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1.8 RECENT TRENDS
Four important trends have changed the contemporary investment environment: (1) globaliza-
tion, (2) securitization, (3) financial engineering, and (4) information and computer networks.

Globalization
If a wider range of investment choices can benefit investors, why should we limit ourselves to
purely domestic assets? Increasingly efficient communication technology and the dismantling
of regulatory constraints have encouraged globalization in recent years. globalization
U.S. investors commonly can participate in foreign investment opportunities in several Tendency toward a
ways: (1) purchase foreign securities using American Depository Receipts (ADRs), which are worldwide investment
domestically traded securities that represent claims to shares of foreign stocks; (2) purchase for- environment, and the
integration of
eign securities that are offered in dollars; (3) buy mutual funds that invest internationally; and
national capital
(4) buy derivative securities with payoffs that depend on prices in foreign security markets.
markets.
Brokers who act as intermediaries for American Depository Receipts purchase an inventory
of stock from some foreign issuer. The broker then issues an American Depository Receipt
that represents a claim to some number of those foreign shares held in inventory. The ADR is
denominated in dollars and can be traded on U.S. stock exchanges but is in essence no more
than a claim on a foreign stock. Thus, from the investor™s point of view, there is no more dif-
ference between buying a British versus a U.S. stock than there is in holding a Massachusetts-
based company compared with a California-based one. Of course, the investment implication
may differ: ADRs still expose investors to exchange-rate risk.
World Equity Benchmark Shares (WEBS) are a variation on ADRs. WEBS use the same
depository structure to allow investors to trade portfolios of foreign stocks in a selected coun-
try. Each WEBS security tracks the performance of an index of share returns for a particular
country. WEBS can be traded by investors just like any other security (they trade on the Amer-
Bodie’Kane’Marcus: I. Elements of Investments 1. Investments: © The McGraw’Hill
Essentials of Investments, Background and Issues Companies, 2003
Fifth Edition




16 Part ONE Elements of Investments




F I G U R E 1.1
Globalization: A debt
issue denominated in
euros
Source: North West Water
Finance PLC, April 1999.




ican Stock Exchange) and thus enable U.S. investors to obtain diversified portfolios of foreign
stocks in one fell swoop.
A giant step toward globalization took place recently when 11 European countries replaced
their existing currencies with a new currency called the euro. The idea behind the euro is that
a common currency will facilitate global trade and encourage integration of markets across na-
tional boundaries. Figure 1.1 is an announcement of a debt offering in the amount of 500 mil-
lion euros. (Each euro is currently worth just about $1; the symbol for the euro is ‚¬.)
pass-through
securities
Securitization
Pools of loans (such
In 1970, mortgage pass-through securities were introduced by the Government National Mort-
as home mortgage
gage Association (GNMA, or Ginnie Mae). These securities aggregate individual home mort-
loans) sold in one
package. Owners of gages into relatively homogeneous pools. Each pool acts as backing for a GNMA pass-through
pass-throughs receive security. Investors who buy GNMA securities receive prorated shares of all the principal and in-
all of the principal
terest payments made on the underlying mortgage pool.
and interest payments
For example, the pool might total $100 million of 8%, 30-year conventional mortgages.
made by the
The rights to the cash flows could then be sold as 5,000 units, each worth $20,000. Each unit
borrowers.
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17
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F I G U R E 1.2
1,400
Asset-backed
Other
securities outstanding
1,200 Debt obligations
Source: The Bond Market
Student loan
Association, 2001.
Home equity
1,000
Credit card
$ billion




Automobile
800


600


400


200


0
1995 1996 1997 1998 1999 2000 2001




holder would then receive 1/5,000 of all monthly interest and principal payments made on the
pool. The banks that originated the mortgages continue to service them (receiving fee-for-
service), but they no longer own the mortgage investment; the investment has been passed
through to the GNMA security holders.
Pass-through securities represent a tremendous innovation in mortgage markets. The securi- securitization
tization of mortgages means mortgages can be traded just like other securities. Availability of Pooling loans into
funds to homebuyers no longer depends on local credit conditions and is no longer subject to lo- standardized
cal banks™ potential monopoly powers; with mortgage pass-throughs trading in national markets, securities backed by
those loans, which
mortgage funds can flow from any region (literally worldwide) to wherever demand is greatest.
can then be traded
Securitization also expands the menu of choices for the investor. Whereas it would have been
like any other security.
impossible before 1970 for investors to invest in mortgages directly, they now can purchase
mortgage pass-through securities or invest in mutual funds that offer portfolios of such securities.
Today, the majority of home mortgages are pooled into mortgage-backed securities. The
two biggest players in the market are the Federal National Mortgage Association (FNMA, or
Fannie Mae) and the Federal Home Loan Mortgage Corporation (FHLMC, or Freddie Mac).
Over $2.5 trillion of mortgage-backed securities are outstanding, making this market larger
than the market for corporate bonds.
Other loans that have been securitized into pass-through arrangements include car loans,
student loans, home equity loans, credit card loans, and debts of firms. Figure 1.2 documents
the rapid growth of nonmortgage asset-backed securities since 1995.
Securitization also has been used to allow U.S. banks to unload their portfolios of shaky
loans to developing nations. So-called Brady bonds (named after former Secretary of Treasury
Nicholas Brady) were formed by securitizing bank loans to several countries in shaky fiscal
condition. The U.S. banks exchange their loans to developing nations for bonds backed by
those loans. The payments that the borrowing nation would otherwise make to the lending bank
are directed instead to the holder of the bond. These bonds are traded in capital markets. There-
fore, if they choose, banks can remove these loans from their portfolios simply by selling the
bonds. In addition, the U.S. in many cases has enhanced the credit quality of these bonds by
designating a quantity of Treasury bonds to serve as partial collateral for the loans. In the event
of a foreign default, the holders of the Brady bonds have claim to the collateral.
Bodie’Kane’Marcus: I. Elements of Investments 1. Investments: © The McGraw’Hill
Essentials of Investments, Background and Issues Companies, 2003
Fifth Edition




