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1. What are agency problems? List three mechanisms that can mitigate agency problems?
Agency problems are known to be issues or conflicts that arise when managers take a part in
activities, engage in behavior or makes decisions based on their own interest rather than of the
shareholders.
The mechanisms that can mitigate agency problems:
Keep the board of directors independent from senior management.
Making managers’ compensations dependent on the success of the firm via
stock optioms.
Large investors can help keep senior management focused on shareholder
intrests.
Poor performing companies that have bad management are subject to
takeovers resulting in senior management being replaced
2. How does Sarbanes-Oxley improve the quality of information in the markets?
The act was designed to tighten the rules of corporate governance thereby reducing the
likelihood of management misrepresenting financial results. For example, the Act requires firms
to have more independent directors that are not affiliated with senior management. Other
requirement of the Act include: requiring CFOâ??s to personally vouch for the firmâ??s financial
statements; creating an oversight board to oversee the audit process; and prohibiting auditors
from providing other services to the firm.
3. What is the difference between asset allocation and security selection?
Allocation is the decision involving which asset classes (e.g. stocks, bonds, cash, real estate, etc.)
to invest and how much; security selection is the decision on which securities to invest with each
asset class.
4. If you believe that there is â??no-free lunchâ? in investing, are you more likely to hire an
active or passive manager to oversee your portfolio? Why?
Since thereâ??s no free lunch in investment, I would rather hire a passive manager. One of the
implications of â??no free lunchâ? means that markets are efficient and you cannot find bargains in
securities since they are fairly priced. Therefore, active managers which charge higher fees to
find such bargains would not be able to consistently add value through security selection. A
manager that adds value would be due to luck much like flipping a coin; rather than skill. An
active manager would have to consistently earn excess returns by finding bargains and avoiding
overpriced stocks in order to cover higher management fees and transaction costs. This would
not be possible if markets were efficient.
5. What is securitization of mortgages? What was a key change in securitization
precipitated the financial crisis?
Securitization of mortgages is the process of bundling of individual mortgages into large pools.
Bonds that are backed by these pools are sold to individual investors. The mortgages in these
pools conformed to regulatory requirements.
The key change in securitization that precipitated the financial crisis of 2008 was the
introduction of non-conforming sub-prime mortgages which were of lower credit quality and did
not have sufficient underwriting criteria as to the credit worthiness of the homeowner.
6. Moral hazard is a situation where people tend to take greater risk because the costs will
not be felt by the party taking the risk. Explain the moral hazard in banks that
securitize sub-prime mortgages they underwrite vs. holding onto the loans?
The originators of sub-prime mortgages did not hold onto the loans but rather sold them to
investment banks that bundled the loans in pools and sold them to investors. Originators had no
vested interest in the loans and were incentivized to make as many loans as possible even if it
meant loaning to riskier potential homebuyers and in many cases even misrepresenting facts
about a borrowerâ??s creditworthiness on the loan application just to get the loan processed. If the
originator had to hold the loans to maturity, this reckless behavior would have been dramatically
curtailed. The investment banks that issued bonds backed by the pools purchased insurance
policies (credit default swaps) on the credit-worthiness of the pools. This reduced the bankâ??s
incentive to better understand the lack of creditworthiness of the mortgage pools they assembled
and sold. Therefore much risk and moral hazard fell on the companies that insured the sub-prime
mortgage pools (AIG and other insurance companies).
7. What is the TED spread and what does it imply about market risk? Why does it rise
during periods of market turmoil?
TED Spread is the difference between the LIBOR rate and Treasury-bill Rate. LIBOR is the rate
at which banks borrow/lend from each other. As markets become more turbulent, banks become
more risky thereby increasing the LIBOR rate due to higher credit risk. During such periods the
flight to quality increases the demand for Treasuries thereby pushing down yields. Therefore,
LIBOR would increase while Treasury-bill rates decreasing increasing the TED spread.
8. What does it mean that securities are fungible and negotiable? Why are stocks fungible
but not used cars built in the same year and have the same features?
Fungible means easily interchangeable. When you buy a share of stock, it does not matter which
share you buy since all are the same assuming the same classification. Money is fungible since
funds used for one purpose can easily be used for another. Money is interchangeable â?? two $5
bills can be exchanged for a $10 bill. Also, funds allocated for a given expense can be used for
another expense. Securities traded in the market are negotiable in that an owner can transfer title
from to another.

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