Structured Finance and Insurance E-Book

Christopher L. Culp

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Serie: Wiley Finance Editions
• Sprache: Englisch

Seitenzahl: 1467

Veröffentlichungsjahr: 2011

Beschreibung

Praise for Structured Finance & Insurance "More and more each year, the modern corporation must decide what risks to keep and what risks to shed to remain competitive and to maximize its value for the capital employed. Culp explains the theory and practice of risk transfer through either balance sheet mechanism such as structured finance, derivative transactions, or insurance. Equity is expensive and risk transfer is expensive. As understanding grows, and, as a result, costs continue to fall, ART will continue to replace equity as the means to cushion knowable risks. This book enhances our understanding of ART." --Myron S. Scholes, Frank E. Buck Professor of Finance, Emeritus, Graduate School of Business, Stanford University "A must-read for everyone offering structured finance as a business, and arguably even more valuable to any one expected to pay for such service." --Norbert Johanning, Managing Director, DaimlerChrysler Financial Services "Culp's latest book provides a comprehensive account of the most important financing and risk management innovations in both insurance and capital markets. And it does so by fitting these innovative solutions and products into a single, unified theory of financial markets that integrates the once largely separate disciplines of insurance and risk management with the current theory and practice of corporate finance." --Don Chew, Editor, Journal of Applied Corporate Finance (a Morgan Stanley publication) "This exciting book is a comprehensive read on alternative insurance solutions available to corporations. It focuses on the real benefits, economical and practical, of alternatives such as captives, rent-a-captive, and mutuals. An excellent introduction to the very complex field of alternative risk transfer (ART)." --Paul Wohrmann, PhD, Head of the Center of Excellence ART and member of theExecutive Management of Global Corporate in Europe, Zurich Financial Services "Structured Finance and Insurance transcends Silos to reach the Enterprise Mountaintop. Culp superbly details integrated, captive, multiple triggers and capital market products, and provides the architectural blueprints for enterprise risk innovation." --Paul Wagner, Director, Risk Management, AGL Resources Inc.

Leseprobe

Contents

Foreword: Wherefore ART Thou? The Importance of Principle-Based Structured Finance

Preface

Part One: Integrated Risk and Capital Management

Chapter 1: Real and Financial Capital

Real Capital and The Value of The Firm

Financial Capital and The Value of The Firm

Financial Capital Through an Options Lens

Economic Balance Sheet of The Firm

Chapter 2: Risk and Risk Management

Financial Versus Nonfinancial Risks

Core Versus Noncore Risks

Risk Management Alternatives

Chapter 3: Leverage

Benefits of Leverage To The Value of The Firm

Costs of Leverage

Optimal Capital Structure?

Chapter 4: Adverse Selection and Corporate Financing Decisions

Adverse Selection and Markets For Lemons

Adverse Selection in Securities Markets

Implications of Adverse Selection in Securities Markets

Chapter 5: Capital Budgeting, Project Selection, and Performance Evaluation

Accounting Metrics For Project Selection and Performance Measurement

Discounted Cash Flow Methods With No Risk Adjustment

Net Present Value Rule

Shareholder Value Added

Economic Value Added and Residual Income

Cash Flow Return On Investment

Chapter 6: Risk Transfer

Risk Transfer and Equity Capital

Risk Transfer and The Value of The Firm

Risk Transfer Versus Risk Capital

Chapter 7: Risk Finance

Cash Flow Distinctions Between Pre- and Postloss Funding

Irrelevance of Risk Finance Under M&M

Motivations For Funding A Retention

Part Two: Traditional Risk Transfer

Chapter 8: Insurance

Insurance Products As Contracts

Insurance Pricing

Moral Hazard and Insurance Contract Design

Adverse Selection and Insurance Contract Design

Insurance Companies

Reserve and Asset-Liability Management at Insurance Companies

Chapter 9: Reinsurance

The Basics

Risks of Writing Primary Insurance

Motivations For Purchasing Reinsurance

Facultative Versus Treaty Reinsurance

Proportional Reinsurance Treaties

Excess of Loss Reinsurance

Horizontal Layering and Blended Cover

Syndication

Chapter 10: Credit Insurance and Financial Guaranties

Credit Insurance Products

Letters Of credit

Who Bears The Cost of Acquiring Credit Protection?

