STOCKS & BONDSFOR INDIVIDUALS, GOVERNMENT & CORPORATIONS,
CURRENT EXPENSES OFTEN EXCEED THEIR CURRENT INCOMES / REVENUES . . .
PEOPLE TAKE OUT LOANS TO ATTEND COLLEGE, BUY HOMES, OR START SMALL BUSINESSES . . .
GOVERNMENTS & BIG BUSINESSES NEED MORE CAPITAL FOR LONGER PERIODS THAN ANY BANK CAN PROVIDE
SELL OWNERSHIP: EQUITY IS THE RIGHT TO COLLECT PROFITS. ISSUING STOCK MORE CAPITAL, BUT OWNERSHIP IS DILUTED
» STOCK = EQUITY = OWNERSHIP
» CITIZENSHIP = EQUITY / OWNERSHIP IN GOVERNMENT; KINGS SOLD “SHARES” (DEMOCRATIZED) TO RAISE FUNDS TO FIGHT WARS (16TH TO 18TH CENTURIES)
SELL DEBT: BONDS EXCHANGE FUTURE CAPITAL FOR CURRENT CAPITAL
» IOU: BUY THIS FOR ME NOW, I WILL PAY YOU BACK LATER
STOCKS & BONDSSTOCKS PRICES & BOND YIELDS TEND TO BE
INVERSELY RELATED WHEN STOCKS GO UP, BONDS GO DOWN
STOCKS 10% CHANCE TO WIN $90BONDS 90% CHANCE TO WIN $10
BONDS = “SAFE HAVEN” WHEN ECONOMIC CONDITIONS WORSEN & GROWTH PROSPECTS FOR FIRMS LOOKS DIM
STOCKS = “GROWTH OPPORTUNITY” PREFERRED WHEN COMPANIES EXPAND THEIR MARKET OR PRODUCTS
RATIONAL COMPANIES SHOULD ISSUE STOCKS WHEN THE ECONOMY RISES & BONDS WHEN IT FALLS . . . BUT TEND TO BE PRO-CYCLICAL, NOT COUNTER-CYCLICAL IN FINANCING
BONDSBOND: PROMISE TO PAY A CERTAIN AMOUNT AT A
FIXED POINT IN THE FUTURE – A POST-DATED CHECK
GOVERNMENTS / CORPORATIONS AUCTION BONDS TO THE HIGHEST BIDDER
– LOAN: PRICE = PRINCIPLE + INTEREST RATE– BOND: PRICE = PAR VALUE – YIELD
BONDS ARE SUPERIOR TO LOANS BECAUSE :1) DEBT SOLD TO MANY DIFFERENT BUYERS (WAR BONDS)
2) THEY CAN BE BOUGHT & SOLD CONTINUOUSLY – PRICES RISE & YIELDS DECLINE AS BOND MATURES
PRICING A BOND
ISSUER CREDIBILITY: CAN & WILL THE ISSUER OF THE BOND MAKE GOOD ON THEIR PROMISE?
• AGENCIES GRADE BONDS FROM “AAA” – HIGHLY RELIABLE – TO “D” – DEFAULT OR “JUNK BONDS” / SIMILAR TO CREDIT SCORES
• TIME HORIZON – UNLIKE INDIVIDUALS, GOVERNMENTS / CORPORATIONS CAN “ROLL OVER” DEBT IN PERPETUITY
• SAFEST = US SHORT –TERM TREASURY BOND• LOWER CREDIBILITY LOWER PRICE HIGHER YIELD
INTEREST RATE: HOW DO BONDS COMPARE TO OTHER “SAFE” INVESTMENTS?
