The Stocks and Bonds Markets

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Business Organizations
and
The Stocks and Bonds Markets
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The New York Stock Exchange
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Floor of the NY Stock Exchange
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What is the reality of American business?
Three kinds of firms 1) Proprietorships
2) Partnerships 3) Corporations
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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.
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2. Partnerships. a. shared ownership b.
unlimited liability (usually) c. difficult to
maintain when a partner leaves the
firm
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3. Corporations. a. fictitious individual b.
ownership shared through equity shares
c. limited liability you cant lose
more than your stock
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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.
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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.
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• So what good is the stock market?
• 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.

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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)
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All said and done is the stock market a
reasonably good investment? Generally,
yes. Through much of the 20th Century, stocks
substantially outperformed bondseven after
accounting for the crashes.
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What can economics honestly advise you?
There are three useful economic theorems 1.
Best to diversify Dont 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.
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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
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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 riskeven if it doesnt
necessarily help your grade average. Moral
Dont put all your eggs in one basket.
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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 expectedbut, 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.
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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.
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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.
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In stock market language Your portfolio of
stocks is both BULLISH and BEARISH about the
market at one and the same time.
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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.
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Merton and Scholes win the Nobel
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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.
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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.
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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.
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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.
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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.
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Russian ruble percipitates a distastrous stock
market for Merton and Scholes.
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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
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• Risk and Return
• Greater risk requires a higher return
• Stocks are riskier than bonds.
• In the 20th Century, stocks substantially
  outperformed
• bonds in terms of return.
• Reminder The return on an investment is its
  percentage
• gain.

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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 yearafter
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?
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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)/(1D)t Present value gt Alternative
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Rate of return to education
You select a discount rate r, so that ? (Ri
Ci)/(1r)t Zero