Chapter 1

The Investment Environment

 Learning Objective 1:

Real assets relationship with

financial asset

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 Real Assets Versus Financial Assets
• Real Assets
– Determine the productive capacity and
net income of the economy
– Examples: Land, buildings, machines,
knowledge used to produce goods and
services

• Financial Assets
– Claims on real assets

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 Real Assets Versus Financial Assets

• If you can’t buy your own factory in GB Auto;

you still can buy shares in GB auto.
• Thus, real assets generate income to the
economy, financial assets allocate the income
to the investors.

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 Real Assets Versus Financial Assets
1. The material wealth of a society is a function of _________.
A. all financial assets
B. all real assets
C. all financial and real assets
D. all physical assets
E. all commodities

B. The material wealth of a society is a function of all real assets.

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 Real Assets Versus Financial Assets

2. _______ is/are a real asset(s).

A. Only land
B. Only machines
C. Only stocks and bonds
D. Only knowledge
E. Land, machines and knowledge are real assets

E. Land, machines and knowledge are real assets; stocks and

bonds are financial assets.

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 Real Assets Versus Financial Assets
3. The means by which individuals hold their claims on real assets in a
well-developed economy are
A. Investment assets.
B. Depository assets.
C. Derivative assets.
D. Financial assets.
E. Exchange-driven assets.

D. Financial assets allocate the wealth of the economy. Example: it is

easier for an individual to own shares of an auto company than to own
an auto company directly.

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 Real Assets Versus Financial Assets
4. _______ is/are financial assets.
A. Only bonds
B. Only machines
C. Only stocks
D. Stocks and bonds
E. Knowledge
D. Machines and knowledge are real assets; stocks and bonds
are financial assets.

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 Real Assets Versus Financial Assets
5. _________ financial asset(s).
A. Buildings are
B. Land is a
C. Derivatives are
D. U.S. Agency bonds are
E. Derivatives and U.S. Agency bonds

E. Land and Buildings are real assets.

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 Real Assets Versus Financial Assets
6. Financial assets ______.
A. directly contribute to the country's productive capacity
B. indirectly contribute to the country's productive capacity
C. contribute to the country's productive capacity both directly and indirectly
D. do not contribute to the country's productive capacity either directly or
indirectly
E. are of no value to anyone

B. Financial assets indirectly contribute to the country's productive capacity

because these assets permit individuals to invest in firms and governments.
This in turn allows firms and governments to increase productive capacity.

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 Learning objective 2:

Financial assets types

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 Financial Assets

• Three types:
1. Fixed income or debt
2. stock or equity
3. Derivative securities

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 Fixed Income

• Payments fixed or determined by a formula

• Types of bonds based on maturity:
• First, Money market debt: short term, highly
marketable, usually low credit risk

• Second, Capital market debt: long term bonds,

can be safe or risky

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 Fixed Income
• Types of bonds based on intererst:
• First, fixed corporate bond typically would promise
that the bondholder will receive a fixed amount of
interest each year.
• Second, floating-rate bonds promise payments that
depend on current interest rates. For example, a
bond may pay an interest rate that is fixed at 2
percentage points above the rate paid on U.S.
Treasury bills.

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 The Bond Market

• Treasury Notes and Bonds

• International Bonds
• Municipal Bonds
• Corporate Bonds
• Mortgages and Mortgage-
Backed Securities

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 Equity Securities
• Common Stock is equity or ownership in a
corporation.
– Payments to stockholders are not fixed, but depend
on the success of the firm. It can be either by capital
gain or dividends gain.
– Example :
– Common stock
– Preferred stock

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 Equity Securities

• Common stock: Ownership

– Residual claim
– Limited liability
• Preferred stock: Perpetuity
– Fixed dividends
– Priority over common stock

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 Derivatives

Derivatives
Value derives from prices of other securities, such
as stocks and bonds.
Used to either hedge or transfer risk.
Its important for international trade. For example,
an construction firm may lock the price of copper by
buying copper future contracts.
Example :
Options, Futures, Swaps

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 Comparison

Option Futures Contract

• Right, but not obligation, • Obliged to make or take
to buy or sell; option is delivery. Long position
exercised only when it is must buy at the futures
profitable price, short position must
• Options must be sell at futures price
purchased (has a cost) • Futures contracts are
• The premium is the price entered into without cost
of the option itself.

