CHAPTER 1: THE INVESTMENT ENVIRONMENT

CHAPTER 1: THE INVESTMENT ENVIRONMENT

PROBLEM SETS
1. While it is ultimately true that real assets determine the material ell!"ein# $% an
e&$n$my' %inan&ial inn$(ati$n in the %$rm $% "undlin# and un"undlin# se&urities
&reates $))$rtunities %$r in(est$rs t$ %$rm m$re e%%i&ient )$rt%$li$s. *$th
instituti$nal and indi(idual in(est$rs &an "ene%it hen %inan&ial en#ineerin# &reates
ne )r$du&ts that all$ them t$ mana#e their )$rt%$li$s $% %inan&ial assets m$re
e%%i&iently. *undlin# and un"undlin# &reate %inan&ial )r$du&ts ith ne )r$)erties
and sensiti(ities t$ (ari$us s$ur&es $% ris+ that all$s in(est$rs t$ redu&e ($latility
"y hed#in# )arti&ular s$ur&es $% ris+ m$re e%%i&iently.
,. Se&uriti-ati$n re.uires a&&ess t$ a lar#e num"er $% )$tential in(est$rs. T$ attra&t
these in(est$rs' the &a)ital mar+et needs:
1. a sa%e system $% "usiness las and l$ )r$"a"ility $% &$n%is&at$ry
ta/ati$n0re#ulati$n1
,. a ell!de(el$)ed in(estment "an+in# industry1
2. a ell!de(el$)ed system $% "r$+era#e and %inan&ial transa&ti$ns1 and
3. ell!de(el$)ed media' )arti&ularly %inan&ial re)$rtin#.
These &hara&teristi&s are %$und in 4indeed ma+e %$r5 a ell!de(el$)ed %inan&ial
mar+et.
2. Se&uriti-ati$n leads t$ disintermediati$n1 that is' se&uriti-ati$n )r$(ides a means
%$r mar+et )arti&i)ants t$ "y)ass intermediaries. 6$r e/am)le' m$rt#a#e!"a&+ed
se&urities &hannel %unds t$ the h$usin# mar+et ith$ut re.uirin# that "an+s $r
thri%t instituti$ns ma+e l$ans %r$m their $n )$rt%$li$s. Se&uriti-ati$n $r+s ell
and &an "ene%it many' "ut $nly i% the mar+et %$r these se&urities is hi#hly li.uid.
As se&uriti-ati$n )r$#resses' h$e(er' and %inan&ial intermediaries l$se
$))$rtunities' they must in&rease $ther re(enue!#eneratin# a&ti(ities su&h as
)r$(idin# sh$rt!term li.uidity t$ &$nsumers and small "usiness and %inan&ial
ser(i&es.
3. The e/isten&e $% e%%i&ient &a)ital mar+ets and the li.uid tradin# $% %inan&ial assets
ma+e it easy %$r lar#e %irms t$ raise the &a)ital needed t$ %inan&e their in(estments
in real assets. I% 6$rd' %$r e/am)le' &$uld n$t issue st$&+s $r "$nds t$ the #eneral
)u"li&' it $uld ha(e a %ar m$re di%%i&ult time raisin# &a)ital. C$ntra&ti$n $% the
su))ly $% %inan&ial assets $uld ma+e %inan&in# m$re di%%i&ult' there"y in&reasin#
the &$st $% &a)ital. A hi#her &$st $% &a)ital results in less in(estment and l$er
real #r$th.
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CHAPTER 1: THE INVESTMENT ENVIRONMENT
7. E(en i% the %irm d$es n$t need t$ issue st$&+ in any )arti&ular year' the st$&+ mar+et
is still im)$rtant t$ the %inan&ial mana#er. The st$&+ )ri&e )r$(ides im)$rtant
in%$rmati$n a"$ut h$ the mar+et (alues the %irm8s in(estment )r$9e&ts. 6$r e/am)le'
i% the st$&+ )ri&e rises &$nsidera"ly' mana#ers mi#ht &$n&lude that the mar+et
"elie(es the %irm8s %uture )r$s)e&ts are "ri#ht. This mi#ht "e a use%ul si#nal t$ the
%irm t$ )r$&eed ith an in(estment su&h as an e/)ansi$n $% the %irm8s "usiness.
In additi$n' shares that &an "e traded in the se&$ndary mar+et are m$re attra&ti(e t$
initial in(est$rs sin&e they +n$ that they ill "e a"le t$ sell their shares. This in
turn ma+es in(est$rs m$re illin# t$ "uy shares in a )rimary $%%erin# and thus
im)r$(es the terms $n hi&h %irms &an raise m$ney in the e.uity mar+et.
