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n investment is the current commitment of money or other resources in the

A expectation of reaping future benefits. For example, an individual might pur-
chase shares of stock anticipating that the future proceeds from the shares
will justify both the time that her money is tied up as well as the risk of the invest-
ment. The time you will spend studying this text (not to mention its cost) also is an in-
vestment. You are forgoing either current leisure or the income you could be earning
at a job in the expectation that your future career will be sufficiently enhanced to jus-
tify this commitment of time and effort. While these two investments differ in many
ways, they share one key attribute that is central to all investments: You sacrifice
something of value now, expecting to benefit from that sacrifice later.
This text can help you become an informed practitioner of investments. We will
focus on investments in securities such as stocks, bonds, or options and futures con-
tracts, but much of what we discuss will be useful in the analysis of any type of in-
vestment. The text will provide you with background in the organization of various
securities markets, will survey the valuation and risk-management principles useful in
particular markets, such as those for bonds or stocks, and will introduce you to the
principles of portfolio construction.
Broadly speaking, this chapter addresses three topics that will provide a useful
perspective for the material that is to come later. First, before delving into the topic
of “investments,” we consider the role of financial assets in the economy. We discuss
the relationship between securities and the “real” assets that actually produce goods
and services for consumers, and we consider why financial assets are important to the
functioning of a developed economy. Given this background, we then take a first look
at the types of decisions that confront investors as they assemble a portfolio of
Bodie’Kane’Marcus: I. Elements of Investments 1. Investments: © The McGraw’Hill
Essentials of Investments, Background and Issues Companies, 2003
Fifth Edition

4 Part ONE Elements of Investments

assets. These investment decisions are made in an environment where higher
returns usually can be obtained only at the price of greater risk, and in which
Commitment of
current resources in it is rare to find assets that are so mispriced as to be obvious bargains. These
the expectation of
themes”the risk-return trade-off and the efficient pricing of financial as-
deriving greater
sets”are central to the investment process, so it is worth pausing for a brief
resources in the
discussion of their implications as we begin the text. These implications will be
fleshed out in much greater detail in later chapters.
Finally, we conclude the chapter with an introduction to the organization
of security markets, the various players that participate in those markets, and
a brief overview of some of the more important changes in those markets in
recent years. Together, these various topics should give you a feel for who the
major participants are in the securities markets as well as the setting in which
they act. We close the chapter with an overview of the remainder of the text.

The material wealth of a society is ultimately determined by the productive capacity of its
economy, that is, the goods and services its members can create. This capacity is a function of
the real assets of the economy: the land, buildings, machines, and knowledge that can be used
real assets
to produce goods and services.
Assets used to
In contrast to such real assets are financial assets, such as stocks and bonds. Such securi-
produce goods and
ties are no more than sheets of paper or, more likely, computer entries and do not contribute
directly to the productive capacity of the economy. Instead, these assets are the means by
which individuals in well-developed economies hold their claims on real assets. Financial as-
financial assets
sets are claims to the income generated by real assets (or claims on income from the govern-
Claims on real assets
ment). If we cannot own our own auto plant (a real asset), we can still buy shares in General
or the income
Motors or Toyota (financial assets) and, thereby, share in the income derived from the pro-
generated by them.
duction of automobiles.
While real assets generate net income to the economy, financial assets simply define the al-
location of income or wealth among investors. Individuals can choose between consuming
their wealth today or investing for the future. If they choose to invest, they may place their
wealth in financial assets by purchasing various securities. When investors buy these securi-
ties from companies, the firms use the money so raised to pay for real assets, such as plant,
equipment, technology, or inventory. So investors™ returns on securities ultimately come from
the income produced by the real assets that were financed by the issuance of those securities.
The distinction between real and financial assets is apparent when we compare the balance
sheet of U.S. households, shown in Table 1.1, with the composition of national wealth in the
United States, shown in Table 1.2. Household wealth includes financial assets such as bank ac-
counts, corporate stock, or bonds. However, these securities, which are financial assets of
households, are liabilities of the issuers of the securities. For example, a bond that you treat as
an asset because it gives you a claim on interest income and repayment of principal from Gen-
eral Motors is a liability of General Motors, which is obligated to make these payments to you.
Your asset is GM™s liability. Therefore, when we aggregate over all balance sheets, these
claims cancel out, leaving only real assets as the net wealth of the economy. National wealth
consists of structures, equipment, inventories of goods, and land.
We will focus almost exclusively on financial assets. But you shouldn™t lose sight of the
fact that the successes or failures of the financial assets we choose to purchase ultimately de-
pend on the performance of the underlying real assets.
Bodie’Kane’Marcus: I. Elements of Investments 1. Investments: © The McGraw’Hill
Essentials of Investments, Background and Issues Companies, 2003
Fifth Edition