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 Financial Assets
7. A fixed-income security pays ____________.
A. a fixed level of income for the life of the owner
B. a fixed stream of income or a stream of income that is determined
according to a specified formula for the life of the security
C. a variable level of income for owners on a fixed income
D. a fixed or variable income stream at the option of the owner
E. a riskless return that is fixed for life

B. A fixed-income security pays a fixed stream of income or a

stream of income that is determined according to a specified formula
for the life of the security.

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 Financial Assets
8. A debt security pays ____________.
A. a fixed level of income for the life of the owner
B. a variable level of income for owners on a fixed income
C. a fixed or variable income stream at the option of the
owner
D. a fixed stream of income or a stream of income that is
determined according to a specified formula for the life of
the security
E. a riskless return that is fixed for life

Only answer D is correct.

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 Financial Assets

9. Money market securities ____________.

A. are short term
B. are highly marketable
C. are generally very low risk
D. are short term, highly marketable, and generally very low risk
E. highly marketable and generally very low risk

D. Are short term, highly marketable, and generally very low risk.

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 Financial Assets
10. An example of a derivative security is/are ______.
A. a common share of Microsoft
B. an Intel bond
C. a commodity futures contract and a call option on Intel stock
D. a call option on Intel stock and an Intel bond
E. a common share of Intel stock

C. A call option on Intel stock and an Intel bond. Common stocks and
bonds are not derivative assets.

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 Financial Assets
11. The value of a derivative security _______.
A. depends on the value of the related security
B. is unable to be calculated
C. is unrelated to the value of the related security
D. has been enhanced due to the recent misuse and negative publicity
regarding these instruments
E. is worthless today

A. Of the factors cited above, only A affects the value of the derivative
and/or is a true statement.

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 Financial Assets

12. Although derivatives can be used as speculative instruments,

businesses most often use them to
A. attract customers.
B. appease stockholders.
C. offset debt.
D. hedge risks.
E. enhance their balance sheets.
D. Firms may use forward contracts and futures to protect against
currency fluctuations or changes in commodity prices. Interest-rate
options help companies control financing costs

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 Financial Markets and the Economy

Learning objective 3:

Financial Markets and the Economy

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 Financial Markets and the Economy
1. Information Role: Capital flows to companies with
best prospects
Thus, Stock price is the collective assessment of firms’
current and future prospects

Market is Easy for firm

Share price Encourage
optimistic to raise
will rise investment
about firm capital

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 Financial Markets and the
Economy (Ctd.)
2. Consumption Timing:
• Some individuals in the economy are earning more than
they spend. “high earning periods”
• Some individuals in the econmy are earning less than they
spend. “low earning period”
• The question is How can you shift your purchasing power from
high-earnings periods to low-earnings periods of life?

Consumption Timing: Use securities to store

wealth and transfer consumption to the future.

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 Financial Markets and the
Economy (Ctd.)
3. Allocation of Risk:
• Virtually all real assets involve some risk.
• For example, if Ford raises the funds to build its auto plant by selling both
stocks and bonds to the public, the more optimistic or risk-tolerant investors
can buy shares of its stock, while the more conservative ones can buy its
bonds. Because the bonds promise to provide a fixed payment, the
stockholders bear most of the business risk but reap potentially higher
rewards.
Thus, Investors can select securities consistent with their tastes for risk
• Do this allocation of risk also benefits the firms that need to raise
capital to finance their Investments?

