Business Organizations and The Stocks and Bonds Markets

Business Organizations and The Stocks and Bonds Markets

The New York Stock Exchange

Floor of the NY Stock Exchange

What is the reality of American business? Three kinds of firms: 1) Proprietorships 2) Partnerships 3) Corporations

Their characteristics: 1. Proprietorships. a. sole owner b. unlimited liability c. includes the “mom and pop” stores and in the old days e.g. Henry Ford, these included some very large businesses, too.

2. Partnerships. a. shared ownership b. unlimited liability (usually) c. difficult to maintain when a partner leaves the firm

3. Corporations. a. fictitious individual b. ownership shared through equity shares c. limited liability: you can’t lose more than your stock

Corporations have advantages in raising capital. They can raise capital in more ways: 1. Sell equity stock (raises capital only on IPO). 2. Retained earnings. 3. Sell corporate bonds.

But the truth: Corporations raise the very largest part of their capital through retained earnings, not from stocks or bonds. Selling stock usually accounts for less than ten percent of the capital U.S. corporations raise for investment.

So what good is the stock market? 1. It backs up the IPOs. (These are the "initial public offerings.") 2. It provides a valuation of the firm. 3. It allows entrepreneurs with hot ideas and relatively little money a chance to capitalize those ideas.

Is there anything bad about the stock market? 1. It has the tendency to become unstable. (For a good read, try a history of the tulip mania "bubble.") 2. For most people, it's just a big casino. (“play the stock market” and you are usually making a mistake.) 3. It is a paradise for con artists. (Ask me my take on Louis Ruckeyser and Wall Street Week)

All said and done is the stock market a reasonably good investment? Generally, yes. Through much of the 20th Century, stocks substantially outperformed bonds—even after accounting for the crashes.

What can economics honestly advise you? There are three useful economic theorems: 1. Best to diversify: “Don’t put all your eggs in one basket.” 2. Hedge your bets: It pays to hold stocks that move in somewhat opposite patterns. 3. The Merton, Black and Scholes theorem to assess risks.

Efficient markets theory: The market rapidly absorbs new economic information and stock prices adjust quickly. Implications: 1) opportunities for abnormal gains disappear immediately. 2) common wisdom cannot yield abnormal gains 3) investment advice on TV is worthless 4) throwing darts will do as well as the “experts”

Why diversification helps: Consider whether and how it helps the student when there are several different kinds grading “opportunities” in a college course. (Most students dislike the one shot test). It lowers your risk—even if it doesn’t necessarily help your grade average. Moral: Don’t put all your eggs in one basket.

Hedging means to take investment steps to reduce the risk in your portfolio. E.g. You buy copper cable stocks hoping fiber optics will develop more slowly than expected—but, you also buy fiber optics, just in case. Why? Offsetting investments can reduce your risk. You never win big, but you gain the market average growth in value without the usual risk.

A real example: Hedging against the yen. Green line: The unhedged fluctuating yen. Red & blue lines: Yen fund hedged here. Notice that hedging dampened the fluctuations.

The usual hedging strategies: Buy both puts and calls in options markets. Go both long and short in the stock. Put options: You buy the right to sell the stock at some future date at an agreed price. Call options: You buy the right to buy the stock at some future date at an agreed price. Going long: Means to hold the stock. Going short: Means to sell stock you don't yet have.

In stock market language: Your portfolio of stocks is both BULLISH and BEARISH about the market at one and the same time.

Merton, Black and Scholes: And the Story of "Limited Capital Investors" Economics as rocket science* (Merton and Scholes won the Nobel Prize in Economics) *They used the same dynamic mathematics that is now used to guide rockets precisely to a target.

Merton and Scholes win the Nobel

How do you make money on call options? If the stock rises higher than the agreed price, we exercise our option to buy and make a profit. If the stock falls lower than the agreed price, we choose not to exercise our option and thus avoid any loss we would have taken had we owned the stock.

To know when to buy an option it helps tremendously to know what the right price to pay for it is. Here is where Merton and Scholes made their ingenious discovery.

Does their discovery improve society? Or, is it just a benefit to stock brokers and players? It benefits society by reducing risk for everyone and it makes the markets more efficient.

The film "The Trillion Dollar Bet" However, the greediness of several dozen people--people who understood the money making potential of this--almost cost the economy a trillion dollars.

Watch for this in the film: Eliminating risk from individual stocks doesn't eliminate the risks from worldwide events: The worldwide financial situation became earthshattering. Asian countries had been doing super well, but suddenly they started to crash. Just when things seemed settled, the Russians suddenly declared that they wouldn't honor their ruble debts.

Russian ruble percipitates a distastrous stock market for Merton and Scholes.

Buying a New Car: Interest, payments and car price. Deals Deal Price Interest rate Monthly Payment Blue Book 17,000 0.07 336 Blue Book w. a gift interest 17,000 0.00 283 “tricky deal” 24,000 0.00 400 Equal deal 18,500 0.03 333 Hidden “deal” 14,850 0.13 339

Risk and Return 1. Greater risk requires a higher return 2. Stocks are riskier than bonds. 3. In the 20th Century, stocks substantially outperformed bonds in terms of return. Reminder: The “return” on an investment is its percentage gain.

Capital investment: What is the true Cost of Capital? The cost of capital: 1. Suppose to might buy a table saw. 2. It would last 10 years. 3. It depreciates by 5% per year—after the 10 years you can sell it but at a substantially lower price. 4. You borrow money to pay for the saw, at 8%. Conclusion: The real cost of this capital for you is 13%, you add the depreciation rate to the interest rate. Problem: What if you paid cash instead?

Capital Investment: When is a capital investment worthwhile? What if you buy some capital that not only cost a price, depreciates, but also yields a money return over a long period of time? (Try college education as an example). You take the yearly return Ri and subtract the yearly costs, ie the depreciation and the interest payments, Ci. Then you select a discount rate: D. (Ri – Ci)/(1 D)t Present value Alternative

Rate of return to education: You select a discount rate: r, so that (Ri – Ci)/(1 r)t Zero