1 Investments: Background and Issues

TA B L E 1.1
Balance sheet of U.S. households

Liabilities and
Assets $ Billion % Total Net Worth $ Billion % Total

Real assets
Real estate $12,567 26.7% Mortgages $ 5,210 11.1%
Durables 2,820 6.0 Consumer credit 1,558 3.3
Other 117 0.2 Bank & other loans 316 0.7
Other 498 1.1
Total real assets $15,504 32.9%
Total liabilities $ 7,582 16.1%
Financial assets
Deposits $ 4,698 10.0%
Live insurance reserves 817 1.7
Pension reserves 8,590 18.2
Corporate equity 5,917 12.6
Equity in noncorp. business 5,056 10.7
Mutual funds shares 2,780 5.9
Personal trusts 949 2.0
Debt securities 2,075 4.4
Other 746 1.6
Total financial assets Net worth
31,628 67.1 39,550 83.9
Total $47,132 100.0% $47,132 100.0%

Note: Column sums may differ from total because of rounding error.
Source: Flow of Funds Accounts of the United States, Board of Governors of the Federal Reserve System, June 2001.

Assets $ Billion
TA B L E 1.2
Real estate $17,438
Domestic net worth
Plant and equipment 18,643
Inventories 1,350
Total $37,431

Note: Column sums may differ from total because of rounding error.
Sources: Flow of Funds Accounts of the United States, Board of Governors of the Federal
Reserve System, June 2001; Statistical Abstract of the United States: 2000, US Census

1. Are the following assets real or financial? Concept
a. Patents
b. Lease obligations
c. Customer goodwill
d. A college education
e. A $5 bill
Pay a specified cash
It is common to distinguish among three broad types of financial assets: fixed income, equity, flow over a specific
and derivatives. Fixed-income securities promise either a fixed stream of income or a stream period.
Bodie’Kane’Marcus: I. Elements of Investments 1. Investments: © The McGraw’Hill
Essentials of Investments, Background and Issues Companies, 2003
Fifth Edition

6 Part ONE Elements of Investments

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 se-
curities 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 pay-
ment 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 se-
curities 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 provi-
sions 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.
equity Unlike fixed-income securities, common stock, or equity, in a firm represents an owner-
ship share in the corporation. Equity holders are not promised any particular payment. They
An ownership share in
receive any dividends the firm may pay and have prorated ownership in the real assets of the
a corporation.
firm. If the firm is successful, the value of equity will increase; if not, it will decrease. The per-
formance 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.
derivative Finally, derivative securities such as options and futures contracts provide payoffs that are
securities determined by the prices of other assets such as bond or stock prices. For example, a call op-
tion on a share of Intel stock might turn out to be worthless if Intel™s share price remains be-
Securities providing
low a threshold or “exercise” price such as $30 a share, but it can be quite valuable if the stock
payoffs that depend
price rises above that level.1 Derivative securities are so named because their values derive
on the values of other
assets. 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 de-
rivatives, 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 com-
monplace 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 dol-
lars. 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.
Bodie’Kane’Marcus: I. Elements of Investments 1. Investments: © The McGraw’Hill
Essentials of Investments, Background and Issues Companies, 2003
Fifth Edition

1 Investments: Background and Issues

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 purchas-
ing 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 fi-
nancial 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 con-
cerning current consumption from constraints that otherwise would be imposed by current


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