Chapter 01
Investments: Background and Issues
Equity is a lower-priority claim on earnings (expressed as dividends) that represents an ownership share in a corporation. Fixed-income (debt) security is a higher-priority claim that legally obligates the issuer to pay the holder of the debt, but does not have an ownership interest. Fixed-income securities typically pay a specified cash flow at pre-contracted time intervals until the last payment on the maturity date. Shares of equity have an indefinite life.
A primary (financial) asset has a claim on the real assets of a firm, whereas a derivative asset provides a payoff that depends on the prices of a primary asset but does not include the claim on the real assets.
Asset allocation is the allocation of an investment portfolio across broad asset classes. Security selection is the choice of specific securities within each asset class.
Agency problems are conflicts of interest between managers and stockholders. They can be addressed through corporate governance mechanisms, such as the design of executive compensation, oversight by the Board, and monitoring from the institutional investors.
Real assets have productive capacity; they are assets used to produce goods and services. Real assets can be tangible (e.g., machinery) or intangible (e.g., a patent). Financial assets are claims on real assets or the income generated by them.
Investment bankers are firms specializing in the sale of new securities to the public, typically by underwriting the issue. Commercial banks accept deposits and lend the money to other borrowers. After the Glass-Steagall Act was repealed in 1999, some commercial banks started transforming to “universal banks” which provide the services of both commercial banks and investment banks. With the passage of the Dodd–Frank Wall Street Reform and Consumer Protection Act in 2010, Glass-Steagall was partially restored via the Volcker Rule (which generally prohibits commercial banks from conducting certain investment activities with their own accounts and investing in hedge funds and private equity funds). In 2018, Congress passed The Economic Growth, Regulatory Relief, and Consumer Protection Act established a threshold ($10 billion) for banks to be exempt from the Volcker Rule.
Financial and Real Assets
Toyota creates a real asset—the factory. The loan is a financial asset that is created in the transaction.
When the loan is repaid, the financial asset is destroyed but the real asset continues to exist.
The cash is a financial asset that is traded in exchange for a real asset, inventory.
Real Estate as a Real Asset
No. The real estate in existence has not changed, only the perception of its value has.
Yes. The financial asset value of the claims on the real estate has changed, and thus the balance sheet of individual investors has been reduced.
The difference between these two answers reflects the difference between real and financial asset values. Real assets still exist, yet the value of the claims on those assets or the cash flows they generate do change. Thus, there is the difference.
Real and Financial Assets
The bank loan is a financial liability for Lanni. Lanni's $50,000 IOU is the bank's financial asset. The cash Lanni receives is a financial asset. The new financial asset created is Lanni's promissory note held by the bank.
The cash paid by Lanni (both the loan and its own cash) is the transfer of a financial asset to the software developer. In return, Lanni gets a real asset, the completed software. No financial assets are created or destroyed. Cash is simply transferred from one firm to another.
Lanni sells the software, which is a real asset, to Microsoft. In exchange Lanni receives a financial asset, 1,000 shares of Microsoft stock. If Microsoft issues new shares in order to pay Lanni, that would be the creation of a new financial asset.
In selling 1,000 shares of stock for $140,000, Lanni is exchanging one financial asset for another. In paying off the IOU with $50,000, Lanni is exchanging financial assets. The loan is "destroyed" in the transaction since it is retired when paid.
Ratio of real to total assets = = 0.3
Ratio of real to total assets = = 1.0
Investments: Background and Issues
Equity is a lower-priority claim on earnings (expressed as dividends) that represents an ownership share in a corporation. Fixed-income (debt) security is a higher-priority claim that legally obligates the issuer to pay the holder of the debt, but does not have an ownership interest. Fixed-income securities typically pay a specified cash flow at pre-contracted time intervals until the last payment on the maturity date. Shares of equity have an indefinite life.
A primary (financial) asset has a claim on the real assets of a firm, whereas a derivative asset provides a payoff that depends on the prices of a primary asset but does not include the claim on the real assets.
Asset allocation is the allocation of an investment portfolio across broad asset classes. Security selection is the choice of specific securities within each asset class.
Agency problems are conflicts of interest between managers and stockholders. They can be addressed through corporate governance mechanisms, such as the design of executive compensation, oversight by the Board, and monitoring from the institutional investors.
Real assets have productive capacity; they are assets used to produce goods and services. Real assets can be tangible (e.g., machinery) or intangible (e.g., a patent). Financial assets are claims on real assets or the income generated by them.
Investment bankers are firms specializing in the sale of new securities to the public, typically by underwriting the issue. Commercial banks accept deposits and lend the money to other borrowers. After the Glass-Steagall Act was repealed in 1999, some commercial banks started transforming to “universal banks” which provide the services of both commercial banks and investment banks. With the passage of the Dodd–Frank Wall Street Reform and Consumer Protection Act in 2010, Glass-Steagall was partially restored via the Volcker Rule (which generally prohibits commercial banks from conducting certain investment activities with their own accounts and investing in hedge funds and private equity funds). In 2018, Congress passed The Economic Growth, Regulatory Relief, and Consumer Protection Act established a threshold ($10 billion) for banks to be exempt from the Volcker Rule.
Financial and Real Assets
Toyota creates a real asset—the factory. The loan is a financial asset that is created in the transaction.
When the loan is repaid, the financial asset is destroyed but the real asset continues to exist.
The cash is a financial asset that is traded in exchange for a real asset, inventory.
Real Estate as a Real Asset
No. The real estate in existence has not changed, only the perception of its value has.
Yes. The financial asset value of the claims on the real estate has changed, and thus the balance sheet of individual investors has been reduced.
The difference between these two answers reflects the difference between real and financial asset values. Real assets still exist, yet the value of the claims on those assets or the cash flows they generate do change. Thus, there is the difference.
Real and Financial Assets
The bank loan is a financial liability for Lanni. Lanni's $50,000 IOU is the bank's financial asset. The cash Lanni receives is a financial asset. The new financial asset created is Lanni's promissory note held by the bank.
The cash paid by Lanni (both the loan and its own cash) is the transfer of a financial asset to the software developer. In return, Lanni gets a real asset, the completed software. No financial assets are created or destroyed. Cash is simply transferred from one firm to another.
Lanni sells the software, which is a real asset, to Microsoft. In exchange Lanni receives a financial asset, 1,000 shares of Microsoft stock. If Microsoft issues new shares in order to pay Lanni, that would be the creation of a new financial asset.
In selling 1,000 shares of stock for $140,000, Lanni is exchanging one financial asset for another. In paying off the IOU with $50,000, Lanni is exchanging financial assets. The loan is "destroyed" in the transaction since it is retired when paid.
Ratio of real to total assets = = 0.3
Ratio of real to total assets = = 1.0