Distinctions Between Different Credit Protection Products

When is A Guaranty Not A Guaranty?

Chapter 11: Derivatives

What Are Derivatives?

Forward and Forwardlike Contracts

Options

Chapter 12: Credit Derivatives and Credit-Linked Notes

Scope of Credit Derivatives Activity

Single-Name Credit Default Swaps

Portfolio Credit Default Swaps

Asset Default Swaps

Equity Default Swaps

Total Return Swaps

Credit-Linked Notes (Recourse)

Part Three: Structured Finance

Chapter 13: The Structuring Process

Types of Structured Financial Solutions

Structuring Process

Tranching and Subordination

Chapter 14: Hybrids, Convertibles, and Structured Notes

Hybrids and Convertibles

Structured Notes

Chapter 15: Contingent Capital

Contingent Capital Facilities As Options

(Re)Insurance Applications of Contingent Capital

Corporate Applications of Contingent Capital

Synthetic Contingent Capital

Chapter 16: Securitization

Securitization Process

Credit Enhancement

Liquidity Support

Interest Rate and Currency Risk

Securitization as Credit Risk Reinsurance

From ABS and ABCP to CDO

Chapter 17: Cash Collateralized Debt Obligations

Types of CDOs

Balance Sheet CDOs

Arbitrage CDOs

Cash CDOs as Whole Capital Structure Products

Chapter 18: Synthetic Collateralized Debt Obligations

First-Generation SCDO Structures

Appeal of Synthetic Structures

Second-Generation SCDO Structures

Flirting With Insurance?

Chapter 19: Structured Synthetic Hybrids

Equity Default Obligations

Hybrid CDO

Nth to Default Basket Hybrid CDO

Rebound Notes

Chapter 20: Securitizing Private Equity and Hedge Funds

Hedge Funds and Private Equity Funds As Collateral

Single-Tranche Capital-Protected Notes

Multiclass CFOs

Chapter 21: Project and Principal Finance

Project and Principal Finance

Project Loan Securitizations

Future Flow Securitizations: Development and Infrastructure

Future Flow Securitizations: Principal Finance

Synthetic Commodity-Based Project Financing

Part Four: Structured Insurance and Alternative Risk Transfer

Chapter 22: Risk Securitizations and Insurance-Linked Notes

General Structure

Synthetic Reinsurance

Corporate Risk Securitizations

Derivatives Structures

Chapter 23: Captives, Protected Cells, and Mutuals

Balance Sheet Self-Insurance

Captives and Other Risk Financing Vehicles

Mutuals or “Self-Insurance Syndicates”

Captives and Mutuals as Users of Other Structured Solutions

Chapter 24: Finite Risk

A Simple Example

Typical Finite Risk Structures

Legitimate Transactions Versus Opportunities For Abuse

Examples of Legitimate Uses of Finite

Sound Principles For Finite

Chapter 25: Multiline and Multitrigger Insurance Structures

Multiline Integrated Risk Transfer

Examples of Multiline Structures

Multitrigger IRM Products

Examples of Multitrigger Structures

Dual-Trigger Insurance Versus Derivatives and FAS 133

Chapter 26: Contingent Cover

Premium Protection Options

Contingent Cover Embedded in Existing Programs

Contingent Insurance-Linked Notes

Part Five: Case and Issue Studies

Chapter 27: The Emerging Role of Patent Law in Risk Finance

Basics of Patentability

Illustration: Method of Exercising A Cat (U.S. PAT. NO. 5,443,036)

A Few Examples of Risk Finance Patents

Evolution of Financial Patents: A Thumbnail Sketch

Conclusion

Chapter 28: Critical Distinctions between Weather Derivatives and Insurance

What Are Weather Derivatives?