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 Financial Markets and the Economy
(Ctd.)
4. Separation of Ownership and Management: With stability comes agency
problems
• Many businesses are owned and managed by the same individual.
• Today, however, For example, GE actually has more than half a million
stockholders with an ownership stake in the firm proportional to their holdings of
shares.
• Such a large group of individuals obviously cannot actively participate in the day-
today management of the firm. Instead, they elect a board of directors that in turn
hires and supervises the management of the firm. This structure means that the
owners and managers of the firm are different parties. This gives the firm a
stability that the owner-managed firm cannot achieve.
• For example, if some stockholders decide they no longer wish to hold shares in
the firm, they can sell their shares to other investors, with no impact on the
management of the firm. Thus, financial assets and the ability to buy and sell
those assets in the financial markets allow for easy separation of ownership and
management.

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 Financial Markets and the Economy
(Ctd.)
Do managers really attempt to maximize firm value?

It is easy to see how they might be tempted to engage in activities

not in the best interest of shareholders. For example, they might
engage in empire building or avoid risky projects to protect their
own jobs or overconsume luxuries such as corporate jets

These potential conflicts of interest are called agency problems

because managers, who are hired as agents of the shareholders, may
pursue their own interests instead.

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 Financial Markets and the
Economy (Ctd.)
Several mechanisms have evolved to mitigate potential agency
problems:
• First, compensation plans tie the income of managers to
the success of the firm, compensation of top executives
is often in the form of stock or stock options.
• Second, board of directors can force out management
teams that are underperforming.
• Third, outsiders such as security analysts and large
institutional investors can monitor the firm progress
• Forth, bad performers are subject to the threat of
takeover.

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 Financial Markets and the Economy
(Ctd.)
15. Theoretically, takeovers should result in ___________.
A. improved management
B. increased stock price
C. increased benefits to existing management of taken over firm
D. improved management and increased stock price
E. worse management and decreased stock price
D. Theoretically, when firms are taken over, better managers come in
and thus increase the price of the stock; existing management often
must either leave the firm, be demoted, or suffer a loss of existing
benefits

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 Financial Markets and the Economy
(Ctd.)
17. Which of the following are mechanisms that have evolved to mitigate potential agency
problems?
I) Compensation in the form of the firm's stock options
II) Hiring bickering family members as corporate spies
III) Underperforming management teams being forced out by boards of directors
IV) Security analysts monitoring the firm closely
V) Takeover threats
A. II and V
B. I, III, and IV
C. I, III, IV, and V
D. III, IV, and V
E. I, III, and V

C. All but the second option have been used to try to limit agency problems.

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 Financial Markets and the Economy
(Ctd.)
18. A disadvantage of using stock options to compensate managers is that
A. it encourages mangers to undertake projects that will increase stock price.
B. it encourages managers to engage in empire building.
C. it can create an incentive for mangers to manipulate information to prop up a stock price
temporarily, giving them a chance to cash out before the price returns to a level reflective of the
firm's true prospects.
D. it causes managers to take undue risks.
E. it causes managers to be too conservative.

C. It can create an incentive for mangers to manipulate information to prop up a stock price
temporarily, giving them a chance to cash out before the price returns to a level reflective of the
firm's true prospects.

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 Financial Markets and the Economy
(Ctd.)
19. Financial assets can permit all of the following except ____________.
A. consumption timing
B. allocation of risk
C. separation of ownership and control
D. elimination of risk
E. easy transfer of ownership

D. Financial assets do not allow risk to be eliminated. However, they do permit allocation of
risk, consumption timing, and separation of ownership and control.

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 Financial Markets and the Economy
(Ctd.)
20. The ____________ refers to the potential conflict between management and shareholders.
A. agency problem
B. diversification problem
C. liquidity problem
D. solvency problem
E. regulatory problem

A.The agency problem describes potential conflict between management and shareholders. The
other problems are those of firm management only.

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