Damien Gonot
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Misc

Basis Points

https://en.wikipedia.org/wiki/Basis_point

Laws & Regulation

Howey Test

https://www.investopedia.com/terms/h/howey-test.asp "The Howey Test refers to the U.S. Supreme Court case for determining whether a transaction qualifies as an "investment contract," and therefore would be considered a security and subject to disclosure and registration requirements under the Securities Act of 1933 and the Securities Exchange Act of 1934."

"Under the Howey Test, an investment contract exists if there is an "investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others.""

Financial Markets

https://www.coursera.org/learn/financial-markets-global/home/welcome Class by Robert Shiller from Yale University.

Intro

Basic course on how finance works.

Finance is not about making money. Making things about is often what finance is about.

How we get things done as a society.

Human nature is manipulative. Therefore it needs to be regulated.

Good and Evil

Finance is a technology, can be used for good or evil.

Retire early, become a philanthropist.

Joe McNay Story

A Yale story.

Class of 1954 gave $370,000 to Yale at its 25th anniversary (1979) but asked Joe McNay to invest it for 25 years. Joe McNay invested it in Walmart, Home Depot and some Internet stocks.

In 2004, it was worth $90M, a 24.6%/year return.

VaR & Stress Tests

VaR

VAR = Variance VaR = Value at Risk

1% one-year VaR of $10M => 1% chance that a portfolio will lose $10M in a year

Stress Tests

Method of assessing firms or portfolios. Asks what vulnerabilities there are for various kinds of financial crisis. Usually ordered by a government.

Do they really work?

S&P 500

Used as a benchmark. Very hard to forecast.

Beta

\(\beta\) is a measure of how an individual asset moves when the overall stock market increases or decreases. "If the beta is one, then the asset tends to go up and down one for one in terms of returns with the aggregate market."

In the case of Apple, \(\beta=1.5\).

Market Risk vs Idiosyncratic Risk

Market Risk

Risk of the overall stock market.

Idiosyncratic Risk

Apple-only risk, like death of Steve Jobs.

Distribution and Outliers

Normal Distribution

Also called "bell curve". Found in nature, like for human heights, human IQs… But not in Finance!

Cauchy Distribution

Named after a mathematician.

Fat-tailed distribution.

Central Limit Theorem

Averages of a large number of independent identically distributed shocks (whose variance is finite) are approximately normally distributed. Can fail if the underlying shocks are fat tailed. Can fail if the underlying shocks lose their independence.

Covariance

You have to be looking at low covariance.

If you invest in companies that are too alike (high covariance), the whole portfolio is either going to blow up or succeed.

Risk is determined by covariance.

Can't get rid of the market risk for the whole world (if you invest in a very broad "world" portfolio ETF/mutual fund).

\(\beta_i = \dfrac{\text{Cov}(r_i, r_m)}{\text{Var}(r_m)}\)

Gold is not exactly negative \(\beta\), but if it was, holding some in your portfolio allows it to go up when everything else is going down.

Insurance

Insurance Fundamentals

Shared risk.

Pay a premium to the insurance company.

Risk Pooling

If \(n\) policies, each has independent probability \(p\) of a claim, then the number of claims follows the binomial distribution. The standard deviation of the fraction of policies that result in a claim is \[\sqrt{p(1-p)/n}\]

Law of large numbers: as \(n\) gets large, standard deviation approaches zero.

Principles and Issues

Insurance Milestones

Insurance actually took a long time to develop. Use of technology allowed it to be use for more use cases.

Only starting from the 1600's did it take off well. Life insurance & fire insurance.

1840: insurance salesmen?! Door-to-door. People didn't want insurance back then.

1880's: large cash value.

Issues with Christianity. Insurance seen as gambling/bets.

Insurance is a Local Phenomenon

Regulated for centuries. In the US, insurance is a local phenomenon. No national insurance companies, all state charters.

What protects you if the insurance company goes under? States started insurance guarantee funds. Similar to FDIC for banks.

Insurance for insurance. Usually quite limited.

AIG was bailed out during the 2008 financial crisis. What prevent them to be careless, knowing they can be bailed out?

50 different regulators, one for each state.

