CHAPTER 1: THE INVESTMENT ENVIRONMENT
PROBLEM SETS
1. While it is ultimately true that real assets determine the material well-being of an economy, financial innovation in the form of bundling and unbundling securities creates opportunities for investors to form more efficient portfolios. Both institutional and individual investors can benefit when financial engineering creates new products that allow them to manage their portfolios of financial assets more efficiently. Bundling and unbundling create financial products with new properties and sensitivities to various sources of risk that allows investors to reduce volatility by hedging particular sources of risk more efficiently.
These characteristics are found in (indeed make for) a well-developed financial market.
3. Securitization leads to disintermediation; that is, securitization provides a means for market participants to bypass intermediaries. For example, mortgage-backed securities channel funds to the housing market without requiring that banks or thrift institutions make loans from their own portfolios. Securitization works well and can benefit many, but only if the market for these securities is highly liquid. As securitization progresses, however, and financial intermediaries lose opportunities, they must increase other revenue-generating activities such as providing short-term liquidity to consumers and small business and financial services.
4. The existence of efficient capital markets and the liquid trading of financial assets make it easy for large firms to raise the capital needed to finance their investments in real assets. If Ford, for example, could not issue stocks or bonds to the general public, it would have a far more difficult time raising capital. Contraction of the supply of financial assets would make financing more difficult, thereby increasing the cost of capital. A higher cost of capital results in less investment and lower real growth.
5. Even if the firm does not need to issue stock in any particular year, the stock market is still important to the financial manager. The stock price provides important information about how the market values the firm's investment projects. For example, if the stock price rises considerably, managers might conclude that the market believes the firm's future prospects are bright. This might be a useful signal to the firm to proceed with an investment such as an expansion of the firm's business.
In addition, shares that can be traded in the secondary market are more attractive to initial investors since they know that they will be able to sell their shares. This in turn makes investors more willing to buy shares in a primary offering and thus improves the terms on which firms can raise money in the equity market.
Remember that stock exchanges like those in New York, London, and Paris are the heart of capitalism, in which firms can raise capital quickly in primary markets because investors know there are liquid secondary markets.
6. a. No. The increase in price did not add to the productive capacity of the economy.
b. Yes, the value of the equity held in these assets has increased.
c. Future homeowners as a whole are worse off, since mortgage liabilities have also increased. In addition, this housing price bubble will eventually burst and society as a whole (and most likely taxpayers) will suffer the damage.
7. a. The bank loan is a financial liability for Lanni, and a financial asset for the bank. The cash Lanni receives is a financial asset. The new financial asset created is Lanni's promissory note to repay the loan.
b. Lanni transfers financial assets (cash) to the software developers. In return, Lanni receives the completed software package, which is a real asset. No financial assets are created or destroyed; cash is simply transferred from one party to another.
PROBLEM SETS
1. While it is ultimately true that real assets determine the material well-being of an economy, financial innovation in the form of bundling and unbundling securities creates opportunities for investors to form more efficient portfolios. Both institutional and individual investors can benefit when financial engineering creates new products that allow them to manage their portfolios of financial assets more efficiently. Bundling and unbundling create financial products with new properties and sensitivities to various sources of risk that allows investors to reduce volatility by hedging particular sources of risk more efficiently.
- Securitization requires access to a large number of potential investors. To attract these investors, the capital market needs:
- a safe system of business laws and low probability of confiscatory taxation/regulation;
- a well-developed investment banking industry;
- a well-developed system of brokerage and financial transactions; and
- well-developed media, particularly financial reporting.
These characteristics are found in (indeed make for) a well-developed financial market.
3. Securitization leads to disintermediation; that is, securitization provides a means for market participants to bypass intermediaries. For example, mortgage-backed securities channel funds to the housing market without requiring that banks or thrift institutions make loans from their own portfolios. Securitization works well and can benefit many, but only if the market for these securities is highly liquid. As securitization progresses, however, and financial intermediaries lose opportunities, they must increase other revenue-generating activities such as providing short-term liquidity to consumers and small business and financial services.
4. The existence of efficient capital markets and the liquid trading of financial assets make it easy for large firms to raise the capital needed to finance their investments in real assets. If Ford, for example, could not issue stocks or bonds to the general public, it would have a far more difficult time raising capital. Contraction of the supply of financial assets would make financing more difficult, thereby increasing the cost of capital. A higher cost of capital results in less investment and lower real growth.
5. Even if the firm does not need to issue stock in any particular year, the stock market is still important to the financial manager. The stock price provides important information about how the market values the firm's investment projects. For example, if the stock price rises considerably, managers might conclude that the market believes the firm's future prospects are bright. This might be a useful signal to the firm to proceed with an investment such as an expansion of the firm's business.
In addition, shares that can be traded in the secondary market are more attractive to initial investors since they know that they will be able to sell their shares. This in turn makes investors more willing to buy shares in a primary offering and thus improves the terms on which firms can raise money in the equity market.
Remember that stock exchanges like those in New York, London, and Paris are the heart of capitalism, in which firms can raise capital quickly in primary markets because investors know there are liquid secondary markets.
6. a. No. The increase in price did not add to the productive capacity of the economy.
b. Yes, the value of the equity held in these assets has increased.
c. Future homeowners as a whole are worse off, since mortgage liabilities have also increased. In addition, this housing price bubble will eventually burst and society as a whole (and most likely taxpayers) will suffer the damage.
7. a. The bank loan is a financial liability for Lanni, and a financial asset for the bank. The cash Lanni receives is a financial asset. The new financial asset created is Lanni's promissory note to repay the loan.
b. Lanni transfers financial assets (cash) to the software developers. In return, Lanni receives the completed software package, which is a real asset. No financial assets are created or destroyed; cash is simply transferred from one party to another.