CHAPTERn 1:n THEn INVESTMENTn ENVIRONMENT
PROBLEMnSETS
1. Ultimately,nitnisntruenthatnrealnassetsndeterminenthenmaterialnwellnbeingnofnanneconom
y.n Nevertheless,nindividualsncannbenefitnwhennfinancialnengineeringncreatesnnewnpro
ductsnthatnallownthemntonmanagentheirnportfoliosnofnfinancialnassetsnmorenefficiently.
nBecausenbundlingnandnunbundlingncreatesnfinancialnproductsnwithnnewnpropertiesna
ndnsensitivitiesntonvariousnsourcesnofnrisk,nitnallowsninvestorsntonhedgenparticularnsou
rcesnofnriskn morenefficiently.
2. Securitizationnrequiresnaccessntonanlargennumbernofnpotentialninvestors.n Tonattractnt
heseninvestors,nthencapitalnmarketn needs:
1. ansafensystemnofnbusinessnlawsnandnlownprobabilitynofnconffiscatorynt
axation/regulation;
2. anwell-developedninvestmentnbankin ngn industry;
3. anwell-developednsystemnofnbrokeragenandnfinancialntransactions,nand;
4. well-developednmedia,nparticularlynfinancialnreporting.
Thesencharacteristicsnarenfoundninn(indnednmak
kenfor)nanwell-
developednfinancialnmarket.
3. Securitizationnleadsntondisintermediation;nthatnis,nsecuritizationnprovidesnanmeansn
fornmarketnparticipantsntonbypassnintermediaries.n Fornexample,nmortgage-
backednsecuritiesnchannelnfundsntonthenhou usingnmarketnwithoutnrequiringnthatnban
ksnornthriftn institutionsn maken loansnfromntheirnownnportfolios.n Asnsecuritizationnp
rogresses,nfinancialnintermediariesnmustnincreasenothernactivitiesnsuchnasnprovidin
gnshort-termnliquidityntonconsumersnandnsmallnbusiness,nandnfinancialnservices.
4. Financialnassetsnmakenitneasynfornlargenfirmsntonraisenthencapitalnneededntonfinancent
heirninvestmentsninnrealnassets.nIfnFord,nfornexample,ncouldnnotnissuenstocksnornbon
dsntonthengeneralnpublic,nitnwouldnhavenanfarnmorendifficultntimenraisingncapital.nCont
ractionnofnthensupplynofnfinancialnassetsnwouldnmakenfinancingn morendifficult,nthere
bynincreasingnthencostnofncapital.nAnhigherncostnofncapitalnresultsninnlessninvestment
n andn lowern realngrowth.
,5. Evennifnthenfirmndoesnnotnneedntonissuenstockninnanynparticularnyear,nthenstocknmarketni
snstillnimportantntonthenfinancialnmanager.n Thenstocknpricenprovidesnimportant
informationnaboutnhownthenmarketnvaluesnthenfirm'sninvestmentnprojects.nFornexample,nif
nthenstocknpricenrisesnconsiderably,n managersnmightn concludenthatnthenmarket
believesnthenfirm'snfuturenprospectsnarenbright.nThisnmightnbenanusefulnsignalntonthenfir
mntonproceednwithnanninvestmentnsuchnasnannexpansionnofnthenfirm'snbusiness.
Innaddition,nsharesnthatncannbentradedninnthensecondarynmarketnarenmorenattractiventonini
tialninvestorsnsincentheynknownthatntheynwillnbenablentonsellntheirnshares.nThisninnturnnm
akesninvestorsnmorenwillingntonbuynsharesninnanprimarynoffering,nandnthusnimprovesnth
entermsnonnwhichnfirmsncannraisen moneyninnthenequitynmarket.
6. a.nNo.n Thenincreaseninnpricendidnnotnaddntonthenproductivencapacitynofnthene
conomy.
b.nYes,nthenvaluenofnthenequitynheldninnthesenassetsnhasnincreased.
c.nFuturenhomeownersnasnanwholenarenworsenoff,nsincenmortgageenliabinitiesnhaven
alsonincreased.nInnaddition,nthisnhousingnpricenbubblenwillneveentuallynburstnandn
societynasnanwholen(andn mostn likelyntaxpayers)nwillnendurenthendamage.
