financial problems that she faces. How would you respond?

Solution: The object of investing for the pension fund is to move the union’s pension assets from the present to the future when they will be needed to pay the union’s retired pensioners. The pension fund managers will typically do this by buying stocks, bonds, and perhaps other assets. The pension fund managers expect to receive a fair rate of return on the pension fund’s assets without paying excessive transaction costs and management fees. The return should compensate the fund for the risks that it bears and for the time that other people are using the fund’s money.

The object of information-motivated trading is to earn a return in excess of the fair rate of return. Information-motivated traders analyze information that they collect with the hope that their analyses will allow them to predict better than others where prices will be in the future. They then buy assets that they think will produce excess returns and sell those that they think will underperform. Active investment managers are information-motivated traders.

The characteristic that most distinguishes investors from information-motivated traders is the return that they expect. Although both types of traders hope to obtain extraordinary returns, investors rationally expect to receive only fair returns during the periods of their investments. In contrast, information-motivated traders expect to make returns in excess of required fair rates of return. Of course, not all investing or information-motivated trading is successful (in other words, the actual returns may not equal or exceed the expected returns).

The financial system facilitates information-motivated trading when liquid markets allow active managers to trade without significant transaction costs. Accounting standards and reporting requirements that produce meaningful financial disclosures reduce the costs of being well informed, but do not necessarily help informed traders profit because they often compete with each other. The most profitable well-informed traders are often those who have the most unique insights into future values.

2.1.7. Summary

People use the financial system for many purposes, the most important of which are saving, borrowing, raising equity capital, managing risk, exchanging assets in spot markets, and information-motivated trading. The financial system best facilitates these uses when people can trade instruments that interest them in liquid markets, when institutions provide financial services at low cost, when information about assets and about credit risks is readily available, and when regulation helps ensure that everyone faithfully honors their contracts.

2.2. Determining Rates of Return

Saving, borrowing, and selling equity are all means of moving money through time. Savers move money from the present to the future whereas borrowers and equity issuers move money from the future to the present.

Because time machines do not exist, money can travel forward in time only if an equal amount of money is travelling in the other direction. This equality always occurs because borrowers and equity sellers create the securities in which savers invest. For example, the bond sold by a company that needs to move money from the future to the present is the same bond bought by a saver who needs to move money from the present to the future.

The aggregate amount of money that savers will move from the present to the future is related to the expected rate of return on their investments. If the expected return is high, they will forgo current consumption and move more money to the future. Similarly, the aggregate amount of money that borrowers and equity sellers will move from the future to the present depends on the costs of borrowing funds or of giving up ownership. These costs can be expressed as the rate of return that borrowers and equity sellers are expected to deliver in exchange for obtaining current funds. It is the same rate that savers expect to receive when delivering current funds. If this rate is low, borrowers and equity sellers will want to move more money to the present from the future. In other words, they will want to raise more funds.

Because the total money saved must equal the total money borrowed and received in exchange for equity, the expected rate of return depends on the aggregate supply of funds through savings and the aggregate demand for funds. If the rate is too high, savers will want to move more money to the future than borrowers, and equity issuers will want to move to the present. The expected rate will have to be lower to discourage the savers and to encourage the borrowers and equity issuers. Conversely, if the rate is too low, savers will want to move less money forward than borrowers and equity issuers will want to move to the present. The expected rate will have to be higher to encourage the savers and to discourage the borrowers and equity issuers. Between rates too high and too low, an expected rate of return exists, in theory, in which the aggregate supply of funds for investing (supply of funds saved) and the aggregate demand for funds through borrowing and equity issuing are equal.

Economists call this rate the equilibrium interest rate. It is the price for moving money through time. Determining this rate is one of the most important functions of the financial system. The equilibrium interest rate is the only interest rate that would exist if all securities were equally risky, had equal terms, and were equally liquid. In fact, the required rates of return for securities vary by their risk characteristics, terms, and liquidity. For a given issuer, investors generally require higher rates of return for equity than for debt, for long-term securities than for short-term securities, and for illiquid securities than for liquid ones. Financial analysts recognize that all required rates of return depend on a common equilibrium interest rate plus adjustments for risk.