What is Insurance?

Distinctions Between Insurance and Derivatives

Analysis of Weather Derivatives As Insurance Discredited

Documentation Considerations

Tax Distinctions

Conclusion

Chapter 29: Is Insurance a Substitute for Capital under the Revised Basel Accord?

Definition of Operational Risk and Related Risk Types

Risk Measurement, Capital Allocation, and Relief For Insurance

Insurance as A Risk Mitigant

Data Dilemma and 20 Percent Capital Relief Limitation

Precursors to Further Regulatory Capital Relief

Conclusion

Chapter 30: Is My SPE a VIE under FIN46R, and, If So, So What?

Scope Exceptions

Variable Interests

Expected Losses and Expected Residual Returns

Primary Beneficiary

Variable Interest Entities

Fin46R Determination Timing

Required Vie Disclosure

Transition

Proposed International Accounting Standards Convergence

Conclusion

Chapter 31: Credit Derivatives, Insurance, and CDOs: The Aftermath of Enron

Management of Credit Risk

What are Credit Derivatives?

Misuse of Credit Derivatives

Credit Derivatives or Insurance

Ongoing Efforts To Improve Documentation

Conclusion

Chapter 32: Project Finance Collateralized Debt Obligations: What? Why? Now?

What?

Why?

Now?

Chapter 33: 2004 Review of Trends in Insurance Securitization: Exploring Outside the Cat Box

New Securities

Pricing Theory

Other Trends

Concluding Remarks

Chapter 34: Enterprise Risk Management: The Case of United Grain Growers

Enterprise Risk Management

The Silo Approach Can Be Inefficient

Enterprise Risk Management at UGG

Erm Process at UGG

UGG’S Decision On Managing Weather Risk

The Contract

Benefits To UGG

Lessons For Other Firms

Appendix To Chapter 34

Chapter 35: Representations and Warranties Insurance and Other Insurance Products Designed to Facilitate Corporate Transactions

Products Designed To Facilitate Mergers, Acquisitions, and Other Transactions

Development of The Market For Tips

Appendixes

Appendix A: Capital Structure Irrelevance

Appendix B: Risk-Based Capital Regulations on Financial Institutions

Appendix C: Risk Capital

Commonly Used Abbreviations

References

Index

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Copyright © 2006 by Christopher L. Culp. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

Published simultaneously in Canada.

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Library of Congress Cataloging-in-Publication Data:

Culp, Christopher L.

Structured finance and insurance : the ART of managing capital and risk / by Christopher L. Culp [et al.].

p. cm.—(Wiley finance series)

Includes bibliographical references and index.

ISBN-13: 978-0-471-70631-1 (cloth)

ISBN-10: 0-471-70631-0 (cloth)

1. Asset-backed financing. 2. Securities. 3. Risk management. 4. Risk (Insurance). I. Title. II. Series.

HG4028.A84C85 2006

658.15’5—dc22

2005019905

Foreword

Wherefore ART Thou? The Importance of Principle-Based Structured Finance

Whenever I get a chance to speak to one of Chris’s MBA classes at the University of Chicago, I enjoy the look on his students’ faces when I start spouting Shakespeare’s views on risk management and corporate finance. For practitioners of structured finance and alternative risk transfer (ART), many of his quotes are quite instructive. For example:

Eye of newt, and toe of frog,

Wool of bat, and tongue of dog,

Adder’s fork, and blind-worm’s sting,

Lizard’s leg, and howlet’s wing,—

For a charm of powerful trouble,

Like a hell-broth boil and bubble.

Macbeth’s witches truly appear to be our first structured finance specialists. At least that is what some may conclude when reading about the efforts of managers and their financial advisers to practice structured finance and ART as a sort of alchemy—turning debt into insurance, taking liabilities off balance sheet, or accelerating earnings to cover known losses. We can’t “bid farewell to magic” (Tempest, Act V, Scene I), but we can establish the fundamentals on which the proper solutions are structured to address fundamental capital and risk management issues.

