BKMCHAPTER1:THEINVESTMENTENVIRONMENT

1. Financialengineeringhasbeendisparagedasnothingmorethanpapershuffling.Criticsargue
thatresourcesusedforrearrangingwealth(thatis,bundlingandunbundlingfinancialassets)
mightbebetterspentoncreatingwealth(thatis,creatingrealassets).Evaluatethiscriticism.Are
anybenefitsrealizedbycreatinganarrayofderivativesecuritiesfromvariousprimary
securities?
Overtime,traditionalfinancialassetssuchasstocks,bondsandmortgageshavedevelopedspecific
typesofpaymentpatterns,risksandreturns.Forexample,governmentbondshavesemiannual
couponssothebondholderincursreinvestmentriskifthecouponincomeisnotspent.Mortgageloans
haveaprepaymentoptionsothemortgagelenderrisksthereturnoftheloanprincipalwhenrates
decrease.Almostalldebtcontractsincurtheriskthattheborrowerwillnotrepaytheloan(defaultor
creditrisk).
Financialengineeringallowsforachangeintheriskandreturnpatternsoftraditionalsecurities.
TreasuryStrips,forexample,allowlendingmoneytotheUSgovernmentwithoutincurring
reinvestmentrisk.Mortgagebackedsecuritiesallowforlendingmoneytohomebuyerswithlower
(possiblyzero)prepaymentanddefaultrisks.
Thesefinanciallyengineeredproducts,whichareclaimsonalargepoolofunderlyingassets,maybe
worthmorethanthevalueoftheunderlyingassetsduetotheredistributionoftherisks.
2. Whywouldyouexpectsecuritizationtotakeplaceonlyinhighlydevelopedcapitalmarkets?
Securitizationrequiresaccesstoalargenumberofpotentialinvestors.Toattracttheseinvestors,the
capitalmarketneeds:
(1)
(2)
(3)
(4)

asafesystemofbusinesslawsandlowprobabilityofconfiscatorytaxation/regulation
awelldevelopedinvestmentbankingindustry
awelldevelopedsystemofbrokerageandfinancialtransactions
welldevelopedmedia,particularlyfinancialreporting

Thesecharacteristicsarefoundin(andanecessaryfor)awelldevelopedfinancialmarket.
3. Whatistherelationshipbetweensecuritizationandtheroleoffinancialintermediariesinthe
economy?Whathappenstofinancialintermediariesassecuritizationprogresses?
Securitizationleadstodisintermediation.Securitizationprovidesameansformarketparticipantsto
bypassintermediariessuchasbanks.Forexample,mortgagebackedsecuritieschannelfundstothe
housingmarketthroughmortgagebrokerswithoutrequiringthatbanksorthriftinstitutionsmake
loansfromtheirownportfolios.
Assecuritizationprogresses,financialintermediariesmustincreaseotheractivitiessuchasproviding
shorttermlendingorotherfinancialserviceswhichcannotbeeasilysecuritizedtoconsumersand
smallbusiness.

4. Althoughwestatedthatrealassetscomprisethetrueproductivecapacityofaneconomy,itis
hardtoconceiveofamoderneconomywithoutwelldevelopedfinancialmarketsandsecurity
types.HowwouldtheproductivecapacityoftheU.S.economybeaffectediftherewereno
marketsinwhichonecouldtradefinancialassets?
Financialassetsmakeiteasyforcommercialfirmstoraisethecapitalneededtofinanceinvestments
in(buy)realassets.IfGeneralElectriccouldnotissuestocksorbondstothepublic,itwouldhavea
farmoredifficulttimeraisingcapitalpayfornewprojects.Theinabilitytousepublicfinancialassets
wouldmakefinancingmoredifficult(costly),therebyincreasingthecostofcapitaltoabusiness.A
highercostofcapitalresultsinlessinvestmentandslowerrealgrowth.
5. Firmsraisecapitalfrominvestorsbyissuingsharesintheprimarymarkets.Doesthisimply
thatcorporatefinancialmanagerscanignoretradingofpreviouslyissuedsharesinthe
secondarymarket?
Secondarymarketsincreasetheliquidityofacompany'ssecurities.Investorsrequireareturn
premiumtoholdilliquidsecurities.Forexample,aninvestormayrequire5.00%returnona
companysbondsifthebondishighlyliquid(ifthebondcouldbesoldimmediatelyinthesecondary
marketwithoutadropinprice).Buttheinvestormightrequireareturnof5.25%toholdanilliquid
bond.Theextra25basispoints(0.25%)liquiditypremiumrequiredbytheinvestorisacostbornby
thecompanyissuingthebond(borrowingthemoney)intheformofhighercouponpayments.
Sharesofacompanysstockentitletheinvestortopercentageoftheearningseitherpaidas
dividendsorretainedbythecompanyfortheinvestorsbenefit.Iftheinvestorcannoteasilysellthe
stock(ifthestockisilliquid)theinvestorwillpaylessforthesamepercentownershipofthe
company.Therefore,ifthecompanywantstoissuenewsharestoraiseafixedamountofmoney,it
willhavetosellmorelowerpricedsharestoraisethatfixedamount.
7. LanniProductsisastartupcomputersoftwaredevelopmentfirm.Itcurrentlyownscomputer
equipmentworth$30,000andhascashonhandof$20,000contributedbyLanni'sowners.For
eachofthefollowingtransactions,identifytherealand/orfinancialassetsthattradehands.Are
anyfinancialassetscreatedordestroyedinthetransaction?
(a) Lannitakesoutabankloan.Itreceives$50,000incashandsignsanotepromisingtopay
backtheloanover3years.
ThebankloanisafinancialliabilityordebtforLanni.Lanni'sIOUisanewfinancialassetforthe
bank.ThecashLannireceivesisalsoafinancialasset.
(b) Lanni uses the cash from the bank plus $20,000 of its own funds to finance the development of
new financial planning software.
Lanni transfers the financial asset (cash) to the software developers. In return, Lanni gets a real
asset, the completed software. No financial assets are created or destroyed; cash is simply
transferred from one party to another.
(c) LannisellsthesoftwareproducttoMicrosoft,whichwillmarketittothepublicunderthe
Microsoftname.Lanniacceptspaymentintheformof1,500sharesofMicrosoftstock.

