Problem Set #1
Chapter 1:
1. 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). E...
1. 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?
Real assets for the most part do determine the well-being of an economy however, financial innovation in
the form of bundling and unbundling securities enables opportunities for investors to tweak and adjust
their portfolios efficiently. In order to evaluate this criticism we must take a look at the average investor.
There is a reason why only 5%, (an overstatement), consistently outperform the stock market. Investing is
hard - therefore investors can benefit greatly from financial engineering. Bundling and unbundling allows
the ability to also create financial products with new properties and expose your portfolio to various
sources of risk however you feel is best for you. A quote I like a lot from Buffett, “Investors should
remember that excitement and expenses are their enemies”. This quote pretty much sums up that for
most investors, the “boring” and less “hands on” investing strategies may well be the best for them.
2. Give an example of three financial intermediaries and explain how they act as a bridge
between small investors and large capital markets or corporations.
Financial intermediaries represent the bridge between personal investors and the open capital market.
Having worked at RBC for the past summer, I dealt a lot with Mutual funds. Mutual funds essentially
accept funds from smaller retail investors and invest it while taking a % of the amount invested. At RBC
we had a lot of funds that represented the S&P500. Realistically, many smaller investors would not be
able to buy shares from every single company listed on the S&P500 however, RBC acts as bridge and
connects the smaller investors with their own mutual funds. This enables smaller investors to have
exposure to all 500 companies and have access to a similar performance as a larger investor who owns
all 500 of the largest companies in the U.S. Pension funds are another example. Similar to mutual funds
they accept funds and invest it, on behalf of current and future retirees (retail investors), thereby bridging
funds from the smaller investors of the economy to the large capital markets. Another example of a
financial intermediary are venture capital firms. These firms essentially pool the funds of private investors
and invest in start-up firms. Since start-up firms are not always publicly listed, investing in them can be
difficult especially for a smaller investor. Venture capital firms bridge this gap and give the opportunity for
smaller investors to be exposed to this side of the market.
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