CHAPTERb 1:b THEb INVESTMENTb ENVIRONMENT
PROBLEMbSETS
1. Ultimately,bitbisbtruebthatbrealbassetsbdeterminebthebmaterialbwellbbeingbofbanbeconom
y.b Nevertheless,bindividualsbcanbbenefitbwhenbfinancialbengineeringbcreatesbnewbpro
ductsbthatballowbthembtobmanagebtheirbportfoliosbofbfinancialbassetsbmorebefficiently.
bBecausebbundlingbandbunbundlingbcreatesbfinancialbproductsbwithbnewbpropertiesba
ndbsensitivitiesbtobvariousbsourcesbofbrisk,bitballowsbinvestorsbtobhedgebparticularbsou
rcesbofbriskbmorebefficiently.
2. Securitizationbrequiresbaccessbtobablargebnumberbofbpotentialbinvestors.b Tobattractbt
hesebinvestors,bthebcapitalbmarketbneeds:
1. absafebsystembofbbusinessblawsbandblowbprobabilitybofbconffiscatorybt
axation/regulation;
2. abwell-developedbinvestmentbbankin ngbindustry;
3. abwell-developedbsystembofbbrokeragebandbfinancialbtransactions,band;
4. well-developedbmedia,bparticularlybfinancialbreporting.
Thesebcharacteristicsbarebfoundbinb(indbedbmak
kebfor)babwell-
developedbfinancialbmarket.
3. Securitizationbleadsbtobdisintermediation;bthatbis,bsecuritizationbprovidesbabmeansb
forbmarketbparticipantsbtobbypassbintermediaries.b Forbexample,bmortgage-
backedbsecuritiesbchannelbfundsbtobthebhou usingbmarketbwithoutbrequiringbthatbban
ksborbthriftbinstitutionsb makebloansbfrombtheirbownbportfolios.b Asbsecuritizationbp
rogresses,bfinancialbintermediariesbmustbincreasebotherbactivitiesbsuchbasbprovidin
gbshort-termbliquiditybtobconsumersbandbsmallbbusiness,bandbfinancialbservices.
4. Financialbassetsbmakebitbeasybforblargebfirmsbtobraisebthebcapitalbneededbtobfinancebt
heirbinvestmentsbinbrealbassets.bIfbFord,bforbexample,bcouldbnotbissuebstocksborbbon
dsbtobthebgeneralbpublic,bitbwouldbhavebabfarbmorebdifficultbtimebraisingbcapital.bCont
ractionbofbthebsupplybofbfinancialbassetsbwouldbmakebfinancingbmorebdifficult,bthere
bybincreasingbthebcostbofbcapital.bAbhigherbcostbofbcapitalbresultsbinblessbinvestment
bandb lowerbrealbgrowth.
,5. Evenbifbthebfirmbdoesbnotbneedbtobissuebstockbinbanybparticularbyear,bthebstockbmarketbi
sbstillbimportantbtobthebfinancialbmanager.b Thebstockbpricebprovidesbimportant
informationbaboutbhowbthebmarketbvaluesbthebfirm'sbinvestmentbprojects.bForbexample,bif
bthebstockbpricebrisesbconsiderably,b managersbmightbconcludebthatbthebmarket
believesbthebfirm'sbfuturebprospectsbarebbright.bThisbmightbbebabusefulbsignalbtobthebfir
mbtobproceedbwithbanbinvestmentbsuchbasbanbexpansionbofbthebfirm'sbbusiness.
Inbaddition,bsharesbthatbcanbbebtradedbinbthebsecondarybmarketbarebmorebattractivebtobini
tialbinvestorsbsincebtheybknowbthatbtheybwillbbebablebtobsellbtheirbshares.bThisbinbturnbm
akesbinvestorsbmorebwillingbtobbuybsharesbinbabprimaryboffering,bandbthusbimprovesbth
ebtermsbonbwhichbfirmsbcanbraisebmoneybinbthebequitybmarket.