EXAMPLE 1-3 Interest Rates

For a presentation to private wealth clients by your firm’s chief economist, you are asked to prepare the audience by explaining the most fundamental facts concerning the role of interest rates in the economy. You agree. What main points should you try to convey?

Solution: Savers have money now that they will want to use in the future. Borrowers want to use money now that they do not have, but they expect that they will have money in the future. Borrowers are loaned money by savers and promise to repay it in the future.

The interest rate is the return that lenders, the savers, expect to receive from borrowers for allowing borrowers to use the savers’ money. The interest rate is the price of using money.

Interest rates depend on the total amount of money that people want to borrow and the total amount of money that people are willing to lend. Interest rates are high when, in aggregate, people value having money now substantially more than they value having money in the future. In contrast, if many people with money want to use it in the future and few people presently need more money than they have, interest rates will be low.

2.3. Capital Allocation Efficiency

Primary capital markets (primary markets) are the markets in which companies and governments raise capital (funds). Companies may raise funds by borrowing money or by issuing equity. Governments may raise funds by borrowing money.

Economies are said to be allocationally efficient when their financial systems allocate capital (funds) to those uses that are most productive. Although companies may be interested in getting funding for many potential projects, not all projects are worth funding. One of the most important functions of the financial system is to ensure that only the best projects obtain scarce capital funds; the funds available from savers should be allocated to the most productive uses.

In market-based economies, savers determine, directly or indirectly, which projects obtain capital. Savers determine capital allocations directly by choosing which securities they will invest in. Savers determine capital allocations indirectly by giving funds to financial intermediaries that then invest the funds. Because investors fear the loss of their money, they will lend at lower interest rates to borrowers with the best credit prospects or the best collateral, and they will lend at higher rates to other borrowers with less secure prospects. Similarly, they will buy only those equities that they believe have the best prospects relative to their prices and risks.

To avoid losses, investors carefully study the prospects of the various investment opportunities available to them. The decisions that they make tend to be well informed, which helps ensure that capital is allocated efficiently. The fear of losses by investors and by those raising funds to invest in projects ensures that only the best projects tend to be funded. The process works best when investors are well informed about the prospects of the various projects.

In general, investors will fund an equity project if they expect that the value of the project is greater than its cost, and they will not fund projects otherwise. If the investor expectations are accurate, only projects that should be undertaken will be funded and all such projects will be funded. Accurate market information thus leads to efficient capital allocation.

EXAMPLE 1-4 Primary Market Capital Allocation

How can poor information about the value of a project result in poor capital allocation decisions?

Solution: Projects should be undertaken only if their value is greater than their cost. If investors have poor information and overestimate the value of a project in which its true value is less than its cost, a wealth-diminishing project may be undertaken. Alternatively, if investors have poor information and underestimate the value of a project in which its true value is greater than its cost, a wealth-enhancing project may not be undertaken.

3. ASSETS AND CONTRACTS

People, companies, and governments use many different assets and contracts to further their financial goals and to manage their risks. The most common assets include financial assets (such as bank deposits, certificates of deposit, loans, mortgages, corporate and government bonds and notes, common and preferred stocks, real estate investment trusts, master limited partnership interests, pooled investment products, and exchange-traded funds), currencies, certain commodities (such as gold and oil), and real assets (such as real estate). The most common contracts are option, futures, forward, swap, and insurance contracts. People, companies, and governments use these assets and contracts to raise funds, to invest, to profit from information-motivated trading, to hedge risks, and/or to transfer money from one form to another.

3.1. Classifications of Assets and Markets

Practitioners often classify assets and the markets in which they trade by various common characteristics to facilitate communications with their clients, with each other, and with regulators.

The most actively traded assets are securities, currencies, contracts, and commodities. In addition, real assets are traded. Securities generally include debt instruments, equities, and shares in pooled investment vehicles. Currencies are monies issued by national monetary authorities. Contracts are agreements to exchange securities, currencies, commodities, or other contracts in the future. Commodities include precious metals, energy products, industrial metals, and agricultural products. Real assets are tangible properties such as real estate, airplanes, or machinery. Securities, currencies, and contracts are classified as financial assets whereas commodities and real assets are classified as physical assets.