Health Insurance

First health insurance: 1694. First US health insurance company: 1850.

Health Maintenance Organization Act of 1973: Required employers with 25 or more employees to offer federally certified HMO (Health Maintenance Organiztion) options. Before, doctors were not incentivized to cure people, as they would earn more money when people were sick.

US Emergency Medical Treatment and Active Labor Act (EMTALA) of 1986: Requires hospitals and ambulance services to provide care to anyone needing emergency treatment. Before, you could probably be treated at the hospital because of their "generosity" but it wasn't mandatory.

US Patient Protection and Affordable Care Act (Obamacare) of 2010: Tries to deal with the selection bias. Penalty for individuals not buying insurance. Penalty for companies not offering insurance for their employees.

Not a great system because uninsured people show up to the Emergency Department and don't get any pre-emptive care.

Disasters

Most people in the world are not insured against earthquake risk.

Haiti Earthquake of 2010: before the incident, there was a movement for Carribean countries to get insured. Haiti got $8M of loss insurance. But the damage was in the billions.

Hurricane Katrina in 2005: city of New Orleans was severely damaged. Insurance wasn't perfect. A lot of policies were for wind damage but not flood damage. Companies have been raising their rates but to global warming fears. People had cancelled their insurance.

Terrorism risk: before 9/11, terrorism wasn't excluded. After 2001, insurers started excluded terrorism risk.

Terrorism Risk Insurance Act of 2002 (TRIA) required insurers to offer terrorism insurance for three years. Gov. agreed to pay 90% of insurance losses > $100B deductible. TRIA keeps getting renewed.

An Alternative to Insurance: Portfolio Management

Managing risk not through purchasing an insurance, but through diversification.

Risk is inherent to investing. If it weren't risky, it wouldn't give you an extra return.

You want to manage your risk by diversifying. Not putting all your eggs in one basket. ^ First appeared in 1874 in a book from Crump about how to invest.

Tolerance to risk can be adjusted by leveraging your portfolio up and down.

You care about the total performance of your portfolio, not individual assets.

Risk Management

Hedge Funds

Hedge funds: investments companies that are not approved for the retail market. Not well known, because they're not allowed to promote themselves. To invest in them, you have to be an accredited investor. => So they're allowed to do sophisticated and dangerous things.

Family office: if you're really rich, you can get a whole team of advisors to manage your family investments. That's who the hedge funds are really for.

In the past, hedge funds have been doing really well, but not in recent years.

Very high management fees.

Regulation

Since 2008/2009, a lot more measure of risks. Especially about the inter-connectedness of businesses/countries together. "Stress tests".

Black Swan event

Kind of what happened in 2008. People thought home prices would never fall.

Not enough data on those big, rare events.

Hedging against labour market risk

Unemployment insurance. Can we do more?

Livelihood/wage insurance. Futuristic idea. When somebody loses their job and have to find another lower paying job, they should be compensated for the difference.

Capital Asset Pricing Model (CAPM)

CAPM asserts that all investors hold their optimal portfolio.

Investment Companies as Providers of Diversification

Different Asset Classes

Equity Premium

US Geometric average stock market return from 1802 to 2012: 6.6% (adjusted for inflation) US Geometrics average short-term gov. return from 1802 to 2021: 2.7%

Equity premium = 6.6%-2.7% = 3.9%

Expected return

\(r_i=r_f+\beta_i(r_m-r_f)\)

Short Sales

Equivalent to negative quantity of an asset. You borrow the security and you sell it. You can do that if you think the price is going to go down.

In a CAPM equilibrium model, everybody has the same ideal portfolio, so in theory there should be no stocks to short.

Calculating the Optimal Portfolio

Not everybody is investing using the CAPM.

