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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 (or
increase, depending on the strategy) volatility by hedging sources of risk more
efficiently.
Estimated Time: 1–5 min
2. Securitization requires access to many potential investors. To attract these investors,
the capital market needs:
1. a safe system of business laws and low probability of confiscatory
taxation/regulation;
2. a well-developed investment banking industry;
3. a well-developed system of brokerage and financial transactions; and
4. well-developed media, particularly financial reporting.
These characteristics are found in (and make for) a well-developed capital market.
Estimated Time: 1–5 min
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, financial intermediaries
lose opportunities; they must increase other revenue-generating activities such as
providing short-term liquidity to consumers and small business as well as other
financial services.
Estimated Time: 1–5 min
1-1
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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. Suppose Ford or Amazon could not issue stocks or bonds to the
public, it would far more difficult raising capital. Contraction of the supply of
financial assets and access to that supply would make financing more difficult,
thereby increasing the cost of capital. A higher cost of capital results in less
investment and lower real growth.
Estimated Time: 1–5 min
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 and
ultimately the decisions of the managers. For example, if the stock price rises
considerably, managers might conclude that the market believes the firm’s
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. Firms can raise capital quickly in primary markets because
investors know there are liquid secondary markets.
Estimated Time: 1–5 min
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 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.
Estimated Time: 1–5 min
1-2
Full download contact
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 (or
increase, depending on the strategy) volatility by hedging sources of risk more
efficiently.
Estimated Time: 1–5 min
2. Securitization requires access to many potential investors. To attract these investors,
the capital market needs:
1. a safe system of business laws and low probability of confiscatory
taxation/regulation;
2. a well-developed investment banking industry;
3. a well-developed system of brokerage and financial transactions; and
4. well-developed media, particularly financial reporting.
These characteristics are found in (and make for) a well-developed capital market.
Estimated Time: 1–5 min
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, financial intermediaries
lose opportunities; they must increase other revenue-generating activities such as
providing short-term liquidity to consumers and small business as well as other
financial services.
Estimated Time: 1–5 min
1-1
Full download contact
, Full download contact
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. Suppose Ford or Amazon could not issue stocks or bonds to the
public, it would far more difficult raising capital. Contraction of the supply of
financial assets and access to that supply would make financing more difficult,
thereby increasing the cost of capital. A higher cost of capital results in less
investment and lower real growth.
Estimated Time: 1–5 min
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 and
ultimately the decisions of the managers. For example, if the stock price rises
considerably, managers might conclude that the market believes the firm’s
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. Firms can raise capital quickly in primary markets because
investors know there are liquid secondary markets.
Estimated Time: 1–5 min
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 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.
Estimated Time: 1–5 min
1-2
Full download contact