Securities are further classified as debt or equity. Debt instruments (also called fixed-income instruments) are promises to repay borrowed money. Equities represent ownership in companies. Pooled investment vehicle shares represent ownership of an undivided interest in an investment portfolio. The portfolio may include securities, currencies, contracts, commodities, or real assets. Pooled investment vehicles, such as exchange-traded funds, which exclusively own shares in other companies generally are also considered equities.

Securities are also classified by whether they are public or private securities. Public securities are those registered to trade in public markets, such as on exchanges or through dealers. In most jurisdictions, issuers must meet stringent minimum regulatory standards, including reporting and corporate governance standards, to issue publicly traded securities.

Private securities are all other securities. Often, only specially qualified investors can purchase private equities and private debt instruments. Investors may purchase them directly from the issuer or indirectly through an investment vehicle specifically formed to hold such securities. Issuers often issue private securities when they find public reporting standards too burdensome or when they do not want to conform to the regulatory standards associated with public equity. Venture capital is private equity that investors supply to companies when or shortly after they are founded. Private securities generally are illiquid. In contrast, many public securities trade in liquid markets in which sellers can easily find buyers for their securities.

Contracts are derivative contracts if their values depend on the prices of other underlying assets. Derivative contracts may be classified as physical or financial depending on whether the underlying instruments are physical products or financial securities. Equity derivatives are contracts whose values depend on equities or indices of equities. Fixed-income derivatives are contracts whose values depend on debt securities or indices of debt securities.

Practitioners classify markets by whether the markets trade instruments for immediate delivery or for future delivery. Markets that trade contracts that call for delivery in the future are forward or futures markets. Those that trade for immediate delivery are called spot markets to distinguish them from forward markets that trade contracts on the same underlying instruments. Options markets trade contracts that deliver in the future, but delivery takes place only if the holders of the options choose to exercise them.

When issuers sell securities to investors, practitioners say that they trade in the primary market. When investors sell those securities to others, they trade in the secondary market. In the primary market, funds flow to the issuer of the security from the purchaser. In the secondary market, funds flow between traders.

Practitioners classify financial markets as money markets or capital markets. Money markets trade debt instruments maturing in one year or less. The most common such instruments are repurchase agreements (defined in Section 3.2.1), negotiable certificates of deposit, government bills, and commercial paper. In contrast, capital markets trade instruments of longer duration, such as bonds and equities, whose values depend on the creditworthiness of the issuers and on payments of interest or dividends that will be made in the future and may be uncertain. Corporations generally finance their operations in the capital markets, but some also finance a portion of their operations by issuing short-term securities, such as commercial paper.

Finally, practitioners distinguish between traditional investment markets and alternative investment markets. Traditional investments include all publicly traded debts and equities and shares in pooled investment vehicles that hold publicly traded debts and/or equities. Alternative investments include hedge funds, private equities (including venture capital), commodities, real estate securities and real estate properties, securitized debts, operating leases, machinery, collectibles, and precious gems. Because these investments are often hard to trade and hard to value, they may sometimes trade at substantial deviations from their intrinsic values. The discounts compensate investors for the research that they must do to value these assets and for their inability to easily sell the assets if they need to liquidate a portion of their portfolios.

The remainder of this section describes the most common assets and contracts that people, companies, and governments trade.

EXAMPLE 1-5 Asset and Market Classification

The investment policy of a mutual fund permits the fund to invest only in public equities traded in secondary markets. Would the fund be able to purchase:

1. Common stock of a company that trades on a large stock exchange?

2. Common stock of a public company that trades only through dealers?

3. A government bond?

4. A single stock futures contract?

5. Common stock sold for the first time by a properly registered public company?

6. Shares in a privately held bank with €10 billion of capital?

Solutions:

1. Yes. Common stock is equity. Those common stocks that trade on large exchanges invariably are public equities that trade in secondary markets.

2. Yes. Dealer markets are secondary markets and the security is a public equity.

3. No. Although government bonds are public securities, they are not equities. They are debt securities.

4. No. Although the underlying instruments for single stock futures are invariably public equities, single stock futures are derivative contracts not equities.