In Parts One and Two of this book, Chris lays out the building blocks of finance and risk management drawing on corporate finance theory and applied research that has been developed over the past 30 years. These tools are then sharpened in Parts Three and Four as we move from theory to applications involving project finance, securitization, and the convergence between insurance and capital markets solutions such as catastrophe bonds and committed capital. Chris brings together two different worlds—the world of corporate finance and the world of insurance—and explains how the tools, while they may look different, are based on the same fundamentals.

These worlds are complicated on their own. When practitioners bring them together they often create Byzantine structures to address accounting, regulatory, tax, and corporate finance drivers that might lead even the most astute shareholder or analyst to proclaim:

Sir, I am vexed;

Bear with my weakness; my old brain is troubled.

(Tempest, Act IV, Scene I)

This is why simple principles are important. Shakespeare’s entreaty “To thine own self be true” (Hamlet, Act I, Scene III) can be used by any manager to question whether the structured transaction is a means for obscuring or addressing underlying risks. Structured transactions—whether they securitize assets, cover difficult-to-insure risks, or access capital markets investors more efficiently—are of questionable value if management cannot explain clearly why considerable time and resources were spent to structure such solutions.

Often, the decision to structure a solution is a type of “To be or not to be” question. Does management of an airline company believe its shareholders wish it to be in the transportation business or the fuel speculation business? To what degree should the future oil price be hedged, for how long, and at what cost? Chris explains the fundamental principles to answer these questions and goes one step further by explaining the confusion shareholders face if they do not know or understand management’s risk management strategy.

Of course, it is because companies can never be “secure from worldly chances and mishaps” (Titus Andronicus) that risk management has a role. It is equally important that risk managers understand that shareholders expect management to take risks. Without taking risk, management cannot create value. It is the balancing act between risk and ruin that Chris concentrates on in such detail by keeping our attention focus on both capital and risk management.

To some financial advisers, ART transactions once appeared as the perfect means to address both core and noncore risks. It was thought that one master insurance policy could cover both insurance and financial risks. Management could use structured insurance transactions as a kind of “cookie jar” to dip into whenever they needed just the right amount of earnings to cover unexpected losses. Chris points out (for example, in Chapters 23 and 24) how this could occur if management and its financial advisers did not apply two important principles:

1. ART transactions should not be used to cover core business risks.

2. ART transactions should not allow management a cookie jar to obscure the true reasons for unexpected losses.

When ART transactions are transparent, are focused on noncore risks, and avoid creating cookie jars for management, we get back to the fundamental purpose of these products.

In the coming years, we will see insurance and capital markets applications come closer together as capital markets investors and insurance underwriters will accept a common language for risk and risk analysis. In Chapter 22, Chris describes why and how capital markets investors have been tapped to take on insurance-based risks through catastrophe bonds and how insurance underwriters have learned to appreciate that they can participate in the recovery of their clients if they provide capital instead of insurance after an insurable event.

To bring these two markets together into effective and responsible structures, it is important to understand how they differ. Students of corporate finance and risk management require this understanding in order to avoid concluding that an insurance or financial solution is just “a rose by any other name.” The characteristics of a debt obligation or the payment of an insurance premium are critically important differences that Chris describes using common sense and clarity. Hopefully, structured finance practitioners as well as future risk managers will read these chapters carefully and understand that:

You are a councillor. . . .

Use your authority. If you cannot,

give thanks you have lived so long. . . .

(Tempest, Act I, Scene I)

Structured solutions are a critical element in our sophisticated financial and insurance markets. Used properly, they provide firms with greater financial flexibility and shareholders with greater confidence that management is focusing on the firm’s core business rather than being exposed to unmanageable risks. Chris helps to bring needed clarity to the profession of structured finance and the responsibility management has to ensure that shareholders understand the value that structured transactions can create for the firm.

Shakespeare put this best when he admonished us to “Leave not wrack behind.” Had he been able to read Chris’s book, he may even have added that structured finance was “such stuff as dreams are made on.”