6. a.bNo.b Thebincreasebinbpricebdidbnotbaddbtobthebproductivebcapacitybofbthebe
conomy.
b.bYes,bthebvaluebofbthebequitybheldbinbthesebassetsbhasbincreased.
c.bFuturebhomeownersbasbabwholebarebworseboff,bsincebmortgageebliabibitiesbhaveb
alsobincreased.bInbaddition,bthisbhousingbpricebbubblebwillbeveentuallybburstbandb
societybasbabwholeb(andbmostblikelybtaxpayers)bwillbendurebthebdamage.
7. a.bThebbankbloanbisbabfinancialbliiabilitybforbLannii.b(Lanni'sbIOUbisbthebbank'sbfina
ncialbasset.)b ThebcashbLannibreceivesbisbabfinancialbasset.b Thebnewbfinancial
assetbcreatedbisbLanni'sbpromissorybnoteb(thaa is,bLanni’sbIOUbtobthebbank).
b. Lannibtransfersbfinancialbassetsb(cassh)btobthebsoftwarebdevelopers.bInbreturn,bLa
nnibgetsbabrealbasset,bthebcompletedbsoftware.b Nobfinancialbassetsbarebcreatedborbdes
troyed;bcashbisbsimplybtransfeerredbfrombonebpartybtobanother.
c. Lannibgivesbthebrealbasssetb(thebsoftware)btobMicrosoftbinbexchangebforbabfinancialb
asset,b1,500bsharesbofbMicrosoftbstock.bIfbMicrosoftbissuesbnewbsharesbinborderbtobpa
ybLanni,bthenbthisbwo
ouldbrepresentbthebcreationbofbnewbfinancialbassets.
d. Lannibexchangesbonebfinancialbassetb(1,500bsharesbofbstock)bforbanotherb($120,00
0).bLannibgivesbabfinancialbassetb($50,000bcash)btobthebbankbandbgetsbbackbanotherbfi
nancialbassetb(itsbIOU).bThebloanbisb"destroyed"binbthebtransaction,bsincebitbisbretiredb
whenbpaidboffbandbnoblongerbexists.
,8. a.
Liabilitiesb&
Assets
b Shareholders’bequity
Cash $b70,000 Bankbloan $b50,000
Computers 30,000 Shareholders’bequity 50,000
Total $100,000 Total $100,000
Ratiobofbrealbassetsbtobtotalbassetsb=b$30,000/$100,000b=b0.30
b.
Liabilitiesb&
Assets
b Shareholders’bequity
Softwarebproduct* $b70,000 Bankbloan $b50,000
Computers 30,000 Shareholders’bequity 50,000
Total $100,000 Total $100,000
*Valuedbatbcost
Ratiobofbrealbassetsbtobtotalbassetsb=b$100,000/$100,000b=b1.0
c.
Liabilitiesb&
Assets
Shareholders’bequity
Microsoftbshares $120,000 Bankbloan $b50,000
Computers 30,000 Shareholdderrs’bequity 100,000
Total $150,000 Totall $150,000
Ratiobofbrealbassetsbtobtotalbassetsb=b$30,000/$150,000b=b0.20
Conclusion:bwhenbthebfirmbstartsbupbandbraisesbworkingbcapital,bitbisbcharacterizedbbyba
blowbratiobofbrealbassetsbtobtotalbassets.b Whenbitb isbinbfullbproduction,bitbhasbabhigh
ratiobofbrealbassetsbtobtotalbassets.b Whenbthebprojectb"shutsbdown"bandbthebfirmbsellsbit
offbforbcash,bfinancialbassetsboncebagainbreplacebrealbassets.
9. Forbcommercialbbank ks,bthebratiobis:b$140.1/$11,895.1b=b0.0118b
Forbnon-financialbfirrms,bthebratiobis:b$12,538/$26,572b=b0.4719
Thebdifferencebshouldbbebexpectedbprimarilybbecausebthebbulkbofbthebbusines
sbofbfinancialbinstitutionsbisbtobmakebloans;bwhichbarebfinancialbassetsbforbfinan
cialbinstitutions.