7. a.nThenbanknloannisnanfinancialnliiabilitynfornLannii.n(Lanni'snIOUnisnthenbank'snfina
ncialnasset.)n ThencashnLanninreceivesnisnanfinancialnasset.n Thennewnfinancial
assetncreatednisnLanni'snpromissorynnoten(thaa is,nLanni’snIOUntonthenbank).
b. Lannintransfersnfinancialnassetsn(cassh)ntonthensoftwarendevelopers.nInnreturn,nLa
nningetsnanrealnasset,nthencompletednsoftware.n Nonfinancialnassetsnarencreatednorndes
troyed;ncashnisnsimplyntransfeerrednfromnonenpartynton another.
c. Lanningivesnthenrealnasssetn(thensoftware)ntonMicrosoftninnexchangenfornanfinancialn
asset,n1,500nsharesnofnMicrosoftnstock.nIfnMicrosoftnissuesnnewnsharesninnorderntonpa
ynLanni,nthennthisnwo
ouldnrepresentnthencreationnofnnewnfinancialnassets.
d. Lanninexchangesnonenfinancialnassetn(1,500nsharesnofnstock)nfornanothern($120,00
0).nLanningivesnanfinancialnassetn($50,000ncash)ntonthenbanknandngetsnbacknanothernfi
nancialnassetn(itsnIOU).nThenloannisn"destroyed"ninnthentransaction,nsincenitnisnretiredn
whennpaidnoffnandn nonlongernexists.
,8. a.
Liabilitiesn&
Assets
n Shareholders’nequity
Cash $n70,000 Banknloan $n50,000
Computers 30,000 Shareholders’nequity 50,000
Total $100,000 Total $100,000
Rationofnrealnassetsntontotalnassetsn=n$30,000/$100,000n=n0.30
b.
Liabilitiesn&
Assets
n Shareholders’nequity
Softwarenproduct* $n70,000 Banknloan $n50,000
Computers 30,000 Shareholders’nequity 50,000
Total $100,000 Total $100,000
*Valuednatncost
Rationofnrealnassetsntontotalnassetsn=n$100,000/$100,000n=n1.0
c.
Liabilitiesn&
Assets
Shareholders’nequity
Microsoftnshares $120,000 Banknloan $n50,000
Computers 30,000 Shareholdderrs’nequity 100,000
Total $150,000 Totall $150,000
Rationofnrealnassetsntontotalnassetsn=n$30,000/$150,000n=n0.20
Conclusion:nwhennthenfirmnstartsnupnandnraisesnworkingncapital,nitnisncharacterizednbyna
nlownrationofnrealnassetsntontotalnassets.n Whennitn isninnfullnproduction,n itnhasnanhigh
rationofnrealnassetsntontotalnassets.n Whennthenprojectn"shutsndown"nandnthenfirmnsellsnit
offnforncash,nfinancialnassetsnoncenagainnreplacenrealnassets.
9. Forncommercialnbank ks,nthenrationis:n$140.1/$11,895.1n=n0.0118n
Fornnon-financialnfirrms,nthenrationis:n$12,538/$26,572n=n0.4719
Thendifferencenshouldnbenexpectednprimarilynbecausenthenbulknofnthenbusines
snofnfinancialninstitutionsnisntonmakenloans;nwhichnarenfinancialnassetsnfornfinan
cialninstitutions.
10. a.n Primary-marketntransaction
b.n Derivativenassets
c.n Investorsnwhonwishntonholdngoldnwithoutnthencomplicationnandncostnofnp
hysicalnstorage.
, 11. a.nAnfixednsalarynmeansnthatncompensationnisn(atnleastninnthenshortnrun)nindependent
nofnthenfirm'snsuccess.n Thisnsalarynstructurendoesnnotntienthenmanager’snimmediatenc
ompensationntonthensuccessnofnthenfirm.nHowever,nthenmanagernmightnviewnthisnasnt
hensafestncompensationnstructurenandnthereforenvaluenitnmorenhighly.
b.nAnsalarynthatnisnpaidninnthenformnofnstockninnthenfirmnmeansnthatnthenmanagernearnsnt
henmostnwhennthenshareholders’nwealthnisnmaximized.nFivenyearsnofnvestingnhelpsnali
gnntheninterestsnofnthenemployeenwithnthenlong-
termnperformancenofnthenfirm.nThisnstructurenisnthereforenmostnlikelyntonalignntheninter
estsnofnmanagersnandnshareholders.nIfnstockncompensationnisnoverdone,nhowever,nthen
managernmightnviewnitnasnoverlynriskynsincenthenmanager’sncareernisnalreadynlinkednto
nthenfirm,nandnthisnundiversifiednexposurenwouldnbenexacerbatednwithnan largen stocknpo
sitionninnthenfirm.
c.nAnprofit-linkednsalaryncreatesngreatnincentivesnfornmanagersntoncontributentonthe
firm’snsuccess.nHowever,nanmanagernwhosensalarynisntiedntonshort-
termnprofitsnwillnbenrisknseeking,nespeciallynifnthesenshort-
termnprofitsndeterminensalarynornifnthencompensationnstructurendoesnnotnbearnthenfullncos
tnofnthenproject’snrisks.nShareholders,ninncontrast,nbearnthenlossesnasnwellnasnthengainsnonnt
henproject,nandnmightnbenless
willingntonassumenthatnrisk.