• BOND YIELD > INTEREST RATE BETTER TO BUY BONDS• AS INTEREST RATES INCREASE, YIELDS SHOULD INCREASE,
DECREASING BOND PRICES
TIME TO MATURITY:• BOND YIELDS NORMALLY DECREASE AS THEY APPROACH MATURITY• COUPONS – SOME BONDS INCLUDE “COUPONS” THAT BEARERS CAN
REDEEM FOR MONEY BEFORE MATURITY
BONDS, SECURITIES & SUB-PRIMEBONDS = FIXED INCOME SECURITY BOND OWNER ENTITLED TO
INCOME “SECURED” BY THE ISSUER’S COLLATERAL– GOVERNMENT BONDS TAX REVENUES – CORPORATE BONDS CORPORATE ASSETS– MORTGAGE BACKED SECURITIES MORTGAGE PAYMENTS
FANNIE MAE & FREDDIE MAC CREATED TO “SECURITIZE” MORTGAGES INTO COLLATERALIZED DEBT OBLIGATIONS (CDOs) OR MORTGAGE BACKED SECURITIES (MBS)
ISSUER CREDIBILITY RATING AGENCIES OVERRATED CDOs & MBS AS “AAA” SECURITIES
INTEREST RATE RATES LOW AFTER 9/11, BUT INCREASED AFTERWARD INCREASED YIELDS & REDUCED PRICES
TIME TO MATURITY MBS “SLICED & DICED” INTO TRANCHES (COUPONS) BY MATURITY / RISK & SOLD TO DIFFERENT BUYERS
***SUB-PRIME / JUNK BONDS – SECURE SPECULATIVE***
NEWTONIAN & BROWNIAN MOTIONNEWTONIANDETERMINISTICUNIVERSALITYGENERALITY
F = M x A
CLOCKSMACHINES
RISK ------
BONDS
BROWNIANPROBABILISTIC
RELATIVITYUNIQUENESS
E = MC2
CLOUDS DNA
SNOWFLAKES
UNCERTAINTY -----
STOCKS
STOCKS & BEAUTY CONTESTSSTOCK MARKET = BETS ON PUBLIC OPINION’S GUESS
WHAT THE MAJORITY WILL CHOOSE TO WIN A BEAUTY CONTEST
YOU WIN IF . . .
1) YOU BET 2) WHAT THE MAJORITY BELIEVED 3) WHAT THE MAJORITY WOULD PICK 4) AS THE WINNER OF A SUBJECTIVE CONTEST
. . . BUT THE PRICE OF THE BET INCREASES AS MORE PEOPLE MAKE THE SAME BET AS YOU
Ex. BOARD GAME: APPLES TO APPLES
STOCKS & RANDOM WALKSFOR EVERY STOCK BOUGHT, ONE MUST BE SOLD . . .
STOCK PRICE = HALF THINK THE PRICE WILL INCREASE & HALF DECREASE RANDOM COIN FLIP
THEREFORE, STOCK PRICES MOVEMENTS IN A FAIR, COMPETITIVE ARE RANDOM OR UNSYSTEMATIC “NOISE”
EXPECTED VALUE OF A STOCK MARKET TRANSACTION = ZEROHALF WIN / HALF LOSE
IMPLICATIONS: – ONLY BROKERS (TRANSACTION FEES) & INSIDERS (CHEATERS)
CAN PROFIT OVER THE LONG RUN; STOCK MARKET = CASINO – A MONKEY THROWING DARTS WILL DO BETTER THAN ANY
EXPERT INVESTMENT STRATEGY (BEGINNER’S LUCK)– PAST NO INDICATOR OF FUTURE SUCCESS; PICKING LOSERS >
PICKING WINNERS
BEATING THE STOCK MARKETFAIR, COMPETITIVE MARKETS NO PROFIT . . .
. . . SO HOW DO PEOPLE MAKE MONEY ON WALL STREET?
MONOPOLY / PSYCHOLOGY / INSIDE-INFORMATION / LEVERAGE / RENT-SEEKING / MATHEMATICS / DIVERSIFICATION
– MONOPOLY – INSTITUTIONAL INVESTORS – HEDGE FUNDS, MUTUAL FUNDS & INVESTMENT BANKS – HAVE MARKET POWER PRICE MAKERS
– LEVERAGE – MATHEMATICS IDENTIFIES MARKET FRICTIONS & PROVIDES PRECISE PROBABILITIES EXPLOIT BY LEVERAGE
– INTERPERSONAL / INTRAPERSONAL PSYCHOLOGY – READ “HERD” PSYCHOLOGY & CONTROL “ANIMAL SPIRITS”
“VALUE INVESTING”
– PROPRIETARY RESEARCH & STRATEGIES: MARKET RESEARCH & SECRET STRATEGIES
– DIVERSIFICATION: BET ON MANY DIFFERENT COIN FLIPS SIMULTANEOUSLY
OPTIONS & FUTURESONE CAN TRADE THE RIGHT TO BUY OR SELL STOCKS,
BONDS, OR COMMODITIES CALLED OPTIONS CALL OPTION: BUY THE RIGHT, BUT NOT THE OBLIGATION, TO PURCHASE AN ASSET AT A CERTAIN PRICE ABOVE PREVAILING PRICE PROFIT: IF ASSET RISES ABOVE “STRIKE PRICE,” BUYER POCKETS THE DIFFERENCE, OTHERWISE, LETS OPTION EXPIRE. “BULLISH”PUT OPTION: BUY THE RIGHT, BUT NOT THE OBLIGATION, TO SELL AN ASSET AT A CERTAIN PRICE BELOW THE PREVAILING PRICEPROFIT: IF ASSET FALLS BELOW “STRIKE PRICE,” BUYER POCKETS THE DIFFERENCE, OTHERWISE, LETS OPTION EXPIRE “BEARISH”