Portfolio of a Risky and Riskless Asset

Risky Asset: \(x\) dollars, return \(r_1\)

Riskless Asset: \(1-x\) dollars, return \(r_f\)

Portfolio Expected Value: \(r=xr_1+(1-x)r_f\)

Portfolio Variance: \(x^2Var(r_1)\)

Portfolio Standard Deviation: \(\sigma=|\dfrac{r-r_f}{r_1-r_f}|\sigma(r_1)\)

Portfolio of 2 Risky Assets

Risky Asset 1: \(x\) dollars, return \(r_1\)

Risky Asset 2: \(1-x\) dollars, return \(r_2\)

Portfolio Expected Value: \(r=x_1r_1+(1-x_1)r_2\)

Portfolio Variance: \(x_1^2\text{Var}(r_1)+(1-x_1)^2\text{Var}(r_2)+2x_1(1-x_1)\text{Cov}(r_1, r_2)\)

Efficient Portfolio Frontier

You don't want to be at the bottom of this chart.

You can sacrifice lower standard deviation for higher return.

Gordon Growth Model

\(PV=\dfrac{x}{r-g}=\dfrac{x}{1+r}+\dfrac{x(1+g)}{(1+r)^2}+\dfrac{x(1+g)^2}{(1+r)^3}+\dots\)

Even for declining industries, if the price is lower than the Present Value (underpriced), then it's a good investment.

Financial Innovation

Invention Takes Time

It sometimes take a surprising amount of time to invent stuff that seems obvious once it exists and is widespread.

Innovation

People love probability of a high gain, like lottery tickets. Reframe it so it's appealing.

Limited Liability

Started in New York State in 1811. Divide up an enterprise into shares, and no shareholder is liable for more than they put in. All businesses flocked to New York. Eventually all states passed limited liability laws.

If you're responsible for everything a company does, you won't supply liquidity to them.

Investors overestimate the minuscule probability of loss beyond initial investment. Lottery effect: with limited liability, an investment in a corp. behaves like a "throwaway" item.

Inflation Indexed Debt

Useful when inflation is really high. First one in 1780. Did not appear again in the US until 1997.

Unidad de Fomento

In 1967, Chile was going through hyperinflation. People would immediately cash their paycheque and spend all of it in the store because otherwise by the end of the month it wouldn't be worth anything.

The UF is a form of consumer price index.

"The exchange rate between the UF and the Chilean peso is constantly adjusted for inflation so that the value of the Unidad de Fomento remains almost constant on a daily basis during low inflation."

Real Estate Risk Management Devices

Values of homes go up and down all the time. Home insurance => protects against fire etc… But no insurance to protects the change of value in the home.

If you're shorting the real estate market in the city you live in, you're just protecting yourself against a big price collapse.

Mortgages aren't protected against price decline. Buy a $500,000 home on a $450,000 mortgage, price of the home falls to $400,000, you're $50,000 under water.

There are now Futures and Options contracts on the CME for real estate/single family homes.

Efficient Markets Hypothesis

Term popularized by Eugene Fama.

Forecasting

Random Walk Theory

Karl Pearson in Nature in 1905. "A random walk is a process that changes in such a way that each change is independent of previous changes and totally unforecastable."

Random Walk & AR-1 Models

Random Walk: \(x_t=x_{t-1}+\epsilon_t\) First-order autoregressive (AR-1) Model: \(x_t=100+\rho(x_{t-1}-100)+\epsilon_t\) Mean reverting (to 100), \(-1<\rho<1\). Random walk as approximate implication of unpredictability of returns. Similarity of both random walk and AR-1 to actual stock prices.

Intuition of Efficiency

Starting in the 19th century, information technology started to develop. Man named Reuter who decided stocks markets needed up-to-date information. Started as carrier pigeons. Could send news from London to Paris. The route would take 4-6 hours.

Then came the telegraph. Sped it up even more. Then came the beepers, and then the Internet. So many smart people are trying to the information fast, it must be hard to beat the market.

Given publicly available information, the asset prices should reflect the true underlying value of the assets.

Harry Roberts, 1967:

Buying stocks with low PE ratio has paid off historically for a long time. Probably explained by Psychology, some stocks get ignored and get underpriced because nobody remembers them. Others get overpriced because they're hot.

Price as Present Discounted Value (PDV)

\(P=\dfrac{E}{r-g}\) \(P/E=\dfrac{1}{r-g}\) (Gordon model)

Doubting Efficiency

Efficient markets theory is a half-truth.

Human emotions play a role.

Behaviourial Finance

Connected to Psychology.