10. a.b Primary-marketbtransaction
b.b Derivativebassets
c.b Investorsbwhobwishbtobholdbgoldbwithoutbthebcomplicationbandbcostbofbp
hysicalbstorage.
, 11. a.bAbfixedbsalarybmeansbthatbcompensationbisb(atbleastbinbthebshortbrun)bindependent
bofbthebfirm's bsuccess.b Thisbsalarybstructurebdoesbnotbtiebthebmanager’sbimmediatebc
ompensationbtobthebsuccessbofbthebfirm.bHowever,bthebmanagerbmightbviewbthisbasbt
hebsafestbcompensationbstructurebandbthereforebvaluebitbmorebhighly.
b.bAbsalarybthatbisbpaidbinbthebformbofbstockbinbthebfirmbmeansbthatbthebmanagerbearnsbt
hebmostbwhenbthebshareholders’bwealthbisbmaximized.bFivebyearsbofbvestingbhelpsbali
gnbthebinterestsbofbthebemployeebwithbtheblong-
termbperformancebofbthebfirm.bThisbstructurebisbthereforebmostblikelybtobalignbthebinter
estsbofbmanagersbandbshareholders.bIfbstockbcompensationbisboverdone,bhowever,btheb
managerbmightbviewbitbasboverlybriskybsincebthebmanager’sbcareerbisbalreadyblinkedbto
bthebfirm,bandbthisbundiversifiedbexposurebwouldbbebexacerbatedbwithbablargeb stockbpo
sitionbinbthebfirm.
c.bAbprofit-linkedbsalarybcreatesbgreatbincentivesbforbmanagersbtobcontributebtobthe
firm’sbsuccess.bHowever,babmanagerbwhosebsalarybisbtiedbtobshort-
termbprofitsbwillbbebriskbseeking,bespeciallybifbthesebshort-
termbprofitsbdeterminebsalaryborbifbthebcompensationbstructurebdoesbnotbbearbthebfullbcos
tbofbthebproject’sbrisks.bShareholders,binbcontrast,bbearbtheblossesbasbwellbasbthebgainsbonbt
hebproject,bandbmightbbebless
willingbtobassumebthatbrisk.
12. Evenbifbanbindividualbshareholderbcouldbmonitorbandbimprovebmanagers’bperformance,b
andbtherebybincreasebthebvaluebofbthebfirm,bthebpayoffbwouldbbebsmall,bsincebthebowner
shipbsharebinbablargebcorporationbwouldbbebverybsmall.b Forbexample,bifbyoubown
$10,000bofbFordbstockbandbcanbincreasebthebvaluebofbthebfirmbbyb5%,babverybambitious
goal,byoubbenefitbbybonly:b0.05 $10,000b=b$500
Inbcontrast,babbankbthatbhasbabmultimilllion-
dollarbloanboutstandingbtobthebfirmbhasbabbigbstakebinbmakingbsurebthatbthebfirmbcanbrepay
bthebloan.bIt bisbclearlybworthwhilebforbthebbankbtobspendbconsiderablebresourcesbtob monit
orbthebfirm.
13. Mutualbfundsbacceptbfundsbfrombsmallbinvestorsbandbinvest,bonbbehalfbofbthesebi
nvebstors,b inb theb nationalbandb internationalbsecuritiesb markets.
Pensionbfundsbacceptbfundsbandbthenbinvest,bonbbehalfbofbcurrentbandbfuturebretirees,bth
erebybchannelingbfundsbfrombonebsectorbofbthebeconomybtobanother.
Venturebcapitalbfirmsbpoolbthebfundsbofbprivatebinvestorsbandbinvestbinbstart-upbfirms.
Banksbacceptbdepositsbfrombcustomersbandbloanbthosebfundsbtobbusinesses,borbusebthebf
undsbtobbuybsecuritiesbofblargebcorporations.
14. Treasurybbillsbservebabpurposebforbinvestorsbwhobpreferbablow-
riskbinvestment.bTheblowerbaveragebratebofbreturnbcomparedbtobstocksbisbthebpri
cebinvestorsbpaybforbpredictabilitybofbinvestmentbperformancebandbportfoliobval
ue.
