CHAPTER1:THEINVESTMENTENVIRONMENT

1.

a. Cashisafinancialassetbecauseitistheliabilityofthegovernment.

b. No.Thecashdoesnotdirectlyaddtotheproductivecapacityoftheeconomy.

c. Yes.Youcanbuymoregoodsandservicesthanpreviously.

d. Iftheeconomyisalreadyoperatingatfullcapacity,andyounowcommandthe
extrapurchasingpowerofferedbythe$10billion,thenyourincreasedabilityto
purchasegoodsmustbeoffsetbyadeclineintheabilityofotherstopurchase
goods.Thus,theotherindividualsintheeconomycanbemadeworseoffby
yourdiscovery.

2.

a. ThebankloanisafinancialliabilityforLanni;conversely,Lanni'sIOUisthe
bank'sfinancialasset.ThecashLannireceivesisafinancialasset.Thenew
financialassetcreatedisLanni'snote(thatis,itsIOUtothebank).
b. Lannitransfersfinancialassets(cash)toitssoftwaredevelopers.Inreturnit
getsarealasset,thecompletedsoftware.Nofinancialassetsarecreatedor
destroyed;cashissimplytransferredfromonepartytoanother.
c. Lannigivestherealasset(thesoftware)toMicrosoftinexchangeforafinancial
asset,sharesinMicrosoft.SinceMicrosoftissuesnewsharestopayLanni,this
representsthecreationofnewfinancialassets.
d. Lanniexchangesonefinancialasset(1,500sharesofstock)foranother($120,000).
Itgivesafinancialasset($50,000cash)tothebankandgetsbackanotherfinancial
asset(itsIOU).Theloanis"destroyed"inthetransaction,sinceitisretiredwhen
paidoff,andnolongerexists.

3.

a. Assets
Cash
Computers
Total

$70,000
30,000
$100,000

Liabilities&shareholders'equity
Bankloan
$50,000
Shareholders'equity 50,000
Total
$100,000

Ratioofrealtototalassets=30,000/100,000=.30

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b. Assets
Liabilities&shareholders'equity
Softwareproduct*
$70,000
Bankloan
$50,000
Computers
30,000
Shareholders'equity 50,000
Total
$100,000
Total
$100,000
*Valuedatcost
Ratioofrealtototalassets=100,000/100,000=1.0

c. Assets
Microsoftshares
Computers
Total

$120,000
30,000
$150,000

Liabilities&shareholders'equity
Bankloan
$50,000
Shareholders'equity 100,000
Total
$150,000

Ratioofrealtototalassets=30,000/150,000=.20
Conclusion:whenthefirmstartsupandraisesworkingcapital,itwillbe
characterizedbyalowratioofrealtototalassets.Whenitisinfullproduction,it
willhaveahighratioofrealassets.Whentheproject"shutsdown"andthefirm
sellsitoffforcash,financialassetsonceagainreplacerealassets.
4.

Theratiois628/17,252=.036forfinancialinstitutions,and8,757/15,783=.
555forthenonfinancialbusinesssector.Thedifferenceshouldbeexpected
mainlybecausethebulkofthebusinessoffinancialinstitutionsistomakeloans
whicharefinancialassets.

5.

ThetaxincreasedtherelativeattractivenessofEurobondscomparedtodollar
denominatedbondsissuedintheU.S.,contributingtothegrowthofthatmarket.
Thisprovidesalessononthepotentialefficacyorlackofefficacyoffinancial
regulationsinglobalmarketswheremarketparticipantscandirecttradesacross
nationalboundaries.

6.

a. Primarymarkettransaction

b. Ifweconsidergoldbulliontobetheprimitiveasset,thenthecertificate,which
isaclaimtogold,wouldbeaderivativeasset.Itsvaluedependsonthevalueof
theprimitiveasset.
c. Investorswhowishtoowngoldwithoutthecomplicationofphysicalstorage.

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7.

Securitizationrequiresaccesstoalargenumberofpotentialinvestors.Toattract
themthecapitalmarketneeds:1)asafesystemofbusinesslawsandlow
probabilityofconfiscatorytaxation/regulation,2)awelldevelopedinvestment
bankingindustry,3)awelldevelopedsystemofbrokerageandfinancial
transactions,and4)welldevelopedinformationsystems,particularlyforfinancial
reporting.Thesearefoundin(indeedmakefor)awelldevelopedfinancial
market.

8.

a. No.Diversificationcallsforinvestingyoursavingsinassetsthatdowellwhen
GMisdoingpoorly.

b. No.AlthoughToyotaisacompetitorofGM,botharesubjecttofluctuationsin
theautomobilemarket.

9.

Unlikefixedsalarycontracts,bonusescreatebetterincentivesforexecutivesto
enhancetheperformanceofthefirm.

10.

Securitizationleadstodisintermediation;thatis,itprovidesameansformarket
participantstobypassintermediaries.Forexample,mortgagebackedsecurities
channelfundstothehousingmarketwithoutrequiringthatbanksorthrift
institutionsmakeloansfromtheirownportfolios.Assecuritizationprogresses,
financialintermediariesmustincreaseotheractivitiessuchasproviding
financialservicesorshorttermliquiditytoconsumersandsmallbusiness.

11.

TheREITmanagerpoolstheresourcesofmanyinvestorsandusesthese
resourcestobuyaportfolioofrealestateassets.EachinvestorintheREITowns
afractionofthetotalportfolioaccordingtohisorherinvestment.TheREIT
givestheinvestortheabilitytoholdadiversifiedportfolio.Moreover,the
investorhastheabilitytobuyandsellsharesintheREITfarmoreeasilyand
cheaplythantheunderlyingrealestateitselfcouldbeboughtorsold.Investors
willbewillingtopaythemanagerofaREITareasonablemanagementfeefor
thesebenefits.Therefore,theprofitmotivewillleadqualifiedfirmstoorganize
andsellREITs.

12.

Ultimately,realassetsdodeterminethematerialwellbeingofaneconomy.
Nevertheless,individualscanbenefitwhenfinancialengineeringcreatesnew
productsthatallowthemtomanagetheirportfoliosoffinancialassetsmore
efficiently.Becausebundlingandunbundlingcreatesfinancialproductswithnew
propertiesandsensitivitiestovarioussourcesofrisk,itallowsinvestorsto
allocateandhedgeparticularsourcesofriskmoreefficiently.
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13.

Financialassetsmakeiteasyforlargefirmstoraisecapitaltofinancetheir
investmentsinrealassets.IfGeneralMotors,forexample,couldnotissue
stocksorbondstothegeneralpublic,itwouldhaveafarmoredifficulttime
raisingcapital.Contractionofthesupplyoffinancialassetswouldmake
financingmoredifficult,increasingthecostofcapital.Ahighercostofcapital
meanslessinvestmentandlowerrealgrowth.

14.

In19thcenturyAmerica,withalargelyagrarianeconomy,uncertaintyincrop
yieldsandpriceswasamajorsourceofeconomywiderisk.Therefore,there
wasagreatincentivetocreatedevicesthatwouldallowbothproducersand
purchasersofagriculturalcommoditiestohedgethisrisk.Incontrast,therisk
ofpaperorpencilpriceswasfarsmaller,andtheneedtohedgeagainstsuchrisk
wasminimal.Therewouldbenodemandfortradinginsecuritiesthatwould
allowinvestorstotransferriskinthepricesofthesegoods.

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