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ERIC WANG
Chapter1solution1.pptx
1. The investment Environment solution
Instructor: Seongcheol Paeng
7/2/2020
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Assignments (Answers)
What are the differences between real assets and financial assets?
This capacity is a function of the real assets of the economy: the land, buildings, machines, and knowledge that can be used to produce goods and services. In contrast to real assets are financial assets such as stocks and bonds. Such securities are no more than sheets of paper or, more likely, computer entries, and they do not contribute directly to the productive capacity of the economy. Financial assets are claims to the income generated by real assets (or claims on income from the government). If we cannot own our own auto plant (a real asset), we can still buy shares in Ford or Toyota (financial assets) and thereby share in the income derived from the production of automobiles.
7/2/2020
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Assignments (Answers)
2. Explain three broad types of financial assets.
Fixed-income or debt securities promise either a fixed stream of income or a stream of income determined by a specified formula. For example, a corporate bond typically would promise that the bondholder will receive a fixed amount of interest each year. Unlike debt securities, common stock, or equity, in a firm represents an ownership share in the corporation. Equity holders are not promised any particular payment. They receive any dividends the firm may pay and have prorated ownership in the real assets of the firm. Finally, derivative securities such as options and futures contracts provide payoffs that are determined by the prices of other assets such as bond or stock prices. For example, a call option on a share of Intel stock might turn out to be worthless if Intel’s share price remains below a threshold or “exercise” price such as $30 a share, but it can be quite valuable if the stock price rises above that level.
7/2/2020
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Assignments (Answers)
3. Explain the informational role.
Stock prices reflect investors’ collective assessment of a firm’s current performance and future prospects. When the market is more optimistic about the firm, its share price will rise. That higher price makes it easier for the firm to raise capital and therefore encourages investment. The stock market encourages allocation of capital to those firms that appear at the time to have the best prospects. Many smart, well-trained, and well-paid professionals analyze the prospects of firms whose shares trade on the stock market. Stock prices reflect their collective judgment.
7/2/2020
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4. Explain several mechanism that mitigate potential agency problems.
First, compensation plans tie the income of managers to the success of the firm. Second, while boards of directors have sometimes been portrayed as defenders of top management, they can, and in recent years, increasingly have, forced out management teams that are underperforming. Third, outsiders such as security analysts and large institutional investors such as mutual funds or pension funds monitor the firm closely and make the life of poor performers at the least uncomfortable. Finally, bad performers are subject to the threat of takeover.
7/2/2020
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Assignments (Answers)
5. Explain efficient markets.
Financial markets process all available information about securities quickly and efficiently, that is, that the security price usually reflects all the information available to investors concerning its value. If markets are efficient and prices reflect all relevant information, perhaps it is better to follow passive strategies instead of spending resources in a futile attempt to outguess your competitors in the financial markets.
7/2/2020
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Assignments (Answers)
6. Why had the rating agencies so dramatically underestimated credit risk in these subprime securities?
First, default probabilities had been estimated using historical data from an unrepresentative period characterized by a housing boom and an uncommonly prosperous and recession-free macroeconomy. Moreover, the ratings analysts had extrapolated historical default experience to a new sort of borrower pool—one without down payments, with exploding-payment loans, and with low- or no-documentation loans (often called liar loans). Past default experience was largely irrelevant given these profound changes in the market. Moreover, the power of cross-regional diversification to minimize risk engendered excessive optimism. Finally, agency problems became apparent. The ratings agencies were paid to provide ratings by the issuers of the securities—not the purchasers. They faced pressure from the issuers, who could shop around for the most favorable treatment, to provide generous ratings.
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