CHAPTER 1: THE INVESTMENT ENVIRONMENT PROBLEM SETS: 1. 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 for investors to form more efficient portfolios. Both institutional and individual investors can benefit when financial engineering creates new products that allow them to manage their portfolios of financial assets more efficiently. Bundling and unbundling create financial products with new properties and sensitivities to various sources of risk that allows investors to reduce volatility by hedging particular sources of risk more efficiently. 2. 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. A well-developed media, particularly financial reporting. These characteristics are found in (indeed make for) a well-developed financial market. 3. 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. Securitization works well and can benefit many, but only if the market for these securities is highly liquid. As securitization progresses, however, and financial intermediaries lose opportunities, they must increase other revenue-generating activities such as providing short-term liquidity to consumers and small business and financial services. 4. The existence of well-developed 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 Suncor Energy, 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