PROBLEMbSETS
1. Ultimately,bitbisbtruebthatbrealbassetsbdeterminebthebmaterialbwellbbeingbofbanbeconom
y.b Nevertheless,bindividualsbcanbbenefitbwhenbfinancialbengineeringbcreatesbnewbpro
ductsbthatballowbthembtobmanagebtheirbportfoliosbofbfinancialbassetsbmorebefficiently.
bBecausebbundlingbandbunbundlingbcreatesbfinancialbproductsbwithbnewbpropertiesba
ndbsensitivitiesbtobvariousbsourcesbofbrisk,bitballowsbinvestorsbtobhedgebparticularbsou
rcesbofbriskbmorebefficiently.
2. Securitizationbrequiresbaccessbtobablargebnumberbofbpotentialbinvestors.b Tobattractbt
hesebinvestors,bthebcapitalbmarketbneeds:
1. absafebsystembofbbusinessblawsbandblowbprobabilitybofbconffiscatorybt
axation/regulation;
2. abwell-developedbinvestmentbbankin ngbindustry;
3. abwell-developedbsystembofbbrokeragebandbfinancialbtransactions,band;
4. well-developedbmedia,bparticularlybfinancialbreporting.
Thesebcharacteristicsbarebfoundbinb(indbedbmak
kebfor)babwell-
developedbfinancialbmarket.
3. Securitizationbleadsbtobdisintermediation;bthatbis,bsecuritizationbprovidesbabmeansb
forbmarketbparticipantsbtobbypassbintermediaries.b Forbexample,bmortgage-
backedbsecuritiesbchannelbfundsbtobthebhou usingbmarketbwithoutbrequiringbthatbban
ksborbthriftbinstitutionsb makebloansbfrombtheirbownbportfolios.b Asbsecuritizationbp
rogresses,bfinancialbintermediariesbmustbincreasebotherbactivitiesbsuchbasbprovidin
gbshort-termbliquiditybtobconsumersbandbsmallbbusiness,bandbfinancialbservices.
4. Financialbassetsbmakebitbeasybforblargebfirmsbtobraisebthebcapitalbneededbtobfinancebt
heirbinvestmentsbinbrealbassets.bIfbFord,bforbexample,bcouldbnotbissuebstocksborbbon
dsbtobthebgeneralbpublic,bitbwouldbhavebabfarbmorebdifficultbtimebraisingbcapital.bCont
ractionbofbthebsupplybofbfinancialbassetsbwouldbmakebfinancingbmorebdifficult,bthere
bybincreasingbthebcostbofbcapital.bAbhigherbcostbofbcapitalbresultsbinblessbinvestment
bandb lowerbrealbgrowth.
,5. Evenbifbthebfirmbdoesbnotbneedbtobissuebstockbinbanybparticularbyear,bthebstockbmarketbi
sbstillbimportantbtobthebfinancialbmanager.b Thebstockbpricebprovidesbimportant
informationbaboutbhowbthebmarketbvaluesbthebfirm'sbinvestmentbprojects.bForbexample,bif
bthebstockbpricebrisesbconsiderably,b managersbmightbconcludebthatbthebmarket
believesbthebfirm'sbfuturebprospectsbarebbright.bThisbmightbbebabusefulbsignalbtobthebfir
mbtobproceedbwithbanbinvestmentbsuchbasbanbexpansionbofbthebfirm'sbbusiness.
Inbaddition,bsharesbthatbcanbbebtradedbinbthebsecondarybmarketbarebmorebattractivebtobini
tialbinvestorsbsincebtheybknowbthatbtheybwillbbebablebtobsellbtheirbshares.bThisbinbturnbm
akesbinvestorsbmorebwillingbtobbuybsharesbinbabprimaryboffering,bandbthusbimprovesbth
ebtermsbonbwhichbfirmsbcanbraisebmoneybinbthebequitybmarket.