Remem"er that st$&+ e/&han#es li+e th$se in Ne :$r+' ;$nd$n' and Paris are the
heart $% &a)italism' in hi&h %irms &an raise &a)ital .ui&+ly in )rimary mar+ets
"e&ause in(est$rs +n$ there are li.uid se&$ndary mar+ets.
<. a. N$. The in&rease in )ri&e did n$t add t$ the )r$du&ti(e &a)a&ity $% the
e&$n$my.
". :es' the (alue $% the e.uity held in these assets has in&reased.
&. 6uture h$me$ners as a h$le are $rse $%%' sin&e m$rt#a#e lia"ilities ha(e
als$ in&reased. In additi$n' this h$usin# )ri&e "u""le ill e(entually "urst and
s$&iety as a h$le 4and m$st li+ely ta/)ayers5 ill su%%er the dama#e.
=. a. The "an+ l$an is a %inan&ial lia"ility %$r ;anni' and a %inan&ial asset %$r
the "an+. The &ash ;anni re&ei(es is a %inan&ial asset. The ne %inan&ial asset
&reated is ;anni8s )r$miss$ry n$te t$ re)ay the l$an.
". ;anni trans%ers %inan&ial assets 4&ash5 t$ the s$%tare de(el$)ers. In return'
;anni re&ei(es the &$m)leted s$%tare )a&+a#e' hi&h is a real asset. N$
%inan&ial assets are &reated $r destr$yed1 &ash is sim)ly trans%erred %r$m $ne )arty
t$ an$ther.
&. ;anni e/&han#es the real asset 4the s$%tare5 %$r a %inan&ial asset' hi&h is 1'7>>
shares $% Mi&r$s$%t st$&+. I% Mi&r$s$%t issues ne shares in $rder t$ )ay ;anni'
then this $uld re)resent the &reati$n $% ne %inan&ial assets.
d. *y sellin# its shares in Mi&r$s$%t' ;anni e/&han#es $ne %inan&ial asset 41'7>>
shares $% st$&+5 %$r an$ther 4?1,>'>>> in &ash5. ;anni uses the %inan&ial asset $%
?7>'>>> in &ash t$ re)ay the "an+ and retire its )r$miss$ry n$te. The "an+ must
return its %inan&ial asset t$ ;anni. The l$an is @destr$yed@ in the transa&ti$n' sin&e it
is retired hen )aid $%% and n$ l$n#er e/ists.
1!,
CHAPTER 1: THE INVESTMENT ENVIRONMENT
A. a.
Assets
Liabilities &
Shareholders Equity
Cash ? =>'>>> *an+ l$an ? 7>'>>>
C$m)uters 2>'>>> Shareh$ldersB e.uity 7>'>>>
T$tal ?1>>'>>> T$tal ?1>>'>>>
Rati$ $% real assets t$ t$tal assets C ?2>'>>>0?1>>'>>> C >.2>
".
Assets
Liabilities &
Shareholders Equity
S$%tare )r$du&tD ? =>'>>> *an+ l$an ? 7>'>>>
C$m)uters 2>'>>> Shareh$ldersB e.uity 7>'>>>
T$tal ?1>>'>>> T$tal ?1>>'>>>
DValued at &$st
Rati$ $% real assets t$ t$tal assets C ?1>>'>>>0?1>>'>>> C 1.>
&.
Assets
Liabilities &
Shareholders Equity
Mi&r$s$%t shares ?1,>'>>> *an+ l$an ? 7>'>>>
C$m)uters 2>'>>> Shareh$ldersB e.uity 1>>'>>>
T$tal ?17>'>>> T$tal ?17>'>>>
Rati$ $% real assets t$ t$tal assets C ?2>'>>>0?17>'>>> C >.,>
C$n&lusi$n: hen the %irm starts u) and raises $r+in# &a)ital' it is &hara&teri-ed "y
a l$ rati$ $% real assets t$ t$tal assets. When it is in %ull )r$du&ti$n' it has a hi#h
rati$ $% real assets t$ t$tal assets. When the )r$9e&t @shuts d$n@ and the %irm sells it
$%% %$r &ash' %inan&ial assets $n&e a#ain re)la&e real assets.
E. 6$r &$mmer&ial "an+s' the rati$ is: ?1<<.10?12'E,<.> C >.>11E
6$r n$n%inan&ial %irms' the rati$ is: ?17'2,>0?2>'<3E C >.3EEE
The di%%eren&e sh$uld "e e/)e&ted )rimarily "e&ause the "ul+ $% the
"usiness $% %inan&ial instituti$ns is t$ ma+e l$ans and the "ul+ $% n$n!