12. Evennifnannindividualnshareholderncouldnmonitornandnimprovenmanagers’nperformance,n
andntherebynincreasenthenvaluenofnthenfirm,nthenpayoffnwouldnbensmall,nsincenthenowner
shipnshareninnanlargencorporationnwouldnbenverynsmall.n Fornexample,nifnyounown
$10,000nofnFordnstocknandncannincreasenthenvaluenofnthenfirmnbyn5%,nanverynambitious
goal,n younbenefitn bynonly:n0.05 $10,000n=n$500
Inncontrast,nanbanknthatnhasnanmultimilllion-
dollarnloannoutstandingntonthenfirmnhasnanbignstakeninnmakingnsurenthatnthenfirmncannrepay
nthenloan.nItnisnclearlynworthwhilenfornthenbankntonspendnconsiderablenresourcesnton monit
ornthenfirm.
13. Mutualnfundsnacceptnfundsnfromnsmallninvestorsnandninvest,nonnbehalfnofntheseni
nvenstors,n inn then nationalnandn internationalnsecuritiesn markets.
Pensionnfundsnacceptnfundsnandnthenninvest,nonnbehalfnofncurrentnandnfuturenretirees,nth
erebynchannelingn fundsnfromnonensectornofntheneconomynton another.
Venturencapitalnfirmsnpoolnthenfundsnofnprivateninvestorsnandninvestninnstart-upnfirms.
Banksnacceptndepositsnfromncustomersnandnloannthosenfundsntonbusinesses,nornusenthenf
undsnton buynsecuritiesnofnlargencorporations.
14. Treasurynbillsnservenanpurposenforninvestorsnwhonprefernanlow-
riskninvestment.nThenlowernaveragenratenofnreturnncomparedntonstocksnisnthenpri
ceninvestorsnpaynfornpredictabilitynofninvestmentn performancenandnportfolion val
ue.
PROBLEMnSETS
1. Ultimately,nitnisntruenthatnrealnassetsndeterminenthenmaterialnwellnbeingnofnanneconom
y.n Nevertheless,nindividualsncannbenefitnwhennfinancialnengineeringncreatesnnewnpro
ductsnthatnallownthemntonmanagentheirnportfoliosnofnfinancialnassetsnmorenefficiently.
nBecausenbundlingnandnunbundlingncreatesnfinancialnproductsnwithnnewnpropertiesna
ndnsensitivitiesntonvariousnsourcesnofnrisk,nitnallowsninvestorsntonhedgenparticularnsou
rcesnofnriskn morenefficiently.
2. Securitizationnrequiresnaccessntonanlargennumbernofnpotentialninvestors.n Tonattractnt
heseninvestors,nthencapitalnmarketn needs:
1. ansafensystemnofnbusinessnlawsnandnlownprobabilitynofnconffiscatorynt
axation/regulation;
2. anwell-developedninvestmentnbankin ngn industry;
3. anwell-developednsystemnofnbrokeragenandnfinancialntransactions,nand;
4. well-developednmedia,nparticularlynfinancialnreporting.
Thesencharacteristicsnarenfoundninn(indnednmak
kenfor)nanwell-
developednfinancialnmarket.
3. Securitizationnleadsntondisintermediation;nthatnis,nsecuritizationnprovidesnanmeansn
fornmarketnparticipantsntonbypassnintermediaries.n Fornexample,nmortgage-
backednsecuritiesnchannelnfundsntonthenhou usingnmarketnwithoutnrequiringnthatnban
ksnornthriftn institutionsn maken loansnfromntheirnownnportfolios.n Asnsecuritizationnp
rogresses,nfinancialnintermediariesnmustnincreasenothernactivitiesnsuchnasnprovidin
gnshort-termnliquidityntonconsumersnandnsmallnbusiness,nandnfinancialnservices.
4. Financialnassetsnmakenitneasynfornlargenfirmsntonraisenthencapitalnneededntonfinancent
heirninvestmentsninnrealnassets.nIfnFord,nfornexample,ncouldnnotnissuenstocksnornbon
dsntonthengeneralnpublic,nitnwouldnhavenanfarnmorendifficultntimenraisingncapital.nCont
ractionnofnthensupplynofnfinancialnassetsnwouldnmakenfinancingn morendifficult,nthere
bynincreasingnthencostnofncapital.nAnhigherncostnofncapitalnresultsninnlessninvestment
n andn lowern realngrowth.