Schiller thinks that in Academia, departments are too separated. Prof. don't go to each other's seminars.

People really like to be praised. Are you pleased about being praised for something you didn't do?

As people mature, the desire for praise morphs into a desire for praiseworthiness.

Prospect Theory

by Kahnema and Tversky, originally published in Econometrica in 1979.

Criticized the core theory of Economics: expected utility theory. Expected Utility Theory: everyone has a utility function, which depends on the things that they consume and it represents their happiness. People in a world with no uncertainty will choose how much to buy at the market prices to maximize their utility function. And if there's uncertainty, then people use the probabilities of possible events to calculate the expected utility and the maximized expected utility.

Kahnema and Tversky changes two things from expected utility theory:

People are overly focused on little losses. People will often try to gamble out of losses.

Logical Fallacies

Overconfidence

Most people think they're above average. Companies will hire CEOs from other companies to lead their companies, thinking they could reproduce the other company's success, but really it was all due to luck. People in business are overly influenced by the random successes of themselves or others.

Wishful thinking bias

People overestimate the probability of the things that they identify with and want to see happen. Can happen for sports team or political party/candidate.

Cognitive Dissonance

Mental conflicts that occurs when one learns one's beliefs are wrong. People who pick the wrong investment will forget about the performance of that investment.

Mental Compartments

People don't look at their whole portfolio. People have a "safe" part of their portfolio that they will not risk and a "risky" part of their portfolio that they can have fun with.

Attention Anomalies

You can't pay attention to everything. And some people would look at the stock market every day.

"No arbitrage assumption". No "free money".

Anchoring

A tendency in ambiguous situations to allow one's decisions to be affected by some anchor.

Subjects are unaware of their own anchoring behaviour. Companies know that stock prices are anchored to past values. Also why companies like to do stock splits.

Representativeness Heuristic

People judge things by similarity to familiar types. Experiment: people were shown a woman with a description (sensitive, artistic) and were asked to guess their occupation between sculptress and bank teller. So many people chose scultpress even though there are so many more bank tellers. Tendency to see patterns in what is a really random walk.

Disjunction Effect

Inability to make decisions in advance in anticipation of future information. People don't anticipate their emotions later.

Magical Thinking

First described by B. F. Skinner in 1948, not using humans but pigeons. He fed hungry pigeons a single pellet of food every 15 seconds. Pigeons started doing weird things. They started doing the same thing they did right before the first pellet of food was dropped.

Stock market responses to events may have similar origins.

Quasi-Magical Thinking

Relates to Newcomb's Paradox. People vote. Why do they vote? The probability that the election would be won by 1 vote is very low. So people shouldn't vote. But people DO vote.

Ellen Langer: people bet more on coin not yet tossed. People pay more for lottery tickets in which they choose the number.

Culture and Social Contagion

Collective memory: we all remember the same facts and statistics, so we reach similar decisions.

There's a tendency for us to adopt beliefs of other people. There's a mathematical theory of disease epidemics that can be applied to speculative behaviour.

Moral anchors for the market in the form of human stories.

Antisocial Personality Disorder

== sociopathy Identity: egocentric, self-esteem from personal gain. Self-direction: absence of prosocial internal standards. Lack of empathy, incapacity for intimacy. Manipulative, deceitful, callous, hostile. Irresponsible, impulsive, risk-taking.

Borderline Personality Disorder

Instability of interpersonal relationships and self image. Extremes of overidealization and then devaluation of others. Depressed moods lasting hours to days. Inappropriate intense anger. Frantic efforts to avoid real or imagined abandonment.

Aspects of Psychology Play a Role in Many Economics Institutions

Insurance and loss aversion. Corporate stocks and gambling. Bonds and Money Illusion. Banks and trust. Central banks and Bubbles. Investment banks and framing. Exchanges and sensation seeking. Options and salience.

Savings & Bonds

1982 Savings Account

7.40% interest rate. There used to be ads for savings account all the time. Now not so much with rates <2%.