6. a.bNo.b Thebincreasebinbpricebdidbnotbaddbtobthebproductivebcapacitybofbthebe
conomy.
b.bYes,bthebvaluebofbthebequitybheldbinbthesebassetsbhasbincreased.
c.bFuturebhomeownersbasbabwholebarebworseboff,bsincebmortgageebliabibitiesbhaveb
alsobincreased.bInbaddition,bthisbhousingbpricebbubblebwillbeveentuallybburstbandb
societybasbabwholeb(andbmostblikelybtaxpayers)bwillbendurebthebdamage.
7. a.bThebbankbloanbisbabfinancialbliiabilitybforbLannii.b(Lanni'sbIOUbisbthebbank'sbfina
ncialbasset.)b ThebcashbLannibreceivesbisbabfinancialbasset.b Thebnewbfinancial
assetbcreatedbisbLanni'sbpromissorybnoteb(thaa is,bLanni’sbIOUbtobthebbank).
b. Lannibtransfersbfinancialbassetsb(cassh)btobthebsoftwarebdevelopers.bInbreturn,bLa
nnibgetsbabrealbasset,bthebcompletedbsoftware.b Nobfinancialbassetsbarebcreatedborbdes
troyed;bcashbisbsimplybtransfeerredbfrombonebpartybtobanother.
c. Lannibgivesbthebrealbasssetb(thebsoftware)btobMicrosoftbinbexchangebforbabfinancialb
asset,b1,500bsharesbofbMicrosoftbstock.bIfbMicrosoftbissuesbnewbsharesbinborderbtobpa
ybLanni,bthenbthisbwo
ouldbrepresentbthebcreationbofbnewbfinancialbassets.
d. Lannibexchangesbonebfinancialbassetb(1,500bsharesbofbstock)bforbanotherb($120,00
0).bLannibgivesbabfinancialbassetb($50,000bcash)btobthebbankbandbgetsbbackbanotherbfi
nancialbassetb(itsbIOU).bThebloanbisb"destroyed"binbthebtransaction,bsincebitbisbretiredb
whenbpaidboffbandbnoblongerbexists.
,8. a.
Liabilitiesb&
Assets
b Shareholders’bequity
Cash $b70,000 Bankbloan $b50,000
Computers 30,000 Shareholders’bequity 50,000
Total $100,000 Total $100,000
Ratiobofbrealbassetsbtobtotalbassetsb=b$30,000/$100,000b=b0.30
b.
Liabilitiesb&
Assets
b Shareholders’bequity
Softwarebproduct* $b70,000 Bankbloan $b50,000
Computers 30,000 Shareholders’bequity 50,000
Total $100,000 Total $100,000
*Valuedbatbcost
Ratiobofbrealbassetsbtobtotalbassetsb=b$100,000/$100,000b=b1.0
c.
Liabilitiesb&
Assets
Shareholders’bequity
Microsoftbshares $120,000 Bankbloan $b50,000
Computers 30,000 Shareholdderrs’bequity 100,000
Total $150,000 Totall $150,000
Ratiobofbrealbassetsbtobtotalbassetsb=b$30,000/$150,000b=b0.20
Conclusion:bwhenbthebfirmbstartsbupbandbraisesbworkingbcapital,bitbisbcharacterizedbbyba
blowbratiobofbrealbassetsbtobtotalbassets.b Whenbitb isbinbfullbproduction,bitbhasbabhigh
ratiobofbrealbassetsbtobtotalbassets.b Whenbthebprojectb"shutsbdown"bandbthebfirmbsellsbit
offbforbcash,bfinancialbassetsboncebagainbreplacebrealbassets.
9. Forbcommercialbbank ks,bthebratiobis:b$140.1/$11,895.1b=b0.0118b
Forbnon-financialbfirrms,bthebratiobis:b$12,538/$26,572b=b0.4719
Thebdifferencebshouldbbebexpectedbprimarilybbecausebthebbulkbofbthebbusines
sbofbfinancialbinstitutionsbisbtobmakebloans;bwhichbarebfinancialbassetsbforbfinan
cialbinstitutions.
10. a.b Primary-marketbtransaction
b.b Derivativebassets
c.b Investorsbwhobwishbtobholdbgoldbwithoutbthebcomplicationbandbcostbofbp
hysicalbstorage.