,5. Evennifnthenfirmndoesnnotnneedntonissuenstockninnanynparticularnyear,nthenstocknmarketni
snstillnimportantntonthenfinancialnmanager.n Thenstocknpricenprovidesnimportant
informationnaboutnhownthenmarketnvaluesnthenfirm'sninvestmentnprojects.nFornexample,nif
nthenstocknpricenrisesnconsiderably,n managersnmightn concludenthatnthenmarket
believesnthenfirm'snfuturenprospectsnarenbright.nThisnmightnbenanusefulnsignalntonthenfir
mntonproceednwithnanninvestmentnsuchnasnannexpansionnofnthenfirm'snbusiness.
Innaddition,nsharesnthatncannbentradedninnthensecondarynmarketnarenmorenattractiventonini
tialninvestorsnsincentheynknownthatntheynwillnbenablentonsellntheirnshares.nThisninnturnnm
akesninvestorsnmorenwillingntonbuynsharesninnanprimarynoffering,nandnthusnimprovesnth
entermsnonnwhichnfirmsncannraisen moneyninnthenequitynmarket.
6. a.nNo.n Thenincreaseninnpricendidnnotnaddntonthenproductivencapacitynofnthene
conomy.
b.nYes,nthenvaluenofnthenequitynheldninnthesenassetsnhasnincreased.
c.nFuturenhomeownersnasnanwholenarenworsenoff,nsincenmortgageenliabinitiesnhaven
alsonincreased.nInnaddition,nthisnhousingnpricenbubblenwillneveentuallynburstnandn
societynasnanwholen(andn mostn likelyntaxpayers)nwillnendurenthendamage.
7. a.nThenbanknloannisnanfinancialnliiabilitynfornLannii.n(Lanni'snIOUnisnthenbank'snfina
ncialnasset.)n ThencashnLanninreceivesnisnanfinancialnasset.n Thennewnfinancial
assetncreatednisnLanni'snpromissorynnoten(thaa is,nLanni’snIOUntonthenbank).
b. Lannintransfersnfinancialnassetsn(cassh)ntonthensoftwarendevelopers.nInnreturn,nLa
nningetsnanrealnasset,nthencompletednsoftware.n Nonfinancialnassetsnarencreatednorndes
troyed;ncashnisnsimplyntransfeerrednfromnonenpartynton another.
c. Lanningivesnthenrealnasssetn(thensoftware)ntonMicrosoftninnexchangenfornanfinancialn
asset,n1,500nsharesnofnMicrosoftnstock.nIfnMicrosoftnissuesnnewnsharesninnorderntonpa
ynLanni,nthennthisnwo
ouldnrepresentnthencreationnofnnewnfinancialnassets.
d. Lanninexchangesnonenfinancialnassetn(1,500nsharesnofnstock)nfornanothern($120,00
0).nLanningivesnanfinancialnassetn($50,000ncash)ntonthenbanknandngetsnbacknanothernfi
nancialnassetn(itsnIOU).nThenloannisn"destroyed"ninnthentransaction,nsincenitnisnretiredn
whennpaidnoffnandn nonlongernexists.
,8. a.
Liabilitiesn&
Assets
n Shareholders’nequity
Cash $n70,000 Banknloan $n50,000
Computers 30,000 Shareholders’nequity 50,000
Total $100,000 Total $100,000
Rationofnrealnassetsntontotalnassetsn=n$30,000/$100,000n=n0.30
b.
Liabilitiesn&
Assets
n Shareholders’nequity
Softwarenproduct* $n70,000 Banknloan $n50,000
Computers 30,000 Shareholders’nequity 50,000
Total $100,000 Total $100,000
*Valuednatncost
Rationofnrealnassetsntontotalnassetsn=n$100,000/$100,000n=n1.0
c.
Liabilitiesn&
Assets
Shareholders’nequity
Microsoftnshares $120,000 Banknloan $n50,000
Computers 30,000 Shareholdderrs’nequity 100,000
Total $150,000 Totall $150,000
Rationofnrealnassetsntontotalnassetsn=n$30,000/$150,000n=n0.20
Conclusion:nwhennthenfirmnstartsnupnandnraisesnworkingncapital,nitnisncharacterizednbyna
nlownrationofnrealnassetsntontotalnassets.n Whennitn isninnfullnproduction,n itnhasnanhigh
rationofnrealnassetsntontotalnassets.n Whennthenprojectn"shutsndown"nandnthenfirmnsellsnit
offnforncash,nfinancialnassetsnoncenagainnreplacenrealnassets.
