the status of the issuer. For example, bonds make stip- ulated interest payments depending only on the solvency of the issuing firm. Dividends paid to stockholders depend as well on the board of directors assessment of the firms financial I. Introduction 1. The Investment Environment The McGraw−Hill Companies, 2001           14 PART I Introduction     position. In contrast, derivative securities yield returns that depend on additional factors pertaining to the prices of other assets. For example, the payoff to stock options depends on the price of the underlying stock. In our mortgage examples, the derivative mortgage- backed securities offer payouts that depend on the original mortgages, which are the prim- itive securities. Much of the innovation in security design may be viewed as the continual creation of new types of derivative securities from the available set of primitive securities. Derivatives have become an integral part of the investment environment. One use of de- rivatives, perhaps the primary use, is to hedge risks. However, derivatives also can be used to take highly speculative positions. Moreover, when complex derivatives are misunder- stood, firms that believe they are hedging might in fact be increasing their exposure to var- ious sources of risk. While occasional large losses attract considerable attention, they are in fact the excep- tion to the more common use of derivatives as risk-management tools. Derivatives will continue to play an important role in portfolio management and the financial system. We will return to this topic later in the text. For the time being, however, we direct you to the primer on derivatives in the nearby box.     CONCEPT C H E C K ☞ QUESTIONS 2 & 3 If you take out a car loan, is the loan a primitive security or a derivative security? Explain how a car loan from a bank creates both financial assets and financial liabilities.     Response to Taxation and Regulation   We have seen that much financial innovation and security creation may be viewed as a nat- ural market response to unfulfilled investor needs. Another driving force behind innovation is the ongoing game played between governments and investors on taxation and