collection of securities, markets, and financial institutions. Although it may appear so, the fi- nancial environment is not chaotic: There is rhyme and reason behind the array of instruments and markets. The central message we want to convey in this chapter is that financial markets and institutions evolve in response to the desires, technolo- gies, and regulatory constraints of the investors in the economy. In fact, we could predict the general shape of the invest- ment environment (if not the design of particular securities) if we knew noth- ing more than these desires, technolo- gies, and constraints. This chapter provides a broad overview of the in- vestment environment. We begin by examining the differences between fi- nancial assets and real assets. We pro- ceed to the three broad sectors of the financial environment: households, businesses, and government. We see how many features of the investment environment are natural responses of profit-seeking firms and individuals to opportunities created by the demands of these sectors, and we examine the driving forces behind financial innovation. Next, we discuss recent trends in fi- nancial markets. Finally, we conclude with a discussion of the relationship between households and the business sector.               2 I. Introduction 1. The Investment Environment The McGraw−Hill Companies, 2001           CHAPTER 1 The Investment Environment 3     1.1 REAL ASSETS VERSUS FINANCIAL ASSETS   The material wealth of a society is determined ultimately by the productive capacity of its economy-the goods and services that can be provided to its members. This productive ca- pacity is a function of the real assets of the economy: the land, buildings, knowledge, and machines that are used to produce goods and the workers whose skills are necessary to use those resources. Together, physical and "human" assets generate the entire spectrum of out- put produced and consumed by the society. In contrast to such real assets are financial assets such as stocks or bonds. These