. 6
( 193 .)


ties. This part also describes the mutual fund industry.
Part Two is a fairly detailed presentation of “modern portfolio theory.” This part of the text
treats the effect of diversification on portfolio risk, the efficient diversification of investor
portfolios, the choice of portfolios that strike an attractive balance between risk and return,
and the trade-off between risk and expected return.
Parts Three through Five cover security analysis and valuation. Part Three is devoted to
debt markets and Part Four to equity markets. Part Five covers derivative assets, such as op-
tions and futures contracts.
Part Six is an introduction to active investment management. It shows how different in-
vestors™ objectives and constraints can lead to a variety of investment policies. This part dis-
cusses the role of active management in nearly efficient markets and considers how one
should evaluate the performance of managers who pursue active strategies. It also shows how
the principles of portfolio construction can be extended to the international setting.

SUMMARY • Real assets create wealth. Financial assets represent claims to parts or all of that wealth.
Financial assets determine how the ownership of real assets is distributed among investors.
• Financial assets can be categorized as fixed income, equity, or derivative instruments.
Top-down portfolio construction techniques start with the asset allocation decision”the
allocation of funds across broad asset classes”and then progress to more specific
security-selection decisions.
• Competition in financial markets leads to a risk-return trade-off, in which securities that
offer higher expected rates of return also impose greater risks on investors. The presence
of risk, however, implies that actual returns can differ considerably from expected returns
at the beginning of the investment period. Competition among security analysts also

results in financial markets that are nearly informationally efficient, meaning that prices
reflect all available information concerning the value of the security. Passive investment
strategies may make sense in nearly efficient markets.
• Financial intermediaries pool investor funds and invest them. Their services are in demand
because small investors cannot efficiently gather information, diversify, and monitor
portfolios. The financial intermediary sells its own securities to the small investors. The
intermediary invests the funds thus raised, uses the proceeds to pay back the small
investors, and profits from the difference (the spread).
• Investment banking brings efficiency to corporate fund-raising. Investment bankers
develop expertise in pricing new issues and in marketing them to investors.
• There are four types of financial markets. Direct search markets are the least efficient and
sophisticated, where each transactor must find a counterpart. In brokered markets, brokers
Bodie’Kane’Marcus: I. Elements of Investments 1. Investments: © The McGraw’Hill
Essentials of Investments, Background and Issues Companies, 2003
Fifth Edition

1 Investments: Background and Issues

specialize in advising and finding counterparts for fee-paying traders. Dealers provide a
step up in convenience. They keep an inventory of the asset and stand ready to buy or sell
on demand, profiting from the bid-ask spread. Auction markets allow a trader to benefit
from direct competition. All interested parties bid for the goods or services.
• Recent trends in financial markets include globalization, securitization, financial
engineering of assets, and growth of information and computer networks.

active management, 10 financial engineering, 19 primary market, 14
agency problem, 8 financial intermediaries, 11 real assets, 4
asset allocation, 8 fixed-income securities, 5 risk-return trade-off, 10
auction market, 15 globalization, 15 secondary markets, 15
bundling, 18 investment, 3 securitization, 17
dealer markets, 14 investment bankers, 13 security analysis, 9
derivative securities, 6 investment companies, 13 security selection, 8
equity, 6 passive management, 10 unbundling, 18
financial assets, 4 pass-through securities, 16

1. Suppose you discover a treasure chest of $10 billion in cash.
a. Is this a real or financial asset?
b. Is society any richer for the discovery?
c. Are you wealthier?
d. Can you reconcile your answers to (b) and (c)? Is anyone worse off as a result of the
2. 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 three years.
b. Lanni uses the cash from the bank plus $20,000 of its own funds to finance the
development of new financial planning software.
c. Lanni sells the software product to Microsoft, which will market it to the public
under the Microsoft name. Lanni accepts payment in the form of 1,500 shares of
Microsoft stock.
d. Lanni sells the shares of stock for $80 per share and uses part of the proceeds to pay
off the bank loan.
3. Reconsider Lanni Products from problem 2.
a. Prepare its balance sheet just after it gets the bank loan. What is the ratio of real
assets to total assets?