Tom Skwarek

Swiss Re Capital Solutions

Mr. Skwarek is Managing Director and Head of Swiss Re’s Corporate Capital Solutions Group. He manages this business from London. The thoughts expressed herein are his alone and do not necessarily represent those of Swiss Re or any of its clients.

Preface

This is a book about how structured finance and structured insurance—a.k.a. alternative risk transfer (ART)—can help corporations achieve their corporate financing and risk management objectives in an integrated and comprehensive fashion. Structured finance is the use of nontraditional financing methods to raise funds in a way that also alters the firm’s risk profile in the process. Structured insurance or ART is the use of nontraditional risk finance and risk transfer techniques to manage risk in a way that also affects the firm’s capital structure and/or weighted average cost of capital. They are two sides of the same coin.

Convergence between insurance and capital markets has been a buzzword for at least a decade. And slowly but surely, each year the worlds of insurance, derivatives, and securities do become progressively more integrated. The trend toward convergence in insurance and capital markets is much more fundamental, however, than just increasing product or institutional similarities. The real convergence is between corporation finance and risk management. It is convergence in a way of thinking.

Unfortunately, one area in which the markets are still badly behind is cross-disciplinary communication. Insurance and derivatives practitioners still speak largely different languages, and even the most similar concepts in the two worlds are often not recognized as being essentially the same thing. This book is intended to help address that by putting both ART and capital markets into the single common denominator and unifying framework of the theory and practice of modern corporation finance.

ORGANIZATION OF THE BOOK

Part One lays a basic foundation about capital, risk, corporation finance, and risk management that is intended to serve as a theoretical backdrop for the more practical discussions in the rest of the book. This firm grounding on first principles of corporate finance and risk management is now even more important than ever, not just so that firms can continue to pursue the most efficient and customized solutions to their risk and capital management problems but also so that firms can avoid the pitfalls of engaging in structured transactions the wrong way, for the wrong reasons, or both.

From the failure of Enron in 2001 to the very recent investigations into structured insurance products like finite risk (see Chapter 24), one might conclude that structured solutions are or are about to be on the wane. One could, of course, have drawn a similar conclusion about derivatives in the 1990s or high-yield debt in the 1980s, and both of those markets are still going strong. The fundamental economic forces that have led more and more firms to pursue integrated financing and risk management tools in the structured finance and insurance markets are not going away. If anything, the recent controversy simply makes it all the more important that the range of these products and solutions be fully understood in the underlying context of what economic and financial objectives those products are intended to accomplish.

After developing our basic foundations in Part One, Part Two provides a brief review of traditional risk transfer methods—insurance, reinsurance, derivatives, and credit protection products in both the (re)insurance and derivatives worlds. Parts Three and Four then examine the main processes, products, and solutions in the structured finance and structured insurance/ART markets today.

In Part Five, a number of experts have been kind enough to share their thoughts on some of the more specific issues and topics facing participants in both markets today. The order in which the guest essays appear roughly corresponds to the part of the text with which they are most closely associated.

A “REVISION”?

Technically and strictly speaking, this book is the second and revised edition of my 2002 text The ART of Risk Management: Alternative Risk Transfer, Capital Structure, and the Convergence of Insurance and Capital Markets (John Wiley & Sons). However, the overlap between this book and that one is fairly minimal. Part of the difference owes to our decision to add a Part Three on structured finance that was not in the prior book. And part owes to new products, case studies, and examples that have occurred in the past five years.

Mainly, however, the substantial revision is a result of my own learning process. As I continue to work closely year after year with both corporations that use structured finance and ART products as well as with firms that provide these solutions, I continue to gain more insight from my clients and colleagues about how this market fits into the broader theory and practice of corporate finance. Hopefully, this “edition” of the book is more streamlined in how it connects the theory to the practice, as well as being more comprehensive and up to date in its product coverage.