Lanni gives the real asset (the software) to Microsoft in exchange for a financial asset, 1,500 shares
of Microsoft stock. If Microsoft issues new shares in order to pay Lanni, then this would represent
the creation of new financial assets and dilute the ownership stake of Microsofts existing
shareholders.
(d) Lanni sells the shares of stock for $80 per share and uses part of the proceeds to pay off the
bank loan.
Lanni exchanges one financial asset (1,500 shares of stock) for another ($120,000 in cash). Lanni
gives a financial asset ($50,000 cash) to the bank and ends a financial asset (its IOU to the bank).
The loan is "destroyed" in the transaction, since it is retired when paid off.
9. ExaminethebalancesheetofcommercialbanksinTable1.3.Whatistheratioofrealassetsto
totalassets?Whatisthatratiofornonfinancialfirms(Table1.4)?Whyshouldthisdifferencebe
expected?
For commercial banks, the ratio is: $140.1/$11,895.1 = 1.18%
For non-financial firms, the ratio is: $12,538/$26,572 = 47.19%
The difference is expected. A financial institutions business is to make loans, which are
financial assets for financial institutions.
11. Discusstheadvantagesanddisadvantagesofthefollowingformsofmanagerialcompensationin
termsofmitigatingagencyproblems,thatis,potentialconflictsofinterestbetweenmanagersand
shareholders.
(a) Afixedsalary.
Afixedsalarymeansthatcompensationis(atleastintheshortrun)independentofthefirm's
success.Thissalarystructuredoesnottiethemanagersimmediatecompensationtothesuccessof
thefirm.However,themanagermightviewthisasthesafestcompensationstructureandtherefore
valueitmorehighly.
(b) Stock in the firm that must be held for five years.
A salary that is paid in the form of stock in the firm means that the manager earns the most when
the shareholders wealth is maximized. This structure is therefore most likely to align the interests
of managers and shareholders. If stock compensation is overdone, however, the manager might
view it as overly risky since the managers career is already linked to the firm, and this
undiversified exposure would be exacerbated with a large stock position in the firm.
(c) Asalarylinkedtothefirm'sprofits.
Call options on shares of the firm create great incentives for managers to contribute to the firms
success. In some cases, however, stock options can lead to other agency problems. For example, a
manager with numerous call options might be tempted to take on a very risky investment project,
reasoning that if the project succeeds the payoff will be huge, while if it fails, the losses are limited

to the lost value of the options. Shareholders, in contrast, bear the losses as well as the gains on the
project, and might be less willing to assume that risk.
Another problem with stock and option compensation is the manager might sacrifice long-run
profits for the short-run profits. The stock price goes up and the manager gets out. Afterwards, the
stock price goes down.
12. Wenotedthatoversightbylargeinstitutionalinvestorsorcreditorsisonemechanismtoreduce
agencyproblems.Whydon'tindividualinvestorsinthefirmhavethesameincentivetokeepan
eyeonmanagement?
The scale for individuals means the gains from influencing the firm are small. If an individual
shareholder could monitor and improve managers performance, and thereby increase the value of the
firm, the payoff would be small. For example, if you own $10,000 of Ford stock and can increase the
value of the firm by 5% (a very ambitious goal) you benefit by only: 0.05 $10,000 = $500.
In contrast, a bank that has a multimillion-dollar loan outstanding to the firm has a big stake in making
sure that the firm can repay the loan. It is clearly worthwhile for the bank to spend considerable
resources to monitor the firm.
13. Giveanexampleofthreefinancialintermediariesandexplainhowtheyactasabridgebetween
smallinvestorsandlargecapitalmarketsorcorporations.
Four Examples:
(1) Mutual funds accept funds from small investors and invest, on behalf of these investors, in the
national and international securities markets.
(2) Pension funds accept funds and then invest, on behalf of current and future retirees, thereby
channeling funds from one sector of the economy to another.
(3) Venture capital firms pool the funds of private investors and invest in start-up firms.
(4) Banks accept deposits from customers and loan those funds to businesses, or use the funds to buy
securities of large corporations.
15. What are some advantages and disadvantages of top-down versus bottom-up investing styles?
(Besureyoucandefinebothtopdownandbottomupportfolioconstructionorinvestingstyles.)
Topdownspecificallyconsidersriskandrisktolerance.Identificationofundervaluedsecuritiesisa
secondaryconsideration.
Identifyingundervaluedsecuritiesistheprimaryfocusofabottomupstyleofportfolioconstruction.
Adisadvantageisthatitdoesnot(primarily)considertheoverallcompositionoftheportfolio,which
mayresultinlowdiversificationandhigherriskorriskinconsistentwiththeinvestorsrisktolerance.In
addition,bottomuptendstorequiremoreactivemanagement,thusgeneratingmoretransactioncosts.