Chapter 01 - The Investment Environment 1-1 CHAPTER 1: THE INVESTMENT ENVIRONMENT PROBLEM SETS 1. Ultimately, it is true that real assets determine the material well being of an economy. Nevertheless, individuals can benefit when financial engineering creates new products that allow them to manage their portfolios of financial assets more efficiently. Because bundling and unbundling creates financial products with new properties and sensitivities to various sources of risk, it allows investors to hedge particular sources of risk more efficiently. 2. Securitization requires access to a large number of 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 (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. As securitization progresses, financial intermediaries must increase other activities such as providing short-term liquidity to consumers and small business, and financial services. 4. Financial assets make it easy for large firms to raise the capital needed to finance their investments in real assets. If General Motors, 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. Chapter 01 - The Investment Environment 1-2 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, the fact that shares can be traded in the secondary market makes the shares more attractive to investors since investors know that, when they wish to, 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. 6. a. Cash is a financial asset because it is the liability of the federal government. b. No. The cash does not directly add to the productive capacity of the economy. c. Yes. d. Society as a whole is worse off, since taxpayers, as a group will make up for the liability. 7. a. The bank loan is a financial liability for Lanni. (Lanni's IOU is the bank's financial asset.) The cash Lanni receives is a financial asset. The new financial asset created is Lanni's promissory note (that is, Lanni’s IOU to the bank). b. Lanni transfers financial assets (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. 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. d. Lanni exchanges one financial asset (1,500 shares of stock) for another ($120,000). Lanni gives a financ

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