TARGET AUDIENCE AND BACKGROUND OF READERS

This book has a conceptual orientation toward the use of structured finance and insurance by nonfinancial corporations and thus will be primarily of interest to corporate risk managers, treasurers, and CFOs, and those on the sell side who deal with corporates, including (re)insurers, insurance brokers, and investment bankers. Professional services firms and regulators with an interest in learning more about where insurance meets derivatives and where both meet the theory and practice of corporate finance should also find some useful material here. Financial institutions, asset managers, collateralized debt obligation (CDO) collateral managers, investors, and others might benefit from getting a bit of the corporate perspective, but only for that reason.

Importantly, this is not a book aimed at financial engineers. This book is based on the MBA course I offer at the University of Chicago’s Graduate School of Business with the same title as the book. That class deliberately gets into nothing concerning issues like cash flow waterfall modeling in CDOs, optimizing attachment points for risk management, term structure modeling, and the like. The reason is that there are other classes at Chicago that do cover those specific areas. My class is intended to be a conceptual and institutional course that connects the theory of corporate finance with the practice of risk management and structured products, and this book has the same broad goals and exclusions as the class.

No prior background in insurance or reinsurance is assumed. Part Two provides you with the basic background to both of those worlds. Some background in basic swaps and options will prove useful, but also is not strictly essential. The critical prerequisite here is a basic fundamental grounding in corporate finance. If you have that, the rest of the material is fairly self-contained.

There are some mildly technical sections and several places where mathematical notation is used extensively. If this bothers you, feel free to read around the equations—you won’t lose out on that much. The math here is not proofs or demonstrations of key points, but is instead included mainly to help clarify certain concepts and ideas. It is, in short, optional.

ACKNOWLEDGMENTS

I have been lucky to have learned so much from those with whom I have worked, and that list has now grown far too long to give everyone the proper thanks they deserve by name. With apologies to those whom I have not listed, I would like to single out a few exceptions.

For their comments on chapters, lengthy conversations, thoughtful feedback, and blunt constructive criticism, I am grateful to Keith Bockus, Stuart Brown, Valerie Butt, Don Chew, Kevin Dages, Greg Ehlinger, Paul Forrester, Ken French, Richard Green, Al Harris, J. B. Heaton, Steve Kaplan, Barb Kavanagh, Andie Kramer, Mort Lane, Alastair Laurie-Walker, Claudio Loderer, Andrea Neves, Paul Palmer, Tom Skwarek, Jeff Summerville, Paul Wöhrmann, and Heinz Zimmermann.

I would also like to thank two different groups of my former students collectively. First, the last two years of students in my Chicago Graduate School of Business MBA class on structured finance and ART have given me good feedback on the manuscript, my lecture notes, and the content of the course and the book, as well as a lot to think about. Reading their term papers has been enjoyable and instructional for me and has made me wish that I could give far more As than I am able to award.

Separately, I have had the great pleasure for several years of working closely with Swiss Re on a seminar that we call “Risk and Capital Management.” We offer this seminar in the United States and in Europe exclusively to Swiss Re clients and Swiss Re personnel, and we cover pretty much the contents of Parts One and Four of this book in a two amazingly full days. The dialogue that occurs between attendees at these events is of the highest quality. I can tell immediately that I am in front of a room full of very senior people who have spent a huge amount of time thinking about this subject and exploring what the market has to offer. I have had a lot of fun playing facilitator in those forums, and I feel like a kid in a candy store in what I learn from them, for which I am obviously grateful.

In that same connection, I am especially grateful to Tom Skwarek, who when he is not busy quoting Shakespeare’s views of risk management is always willing to take the time to help me broaden my understanding of the structured insurance market and to push the boundaries of how theory and practice meet in this world. I keep waiting for the day when he sends me the note that he’s sick of getting my e-mails and tells me to go away, but he hasn’t yet. And for that, I am deeply grateful. I have learned much from our discussions.

A special word of thanks is in order to all of those colleagues who contributed guest essays to this book. As with the prior edition, their contributions make this a vastly more interesting and useful book than if the text were mine alone. Their expertise and knowledge are matched only by their dedication and willingness to contribute.

