HW1s-s10 - Solution Key to Problem Set 1 ECN 134 Financial...

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Solution Key to Problem Set 1 ECN 134 Financial Economics Prof. Farshid Mojaver Part A: Investment Environment 1. Suppose you discover a treasure check 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 discovery? Answer) a. Cash is a financial asset because it is the liability of the federal government. b. No. The cash does not directly add to the productive capacity of the economy. c. Yes. d. Society as a whole (except you) is worse off, since taxpayers, as a group will make up for the liability. 2. 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? Answer) Ultimately, it is true that real assets do determine the material well being of an economy. Nevertheless, individuals can benefit when financial engineering creates new products that allow them to manage their portfolios of financial assets more efficiently. Because bundling and unbundling creates financial products with new properties and sensitivities to various sources of risk, it allows investors to hedge particular sources of risk more efficiently. In recent years financial engineering has been used to hide up risk of the underlying asset by clever designs that severs that interest of the fee collector, robs the customer and endangers the stability of the whole financial system. 3. 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. Answer) a. A fixed salary means that 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. However, the manager might view this as the safest compensation structure and therefore value it more highly.
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b. A salary that is paid in the form of stock in the firm means that the manager earns the most when the shareholders’ wealth is maximized. This structure is therefore most likely to align the interests of managers and shareholders. If stock compensation is overdone, however, the manager might view it as overly risky since the manager’s career is already linked to the firm, and this undiversified exposure would be exacerbated with a large stock position in the firm. c.
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HW1s-s10 - Solution Key to Problem Set 1 ECN 134 Financial...

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