Chapter 1: The Investment Environment (Problem Sets)

You see an advertisement for a book that claims to show how you can make $1 million with no risk and with no money down. Will you buy the book?

You should be skeptical. If the author actually knows how to achieve such returns, one must question why the author would then be so ready to sell the secret to others. Financial markets are very competitive; one of the implications of this fact is that riches do not come easily. High expected returns require bearing some risk, and obvious bargains are few and far between. Odds are that the only one getting rich from this book is its author.

Discuss the advantages and disadvantages of the following forms of managerial compensation in terms of mitigating agency problems, that is, potential conflicts of interest between managers and shareholders. A fixed salary.

A fixed salary means compensation is (at least in the short run) independent of the firm's success. This salary structure does not tie the manager's immediate compensation to the success of the firm, and thus allows the manager to focus on the long-run and on safe operation of the firm. However, since the compensation is secured and not tied to the performance of the firm, the manager might not be motivated to take any risk to maximize the value of the company

Discuss the advantages and disadvantages of the following forms of managerial compensation in terms of mitigating agency problems, that is, potential conflicts of interest between managers and shareholders. Stock in the firm that must be held for five years.

A salary paid in the form of stock in the firm means the manager earns the most when shareholder wealth is maximized. When the stock must be held for five years, the manager has less of an incentive to manipulate the stock price. This structure is most likely to align the interests of managers with the interests of the shareholders. If stock compensation is used too much, the manager might view it as overly risky since the manager's career is already linked to the firm as it creates a large undiversified exposure.

Oversight by large institutional investors or creditors is one mechanism to reduce agency problems. Why don't individual investors in the firm have the same incentive to keep an eye on management?

Even if an individual shareholder could monitor and improve managers' performance, and thereby increase the value of the firm, the payoff would be small, since the ownership share in a large corporation would be very small. For example, if you own $10,000 of GM stock and can increase the value of the firm by 5%, a very ambitious goal, you benefit by only: 0.05 $10,000 = $500In 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.

Firms raise capital from investors by issuing shares in the primary markets. Does this imply that corporate financial managers can ignore trading of previously issued shares in the second- ary market?

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.

Suppose housing prices across the world double. Can you reconcile your answers to (a) and (b)? Is anyone worse off as a result of the change?

Future homeowners as a whole 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 endure the damage.

Give an example of three financial intermediaries and explain how they act as a bridge between small investors and large capital markets or corporations.

Mutual funds accept funds from small investors and invest, on behalf of these investors, in the national and international securities markets.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.Venture capital firms pool the funds of private investors and invest in start-up firms.Banks accept deposits from customers and loan those funds to businesses, or use the funds to buy securities of large corporations.

Suppose housing prices across the world double. Is society any richer for the change?

No. The increase in price did not add to the productive capacity of the economy.

Why do financial assets show up as a component of household wealth, but not of national wealth? Why do financial assets still matter for the material well-being of an economy?

Only assets that contribute to the economy such as real assets (land, equipment, buildings) impact the economy. Financial assets are important too because they are the claim of an individual on another's real assets but in the form of liability. However, they determine the efficient use of resources so they count for the well-being for an economy.

What reforms to the financial system might reduce its exposure to systemic risk?

Passed in 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act proposes several mechanisms to mitigate systemic risk. The act attempts to limit the risky activities in which the banks can engage and calls for stricter rules for bank capital, liquidity, and risk management practices, especially as banks become larger and their potential failure becomes more threatening to other institutions. The act seeks to unify and clarify the lines of regulatory authority and responsibility in government agencies and to address the incentive issue by forcing employee compensation to reflect longer-term performance. It also mandates increased transparency, especially in derivatives markets.

What is the relationship between securitization and the role of financial intermediaries in the economy? What happens to financial intermediaries as securitization progresses?

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.

Why would you expect securitization to take place only in highly developed capital markets?

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.

Wall Street firms have traditionally compensated their traders with a share of the trading profits that they generated. How might this practice have affected traders' willingness to assume risk? What is the agency problem this practice engendered?

Since the traders benefited from profits but did not get penalized by losses, they were encouraged to take extraordinary risks. Since traders sell to other traders, there also existed a moral hazard since other traders might facilitate the misdeed. In the end, this represents an agency problem.

Lanni Products is a start-up computer software development firm. It currently owns computer equipment worth $30,000 and has cash on hand of $20,000 contributed by Lanni's owners. For each of the following transactions, identify the real and/or financial assets that trade hands. Are any financial assets created or destroyed in the transaction?b. Lanni uses the cash from the bank plus $20,000 of its own funds to finance the development of new financial planning software.

The cash paid by Lanni is the transfer of a financial asset to the software developer. In return, Lanni gets a real asset, the completed software. No financial assets are created or destroyed. Cash is simply transferred from one firm to another.

Although we stated that real assets constitute the true productive capacity of an economy, it is hard to conceive of a modern economy without well-developed financial markets and security types. How would the productive capacity of the U.S. economy be affected if there were no markets in which to trade financial assets?

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. If BHP, 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.

The average rate of return on investments in large stocks has outpaced that on investments in Treasury bills by about 8% since 1926. Why, then, does anyone invest in Treasury bills?

Treasury bills serve a purpose for investors who prefer a low-risk investment. The lower average rate of return compared to stocks is the price investors pay for predictability of investment performance and portfolio value.

Discuss the advantages and disadvantages of the following forms of managerial compensation in terms of mitigating agency problems, that is, potential conflicts of interest between managers and shareholders. A salary linked to the firm's profits.

When executive salaries are linked to firm profits, the firm creates incentives for managers to contribute to the firm's success. However, this may also lead to earnings manipulation or accounting fraud (or at least questionable or non-transparent accounting practices), such as divestment of its subsidiaries or unreasonable revenue recognition.

Financial engineering has been disparaged as nothing more than paper shuffling. Critics argue that resources used for rearranging wealth (i.e., bundling and unbundling financial assets) might be better spent on creating wealth (i.e., creating real assets). Evaluate this criticism. Are any benefits realized by creating an array of derivative securities from various primary securities?

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 forinvestors to form more efficient portfolios. Both institutional and individual investors can benefitwhen financial engineering creates new products that allow them to manage their portfolios offinancial assets more efficiently. Bundling and unbundling create financial products with newproperties and sensitivities to various sources of risk that allows investors to reduce volatility byhedging particular sources of risk more efficiently

What are some advantages and disadvantages of top-down versus bottom-up investing styles?

With a top-down investing style, you focus on asset allocation or the broad composition of the entire portfolio, which is the major determinant of overall performance. Moreover, top-down management is the natural way to establish a portfolio with a level of risk consistent with your risk tolerance. The disadvantage of an exclusive emphasis on top-down issues is that you may forfeit the potential high returns that could result from identifying and concentrating in undervalued securities or sectors of the market. With a bottom-up investing style, you try to benefit from identifying undervalued securities. The disadvantage is that investors might tend to overlook the overall composition of your portfolio, which may result in a nondiversified portfolio or a portfolio with a risk level inconsistent with the appropriate level of risk tolerance

Suppose housing prices across the world double. Are homeowners wealthier?

Yes, the value of the equity held in these assets has increased.

Lanni Products is a start-up computer software development firm. It currently owns computer equipment worth $30,000 and has cash on hand of $20,000 contributed by Lanni's owners. For each of the following transactions, identify the real and/or financial assets that trade hands. Are any financial assets created or destroyed in the transaction? a. Lanni takes out a bank loan. It receives $50,000 in cash and signs a note promising to pay back the loan over 3 years.

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 held by the bank.