Finally, a brief personal word of thanks to all the friends and family who have helped me get through this seemingly never-ending project. Although this book is technically a second edition, it has taken far longer to complete than any of my prior works. As a direct result, the entire rest of my life has been thoroughly disrupted and put on hold. I am very blessed to have clients that are willing to go away for a few months and still be there when I resurface, and friends and family who seem to know exactly when to call or stop by as well as when not to do so. I am deeply appreciative to all of you—you know who you are.

Bill Falloon and Pamela van Giessen at John Wiley & Sons, Inc., were patient with me beyond all expectations of reasonableness. I lost count of the number of deadlines that I missed, and I am grateful to both of them for not having a contract put out on my life. Aside from their patience and understanding, it’s also a pleasure to work with people who care more about publishing a good book than just ticking off an item on a production checklist.

Notwithstanding all the help, cooperation, feedback, and comments I have received, the usual disclaimer applies, and I alone am responsible for all remaining errors and omissions. In addition, any opinions I have expressed herein are mine alone and are not necessarily those of any of my clients or any institution with which I am affiliated.

Christopher L. Culp

Chicago, Illinois

November 2005

PART ONE

Integrated Risk and Capital Management

CHAPTER 1

Real and Financial Capital

A firm is essentially a transformation function (held together as a “nexus of contracts”) that takes certain inputs and transforms them into outputs.1 In this transformation process, capital has two altogether distinct conceptual meanings. The first is the traditional notion of capital as a factor of production—some kind of asset that helps a firm transform inputs into widgets. In order to finance the required investments in such capital and to disperse the risks of the firm’s assets among a pool of investors, firms issue securities. These securities are also referred to as capital.

The two concepts are, of course, related—too related, unfortunately, despite representing different sides of the traditional corporate balance sheet. It is precisely this close connection that can lead to a fairly significant amount of confusion, especially when it comes to discussing the relation between risk and capital in a practical capital management exercise such as capital budgeting. A banker, for example, is quite likely to define capital budgeting as the allocation of capital to business units. The role played by risk in that exercise is in computing some risk-adjusted return on capital at risk that serves as the hurdle rate or performance measure for these attributions of risk capital to business risks. A corporate treasurer faced with a capital budgeting problem, by contrast, will more likely faithfully compute the net present values of all projects under consideration in order to decide which ones to pursue as new investments in hard assets. Risk comes into the picture through the weighted average cost of capital—itself a risk-adjusted measure of expected returns—used to discount the future risky cash flows on the investment project.

Neither perspective is wrong per se. In fact, we’ll see in Chapter 5 the conditions under which the two approaches imply the same decision rule for whether to accept a new investment project. Clearly, though, the potential for confusion is enormous. Our sole objective in this introductory chapter is to eliminate those sources of confusion by introducing the concepts of capital in a careful, systematic way—specifically, by considering the relationships of the market values of both real capital and financial capital to the market value of the firm. Not surprisingly, we will conclude that they are equal!

In the process of showing this result, we also accomplish two other objectives. First, we provide a quick review of how corporate securities can be viewed through an “options contract lens.” Second, we develop the notion of an economic balance sheet for a firm—a concept that will be very simplistic in this chapter, but which will play an important role and become increasingly complex as we move forward through Part One and the rest of the book.

REAL CAPITAL AND THE VALUE OF THE FIRM

A real asset is any asset that can be consumed or used directly.2 The ability of people or organizations to consume or use a real asset is what gives that asset its value.3 More colloquially, we sometimes say that real assets have value because we can either eat them, give them to someone else to eat, or use them to produce something edible.

A real capital asset—or just real capital—is a specific type of real asset that contributes to the production of a sequence of goods or services over time. What distinguishes a real capital asset from any other real asset is mainly the time dimension. Real capital is involved in medium- and long-term production, whereas real capital assets are often consumed immediately. A large dump truck is a real capital asset, for example, whereas an apple is a real capital asset intended more for immediate consumption. Other examples of real capital include plants, equipment, patented production processes and technologies, and the like.