Recent Trends in Investment & the Investment Process

This lecture discusses the following points:
1. Recent trends in the investment environment
2. The investment process

1. Recent trends in the investment environment
The investment environment has changed dramatically because of four forces:
1) Globalization
2) Securitization
3) Financial Engineering
4) Information Technology and computer networks

1) Globalization
- Globalization here means that investment is no longer limited to domestic assets, but it extends to foreign markets to invest internationally as well.
- Or simply, it is a tendency toward a world wide investment environment, and the integration of a national capital markets.
The expansion to foreign markets can come through four ways:
a) American Depository Receipts (ADRs)
ADRs are domestically traded securities that represent claims to share in foreign stocks. Or simply it is a claim on a foreign stock by a domestic shareholder.
The broker or “the domestic bank” acts as intermediary by purchasing an inventory of stock from some foreign issuer which always will be “foreign bank”, then the intermediary which is the “domestic bank” issues an ADR that represent a claim to some number of those foreign shares held in inventory.
Advantages of ADR: Allow investors to diversify without foreign currency problems.
Disadvantages of ADR: ADRs are subject to the risk of exchange rate fluctuations.
My comment on how to avoid the disadvantage:
If the government has a tendency toward encouraging this kind of investment, it can hold its exchange rate fixed toward the host country exchange rate. For example $1=LE3 and keeping it as it is fixed.

b) Purchase of foreign securities that are offered in the currency of the domestic country.
c) Buy mutual fund that invest internationally, mutual funds are companies that buy shares on other people behalf.
d) Buy derivative securities with payoffs that depend on prices in foreign security markets.
2) Securitization
- Securitization was first introduced by Government National Mortgage Association. GNMA.
- Securitization means converting illiquid assets (mortgage loans) into marketable securities. These securities aggregate individual home mortgages into relatively homogeneous pools. Each pool acts as backing (financing) for a GMNA pass-through security. Investors who buy GNMA securities receive prorated shares of all the principal and interest payments made on the underlying mortgage pool.
- Securitization of mortgages means mortgages can be traded just like other securities.
Abuse of Securitization
Securitization has been used to allow US banks to unload their portfolios of shaky loans to developing nations. The so-called Brady Bonds were formed by securitizing bank loans to several countries in shaky fiscal condition.
3) Financial Engineering:
Creating a new hybrid asset or a new hybrid security by either:
a) Bundling: combining more than one security into a composite security. Or,
b) Unbundling: Breaking up and allocating the cash flow from one security to create several new securities.
Advantages of Financial Engineering
Such creative engineering of new investment products allows one to design securities with custom-tailored risk attributes.
Question: Financial Engineering creates custom-tailored securities. Comment
Answer: The process of bundling and unbundling is called financial engineering and it is referred to the creation and design of securities with custom-tailored characteristics, Financial engineers view securities as bundles of (possible risky) cash flows that may be carved up and rearranged according to the needs or desires of traders in the security markets.
4) Computer Networks
When talking about the effect of computer networks on the investment environment, we can mention the three important innovations:
a) Online trading: connects a customer directly to a brokerage firm
Advantage:
Online trading can process trades more cheaply and therefore can charge lower commissions.
b) Online information dissemination: vast amounts of data can be cheaply and widely obtained through the internet. Individual investors today can obtain data, investment tools, and even analyst reports that just a decade ago would have been available only to professionals.
c) Automated trade crossing: the networks allow members to post buy or sell orders and to have those orders matched up or “crossed” with orders of traders in the system.
Advantage:
The interference of an intermediary such as securities dealer will be unnecessary because the automated trade crossing will do this job.


2. The Investment Process

Before examining the investment process we have to know that:
- The investor’s portfolio: is simply his collection of assets.
- Asset Classes: are stocks, bonds, real estate, commodities, and so on.
- The composition of one’s portfolio depends on (1) his goal (2) his tolerance to risk.
The investment process consists of three stages:
a) Asset Allocation: the asset allocation decision is the choice among the broad asset classes
b) Security Selection: the security selection decision is the choice of which particular securities to hold within each asset class
c) Security Analysis: security analysis is analysis of the value of securities to evaluate and identify mispriced securities.
Why we do security analysis?
To evaluate and identify mispriced securities. Securities are correctly priced only in Efficient Markets.
Efficient Market assumes that investors process all relevant information about securities quickly and efficiently, that is security price reflects all the information available to investors concerning the value of the security. In this market, there would be neither underpriced nor overpriced securities.
Portfolio’s Management Strategies under the hypothesis of Efficient Markets:
A. Passive Management
Buying and holding a diversified portfolio without attempting to identify mispriced securities.
B. Active Management
Attempting to identify mispriced securities or to forecast broad market trends.

Q: Under Efficient Market, does the investor who adopt the passive management strategy will continue adopting his strategy for ever?
Answer: under Efficient Market hypothesis all securities are correctly priced, so the investors will only set the proportions between each asset classes at the first time he establishes his portfolio, and then this proportion will stay the same because each security is correctly priced. However, if the market conditions do not change the investor’s goals change. We know that the composition of one’s portfolio depends on his (1) degree of risk tolerance that will be held constant under the Efficient Market hypothesis, and (2) his goals which will never be hold constant because it changes over time.