, 11. a.bAbfixedbsalarybmeansbthatbcompensationbisb(atbleastbinbthebshortbrun)bindependent
bofbthebfirm's bsuccess.b Thisbsalarybstructurebdoesbnotbtiebthebmanager’sbimmediatebc
ompensationbtobthebsuccessbofbthebfirm.bHowever,bthebmanagerbmightbviewbthisbasbt
hebsafestbcompensationbstructurebandbthereforebvaluebitbmorebhighly.
b.bAbsalarybthatbisbpaidbinbthebformbofbstockbinbthebfirmbmeansbthatbthebmanagerbearnsbt
hebmostbwhenbthebshareholders’bwealthbisbmaximized.bFivebyearsbofbvestingbhelpsbali
gnbthebinterestsbofbthebemployeebwithbtheblong-
termbperformancebofbthebfirm.bThisbstructurebisbthereforebmostblikelybtobalignbthebinter
estsbofbmanagersbandbshareholders.bIfbstockbcompensationbisboverdone,bhowever,btheb
managerbmightbviewbitbasboverlybriskybsincebthebmanager’sbcareerbisbalreadyblinkedbto
bthebfirm,bandbthisbundiversifiedbexposurebwouldbbebexacerbatedbwithbablargeb stockbpo
sitionbinbthebfirm.
c.bAbprofit-linkedbsalarybcreatesbgreatbincentivesbforbmanagersbtobcontributebtobthe
firm’sbsuccess.bHowever,babmanagerbwhosebsalarybisbtiedbtobshort-
termbprofitsbwillbbebriskbseeking,bespeciallybifbthesebshort-
termbprofitsbdeterminebsalaryborbifbthebcompensationbstructurebdoesbnotbbearbthebfullbcos
tbofbthebproject’sbrisks.bShareholders,binbcontrast,bbearbtheblossesbasbwellbasbthebgainsbonbt
hebproject,bandbmightbbebless
willingbtobassumebthatbrisk.
12. Evenbifbanbindividualbshareholderbcouldbmonitorbandbimprovebmanagers’bperformance,b
andbtherebybincreasebthebvaluebofbthebfirm,bthebpayoffbwouldbbebsmall,bsincebthebowner
shipbsharebinbablargebcorporationbwouldbbebverybsmall.b Forbexample,bifbyoubown
$10,000bofbFordbstockbandbcanbincreasebthebvaluebofbthebfirmbbyb5%,babverybambitious
goal,byoubbenefitbbybonly:b0.05 $10,000b=b$500
Inbcontrast,babbankbthatbhasbabmultimilllion-
dollarbloanboutstandingbtobthebfirmbhasbabbigbstakebinbmakingbsurebthatbthebfirmbcanbrepay
bthebloan.bIt bisbclearlybworthwhilebforbthebbankbtobspendbconsiderablebresourcesbtob monit
orbthebfirm.
13. Mutualbfundsbacceptbfundsbfrombsmallbinvestorsbandbinvest,bonbbehalfbofbthesebi
nvebstors,b inb theb nationalbandb internationalbsecuritiesb markets.
Pensionbfundsbacceptbfundsbandbthenbinvest,bonbbehalfbofbcurrentbandbfuturebretirees,bth
erebybchannelingbfundsbfrombonebsectorbofbthebeconomybtobanother.
Venturebcapitalbfirmsbpoolbthebfundsbofbprivatebinvestorsbandbinvestbinbstart-upbfirms.
Banksbacceptbdepositsbfrombcustomersbandbloanbthosebfundsbtobbusinesses,borbusebthebf
undsbtobbuybsecuritiesbofblargebcorporations.
14. Treasurybbillsbservebabpurposebforbinvestorsbwhobpreferbablow-
riskbinvestment.bTheblowerbaveragebratebofbreturnbcomparedbtobstocksbisbthebpri
cebinvestorsbpaybforbpredictabilitybofbinvestmentbperformancebandbportfoliobval
ue.