b. Prepare the balance sheet after Lanni spends the $70,000 to develop its software
product. What is the ratio of real assets to total assets?
c. Prepare the balance sheet after Lanni accepts the payment of shares from Microsoft.
What is the ratio of real assets to total assets?
4. Financial engineering has been disparaged as nothing more than paper shuffling. Critics
argue that resources used for rearranging wealth (that is, bundling and unbundling
financial assets) might be better spent on creating wealth (that is, creating real assets).
Evaluate this criticism. Are any benefits realized by creating an array of derivative
securities from various primary securities?
5. Examine the balance sheet of the financial sector in Table 1.3. What is the ratio of
tangible assets to total assets? What is that ratio for nonfinancial firms (Table 1.4)? Why
should this difference be expected?
Bodie’Kane’Marcus: I. Elements of Investments 1. Investments: © The McGraw’Hill
Essentials of Investments, Background and Issues Companies, 2003
Fifth Edition

22 Part ONE Elements of Investments

6. Consider Figure 1.5, below, which describes an issue of American gold certificates.
a. Is this issue a primary or secondary market transaction?
b. Are the certificates primitive or derivative assets?
c. What market niche is filled by this offering?
7. 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. A fixed salary.
b. Stock in the firm.
c. Call options on shares of the firm.
8. We noted that 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?
9. Why would you expect securitization to take place only in highly developed capital
10. What is the relationship between securitization and the role of financial intermediaries
in the economy? What happens to financial intermediaries as securitization progresses?
11. Although we stated that real assets comprise 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 one could trade financial assets?
12. Give an example of three financial intermediaries and explain how they act as a bridge
between small investors and large capital markets or corporations.
13. 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 secondary market?

F I G U R E 1.5
A gold-backed security
Bodie’Kane’Marcus: I. Elements of Investments 1. Investments: © The McGraw’Hill
Essentials of Investments, Background and Issues Companies, 2003
Fifth Edition

1 Investments: Background and Issues

14. The rate of return on investments in large stocks has outpaced that on investments in
Treasury bills by over 8% since 1926. Why, then, does anyone invest in Treasury bills?
15. What are some advantages and disadvantages of top-down versus bottom-up investing
16. 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?


Stock Options
Go to http://www.businessweek.com/magazine/content/ 02_09/b3772049.htm to view
the article “Too Much of a Good Incentive.” This article discusses current issues related
to stock option compensation.
After reading this article, answer the following questions:
1. What factors did the author suggest caused problems with options being granted
to companies in the late 1990s?
2. What is the controversy related to having companies expense options when they
are given rather than the current method of not recording an expense?
3. What does the author suggest is the real cost associated with options that is not
recognized when the options are granted?

1. a. Real
b. Financial
< Concept
c. Real
d. Real
e. Financial
2. If the new technology enables investors to trade and perform research for themselves, the need for
financial intermediaries will decline. Part of the service intermediaries now offer is a lower-cost
method for individuals to participate in securities markets. This part of the intermediaries™ service
would be less sought after.
3. a. Used cars trade in dealer markets (used-car lots or auto dealerships) and in direct search markets
when individuals advertise in local newspapers.
b. Paintings trade in broker markets when clients commission brokers to buy or sell art for them, in
dealer markets at art galleries, and in auction markets.
c. Rare coins trade mostly in dealer markets in coin shops, but they also trade in auctions and in
direct search markets when individuals advertise they want to buy or sell coins.

4. a. The pass-through agencies are far better equipped to evaluate the credit risk associated with the
pool of mortgages. They are constantly in the market, have ongoing relationships with the
originators of the loans, and find it economical to set up “quality control” departments to
monitor the credit risk of the mortgage pools. Therefore, the pass-through agencies are better
able to incur the risk; they charge for this “service” via a “guarantee fee.” Investors might not
find it worthwhile to purchase these securities if they must assess the credit risk of these loans
for themselves. It is far cheaper for them to allow the agencies to collect the guarantee fee.
b. In contrast to mortgage-backed securities, which are backed by large numbers of mortgages,
Brady bonds are backed by large government loans. It is more feasible for the investor to
evaluate the credit quality of a few governments than it is to evaluate dozens or hundreds of
individual mortgages.
Bodie’Kane’Marcus: I. Elements of Investments 2. Global Financial © The McGraw’Hill
Essentials of Investments, Instruments Companies, 2003
Fifth Edition



> Distinguish among the major assets that trade in money
markets and in capital markets.

> Describe the construction of stock market indexes.

> Calculate the profit or loss on investments in options and
futures contracts.

Bodie’Kane’Marcus: I. Elements of Investments 2. Global Financial © The McGraw’Hill
Essentials of Investments, Instruments Companies, 2003
Fifth Edition

Related Websites
This site provides a list of links related to all aspects of
These two sites contain extensive glossaries of financial
business, including extensive sites related to finance
and investment.


. 6
( 193 .)