%inan&ial &$r)$rati$ns is t$ in(est in e.ui)ment' manu%a&turin# )lants' and
)r$)erty. The l$ans are %inan&ial assets %$r %inan&ial instituti$ns' "ut the
in(estments $% n$n!%inan&ial &$r)$rati$ns are real assets.
1>. a. Primary!mar+et transa&ti$n in hi&h #$ld &erti%i&ates are "ein# $%%ered t$
)u"li& in(est$rs %$r the %irst time "y an underritin# syndi&ate led "y FW G$rth
Ca)ital.
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CHAPTER 1: THE INVESTMENT ENVIRONMENT
". The &erti%i&ates are deri(ati(e assets "e&ause they re)resent an in(estment in
)hysi&al #$ld' "ut ea&h in(est$r re&ei(es a &erti%i&ate and n$ #$ld. N$te that
in(est$rs &an &$n(ert the &erti%i&ate int$ #$ld durin# the %$ur!year )eri$d.
&. In(est$rs h$ ish t$ h$ld #$ld ith$ut the &$m)li&ati$n' ris+' and
&$st $% )hysi&al st$ra#e.
11. a. A %i/ed salary means that &$m)ensati$n is 4at least in the sh$rt run5 inde)endent
$% the %irm8s su&&ess. This salary stru&ture d$es n$t tie the mana#erBs immediate
&$m)ensati$n t$ the su&&ess $% the %irm' s$ a mana#er mi#ht n$t %eel t$$
&$m)elled t$ $r+ hard t$ ma/imi-e %irm (alue. H$e(er' the mana#er mi#ht
(ie this as the sa%est &$m)ensati$n stru&ture and there%$re (alue it m$re hi#hly.
". A salary that is )aid in the %$rm $% st$&+ in the %irm means that the mana#er earns
the m$st hen the shareh$ldersB ealth is ma/imi-ed. 6i(e years $% (estin# hel)s
ali#n the interests $% the em)l$yee ith the l$n#!term )er%$rman&e $% the %irm. This
stru&ture is there%$re m$st li+ely t$ ali#n the interests $% mana#ers and shareh$lders.
I% st$&+ &$m)ensati$n is $(erd$ne' h$e(er' the mana#er mi#ht (ie it as $(erly
ris+y sin&e the mana#erBs &areer is already lin+ed t$ the %irm' and this undi(ersi%ied
e/)$sure $uld "e e/a&er"ated ith a lar#e st$&+ )$siti$n in the %irm.
&. A )r$%it!lin+ed salary &reates #reat in&enti(es %$r mana#ers t$ &$ntri"ute t$ the
%irmBs su&&ess. H$e(er' a mana#er h$se salary is tied t$ sh$rt!term )r$%its ill "e
ris+ see+in#' es)e&ially i% these sh$rt!term )r$%its determine salary $r i% the
&$m)ensati$n stru&ture d$es n$t "ear the %ull &$st $% the )r$9e&tBs ris+s. Shareh$lders'
in &$ntrast' "ear the l$sses as ell as the #ains $n the )r$9e&t and mi#ht "e less
illin# t$ assume that ris+.
1,. E(en i% an indi(idual shareh$lder &$uld m$nit$r and im)r$(e mana#ersB )er%$rman&e
and there"y in&rease the (alue $% the %irm' the )ay$%% $uld "e small' sin&e the
$nershi) share in a lar#e &$r)$rati$n $uld "e (ery small. 6$r e/am)le' i% y$u $n
?1>'>>> $% 6$rd st$&+ and &an in&rease the (alue $% the %irm "y 7H' a (ery am"iti$us
#$al' y$u "ene%it "y $nly: >.>7 ?1>'>>> C ?7>>. The &$st' "$th )ers$nal and
%inan&ial t$ an indi(idual in(est$r' is li+ely t$ "e )r$hi"iti(e and $uld ty)i&ally
easily e/&eed any a&&rued "ene%its' in this &ase ?7>>.
In &$ntrast' a "an+ that has a multimilli$n!d$llar l$an $utstandin# t$ the %irm has a "i#
sta+e in ma+in# sure that the %irm &an re)ay the l$an. It is &learly $rthhile %$r the
"an+ t$ s)end &$nsidera"le res$ur&es t$ m$nit$r the %irm.
12. Mutual %unds a&&e)t %unds %r$m small in(est$rs and in(est' $n "ehal% $% these
in(est$rs' in the d$mesti& and internati$nal se&urities mar+ets.
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CHAPTER 1: THE INVESTMENT ENVIRONMENT
Pensi$n %unds a&&e)t %unds and then in(est in a ide ran#e $% %inan&ial se&urities' $n
"ehal% $% &urrent and %uture retirees' there"y &hannelin# %unds %r$m $ne se&t$r $% the
e&$n$my t$ an$ther.