9. Forncommercialnbank ks,nthenrationis:n$140.1/$11,895.1n=n0.0118n
Fornnon-financialnfirrms,nthenrationis:n$12,538/$26,572n=n0.4719
Thendifferencenshouldnbenexpectednprimarilynbecausenthenbulknofnthenbusines
snofnfinancialninstitutionsnisntonmakenloans;nwhichnarenfinancialnassetsnfornfinan
cialninstitutions.
10. a.n Primary-marketntransaction
b.n Derivativenassets
c.n Investorsnwhonwishntonholdngoldnwithoutnthencomplicationnandncostnofnp
hysicalnstorage.
, 11. a.nAnfixednsalarynmeansnthatncompensationnisn(atnleastninnthenshortnrun)nindependent
nofnthenfirm'snsuccess.n Thisnsalarynstructurendoesnnotntienthenmanager’snimmediatenc
ompensationntonthensuccessnofnthenfirm.nHowever,nthenmanagernmightnviewnthisnasnt
hensafestncompensationnstructurenandnthereforenvaluenitnmorenhighly.
b.nAnsalarynthatnisnpaidninnthenformnofnstockninnthenfirmnmeansnthatnthenmanagernearnsnt
henmostnwhennthenshareholders’nwealthnisnmaximized.nFivenyearsnofnvestingnhelpsnali
gnntheninterestsnofnthenemployeenwithnthenlong-
termnperformancenofnthenfirm.nThisnstructurenisnthereforenmostnlikelyntonalignntheninter
estsnofnmanagersnandnshareholders.nIfnstockncompensationnisnoverdone,nhowever,nthen
managernmightnviewnitnasnoverlynriskynsincenthenmanager’sncareernisnalreadynlinkednto
nthenfirm,nandnthisnundiversifiednexposurenwouldnbenexacerbatednwithnan largen stocknpo
sitionninnthenfirm.
c.nAnprofit-linkednsalaryncreatesngreatnincentivesnfornmanagersntoncontributentonthe
firm’snsuccess.nHowever,nanmanagernwhosensalarynisntiedntonshort-
termnprofitsnwillnbenrisknseeking,nespeciallynifnthesenshort-
termnprofitsndeterminensalarynornifnthencompensationnstructurendoesnnotnbearnthenfullncos
tnofnthenproject’snrisks.nShareholders,ninncontrast,nbearnthenlossesnasnwellnasnthengainsnonnt
henproject,nandnmightnbenless
willingntonassumenthatnrisk.
12. Evennifnannindividualnshareholderncouldnmonitornandnimprovenmanagers’nperformance,n
andntherebynincreasenthenvaluenofnthenfirm,nthenpayoffnwouldnbensmall,nsincenthenowner
shipnshareninnanlargencorporationnwouldnbenverynsmall.n Fornexample,nifnyounown
$10,000nofnFordnstocknandncannincreasenthenvaluenofnthenfirmnbyn5%,nanverynambitious
goal,n younbenefitn bynonly:n0.05 $10,000n=n$500
Inncontrast,nanbanknthatnhasnanmultimilllion-
dollarnloannoutstandingntonthenfirmnhasnanbignstakeninnmakingnsurenthatnthenfirmncannrepay
nthenloan.nItnisnclearlynworthwhilenfornthenbankntonspendnconsiderablenresourcesnton monit
ornthenfirm.
13. Mutualnfundsnacceptnfundsnfromnsmallninvestorsnandninvest,nonnbehalfnofntheseni
nvenstors,n inn then nationalnandn internationalnsecuritiesn markets.
Pensionnfundsnacceptnfundsnandnthenninvest,nonnbehalfnofncurrentnandnfuturenretirees,nth
erebynchannelingn fundsnfromnonensectornofntheneconomynton another.
Venturencapitalnfirmsnpoolnthenfundsnofnprivateninvestorsnandninvestninnstart-upnfirms.
Banksnacceptndepositsnfromncustomersnandnloannthosenfundsntonbusinesses,nornusenthenf
undsnton buynsecuritiesnofnlargencorporations.
14. Treasurynbillsnservenanpurposenforninvestorsnwhonprefernanlow-
riskninvestment.nThenlowernaveragenratenofnreturnncomparedntonstocksnisnthenpri
ceninvestorsnpaynfornpredictabilitynofninvestmentn performancenandnportfolion val
ue.