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>
4. When mortgages are pooled into securities, the pass-through agencies (Freddie
Concept
Mac and Fannie Mae) typically guarantee the underlying mortgage loans. If the
CHECK homeowner defaults on the loan, the pass-through agency makes good on the
loan; the investor in the mortgage-backed security does not bear the credit risk.
a. Why does the allocation of risk to the pass-through agency rather than the se-
curity holder make economic sense?
b. Why is the allocation of credit risk less of an issue for Brady bonds?


Financial Engineering
bundling, Financial engineering refers to the creation of new securities by unbundling”breaking up
unbundling and allocating the cash flows from one security to create several new securities”or by
bundling”combining more than one security into a composite security. Such creative engi-
Creation of new
neering of new investment products allows one to design securities with custom-tailored risk
securities either by
attributes. An example of bundling appears in Figure 1.3.
combining primitive
and derivative Boise Cascade, with the assistance of Goldman, Sachs and other underwriters, has issued a
securities into one
hybrid security with features of preferred stock combined with various call and put option
composite hybrid or
contracts. The security is structured as preferred stock for four years, at which time it is con-
by separating returns
verted into common stock of the company. However, the number of shares of common stock
on an asset into
into which the security can be converted depends on the price of the stock in four years, which
classes.
means that the security holders are exposed to risk similar to the risk they would bear if they
held option positions on the firm.


F I G U R E 1. 3
Bundling creates a
complex security
Source: The Wall Street
Journal, December 19, 2001.
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Fifth Edition




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1 Investments: Background and Issues


Often, creating a security that appears to be attractive requires the unbundling of an asset.
An example is given in Figure 1.4. There, a mortgage pass-through certificate is unbundled
into classes. Class 1 receives only principal payments from the mortgage pool, whereas Class
2 receives only interest payments.
The process of bundling and unbundling is called financial engineering, which refers to financial
the creation and design of securities with custom-tailored characteristics, often regarding ex- engineering
posures to various sources of risk. Financial engineers view securities as bundles of (possible The process of
risky) cash flows that may be carved up and rearranged according to the needs or desires of creating and
traders in the security markets. designing securities
with custom-tailored
characteristics.
Computer Networks
The Internet and other advances in computer networking are transforming many sectors of the
economy, and few more so than the financial sector. These advances will be treated in greater
detail in Chapter 3, but for now we can mention a few important innovations: online trading,
online information dissemination, and automated trade crossing.
Online trading connects a customer directly to a brokerage firm. Online brokerage firms
can process trades more cheaply and therefore can charge lower commissions. The average
commission for an online trade is now below $20, compared to perhaps $100“$300 at full-
service brokers.




F I G U R E 1.4
Unbundling of
mortgages into
principal- and
interest-only securities
Source: Goldman, Sachs &
Co., March 1985.
Bodie’Kane’Marcus: I. Elements of Investments 1. Investments: © The McGraw’Hill
Essentials of Investments, Background and Issues Companies, 2003
Fifth Edition




20 Part ONE Elements of Investments


The Internet has also allowed vast amounts of information to be made cheaply and widely
available to the public. Individual investors today can obtain data, investment tools, and even
analyst reports that just a decade ago would have been available only to professionals.
Electronic communication networks that allow direct trading among investors have ex-
ploded in recent years. These networks allow members to post buy or sell orders and to have
those orders automatically matched up or “crossed” with orders of other traders in the system
without benefit of an intermediary such as a securities dealer.


1.9 OUTLINE OF THE TEXT
The text has six parts, which are fairly independent and may be studied in a variety of se-
quences. Part One is an introduction to financial markets, instruments, and trading of securi-

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