Venture &a)ital %irms )$$l the %unds $% )ri(ate in(est$rs and in(est in start!u) %irms.
*an+s a&&e)t de)$sits %r$m &ust$mers and l$an th$se %unds t$ "usinesses $r use the
%unds t$ "uy se&urities $% lar#e &$r)$rati$ns.
13. Treasury "ills ser(e a )ur)$se %$r in(est$rs h$ )re%er a l$!ris+ in(estment.
The l$er a(era#e rate $% return &$m)ared t$ st$&+s is the )ri&e in(est$rs )ay
%$r )redi&ta"ility $% in(estment )er%$rman&e and )$rt%$li$ (alue.
17. With a t$)!d$n in(estin# style' y$u %$&us $n asset all$&ati$n $r the "r$ad
&$m)$siti$n $% the entire )$rt%$li$' hi&h is the ma9$r determinant $% $(erall
)er%$rman&e. M$re$(er' t$)!d$n mana#ement is the natural ay t$ esta"lish a
)$rt%$li$ ith a le(el $% ris+ &$nsistent ith y$ur ris+ t$leran&e. The disad(anta#e $%
an exclusive em)hasis $n t$)!d$n issues is that y$u may %$r%eit the )$tential hi#h
returns that &$uld result %r$m identi%yin# and &$n&entratin# in under(alued se&urities
$r se&t$rs $% the mar+et.
With a "$tt$m!u) in(estin# style' y$u try t$ "ene%it %r$m identi%yin# under(alued
se&urities. The disad(anta#e is that in(est$rs mi#ht tend t$ $(erl$$+ the $(erall
&$m)$siti$n $% y$ur )$rt%$li$' hi&h may result in a n$ndi(ersi%ied )$rt%$li$ $r a
)$rt%$li$ ith a ris+ le(el in&$nsistent ith the a))r$)riate le(el $% ris+ t$leran&e. In
additi$n' this te&hni.ue tends t$ re.uire m$re a&ti(e mana#ement' thus #eneratin#
m$re transa&ti$n &$sts. 6inally' the "$tt$m!u) analysis may "e in&$rre&t' in hi&h &ase
there ill "e a %ruitlessly e/)ended e%%$rt and m$ney attem)tin# t$ "eat a sim)le "uy!
and!h$ld strate#y.
1<. :$u sh$uld "e s+e)ti&al. I% the auth$r a&tually +n$s h$ t$ a&hie(e su&h returns' $ne
must .uesti$n hy the auth$r $uld then "e s$ ready t$ sell the se&ret t$ $thers.
6inan&ial mar+ets are (ery &$m)etiti(e1 $ne $% the im)li&ati$ns $% this %a&t is that
ri&hes d$ n$t &$me easily. Hi#h e/)e&ted returns re.uire "earin# s$me ris+' and
$"(i$us "ar#ains are %e and %ar "eteen. Odds are that the $nly $ne #ettin# ri&h %r$m
the "$$+ is its auth$r.
1=. 6inan&ial assets )r$(ide %$r a means t$ a&.uire real assets as ell as an e/)ansi$n
$% these real assets. 6inan&ial assets )r$(ide a measure $% li.uidity t$ real assets
and all$ %$r in(est$rs t$ m$re e%%e&ti(ely redu&e ris+ thr$u#h di(ersi%i&ati$n.
1A. All$in# traders t$ share in the )r$%its in&reases the tradersB illin#ness t$
assume ris+. Traders ill share in the u)side )$tential dire&tly in the %$rm $%
hi#her &$m)ensati$n "ut $nly in the d$nside indire&tly in the %$rm $% )$tential
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CHAPTER 1: THE INVESTMENT ENVIRONMENT
9$" l$ss i% )er%$rman&e is "ad en$u#h. This s&enari$ &reates a %$rm $% a#en&y
&$n%li&t +n$n as m$ral ha-ard' in hi&h the $ners $% the %inan&ial instituti$n
share in "$th the t$tal )r$%its and l$sses' hile the traders ill tend t$ share m$re
$% the #ains than the l$sses.
1E. Ansers may (ary' h$e(er' students sh$uld t$u&h $n the %$ll$in#: in&reased
trans)aren&y' re#ulati$ns t$ )r$m$te &a)ital ade.ua&y "y in&reasin# the %re.uen&y
$% #ain $r l$ss settlement' in&enti(es t$ dis&$ura#e e/&essi(e ris+ ta+in#' and the
)r$m$ti$n $% m$re a&&urate and un"iased ris+ assessment.
1!<