Federal Funds and Interest Rates

Term = time you have to leave your money in. Shortest-term (overnight) interest rate in the US is virtually 0%. EONIA (European Over Night Index Average) is at a negative rate. About -30bps. bps (basis points) = 1/100th of a percentage point

Why would banks lend money at a negative rate? Because it's costly to store physical cash. Need to hire trucks and armed guards…

Compound Interest

With annual rate \(r\):

Discount Bonds

Bonds typically pay coupons. A discount bond is a bond that carries no coupon. Why would you buy that? Because you can buy it for less than what it would be worth at maturity (conventionally, $100). Term \(T\), Yield to Maturity (YTM) \(r\)

Compounding once a year: \(P=\frac{1}{(1+r)^T}\)

Compounding twice a year: \(P=\frac{1}{(1+\frac{r}{2})^{2T}}\)

Present Discounted Value (PDV)

PDV of a dollar in one year: \(\frac{1}{1+r}\) PDV of a dollar in \(n\) years: \(\frac{1}{(1+r)^n}\) PDV of a stream of payments: \(x_1,...,x_n\)

Conventional Bonds Carry Coupons

Conventional Bond issued at par ($100), coupons every six months. Term is time to maturity.

Compounding once a year: \(P_t=c(\frac{1}{r}-\frac{1}{(1+r)^T}\frac{1}{r})+\frac{100}{(1+r)^T}\)

Compounding twice a year: \(P_t=\frac{c}{2}(\frac{1}{r/2}-\frac{1}{(1+r/2)^{2T}}\frac{1}{r/2})+\frac{100}{(1+r/2)^{2T}}\)

Consol and Annuity Formulas

Consol pays constant quantity \(x\) forever. Growing consol pays \(x(1+g)^{(t-1)}\) in \(t\). Annuity pays \(x\) from time 1 to T.

\(\text{Consol PDV} = \frac{x}{r}\)

\(\text{Growing Consol PDV} = \frac{x}{r-g}\)

\(\text{Annuity PDV} = x\frac{1-1/(1+r)^T}{r}\)

Forward Rates

Forward rates are interest rates that can be taken in advance using the term structure.

\((1+r_2)^2=(1+r_1)(1+f_2)\)

\((1+r_k)^k=(1+r_{k-1})^{k-1}(1+f_k)\)

Inflation

Nominal rate quoted in dollars, real rate quoted market baskets.

Nominal rate usually greater than real rate.

\((1+r_{\text{money}}) = (1+r_{\text{real}})(1+i)\)

\(r_{\text{money}} \approx r_{\text{real}}+i\)

Leverage

If a company or individual borrows money to buy assets, we say that they are leveraging. Leveraging means putting more money into the asset than you have. If you have $100 to invest you could buy $100 of stocks, or you could buy $200 of stocks and borrow $100.

Can be risky. If you bought $100 worth of stock and it falls in value by 50%, you're down to $50 (lost $50). But if you leveraged and borrowed $200 worth of stock and borrowed $100, if it falls by 50% you're wiped out.

Start of the 2008/2009 financial crisis had to do with home buyers in the US borrowing to buy homes. China today is a highly leveraged economy, arousing concerns.

Stock Market Capitalization by Country

Market Capitalization = price per share * number of shares.

US did not invent corporate stock, though the US did invent general limited liability law.

US market cap in 2014 was $26.33T. No other countries come close. Maybe all EU countries in you combine them together.

US households had assets worth $98.3T in 2014. And $14.2T for liabilities. Hence a net worth of $84.1T.

Real estate owned by households is worth $23.7T.

Corporations

"Corporation" comes from the Latin word corpus, meaning body. As if it had a body, as if it's a person. In fact the word person in the law typically includes corporations. Individual = natural person.

Board of Directors

A corporation is governed by a board of directors, elected by the shareholders. Typically, 1 share = 1 vote.

Board of directors then votes on who would be the President. The CEO/President is hired by the board. An employee who reports to the board of directors.

In Germany, firms have two boards of directors. A Supervisory Board and a Management Board.

For-Profit vs Non-Profit

For-profit corporations are owned by the shareholders, equal claim after debts paid, subject to corporate profits tax. Non-profit corporations are not owned by anyone and not subject to corporate profits tax. For-profit corporations have a price per share, non-profits do not.

Shares

The # of shares doesn't matter, it depends on the total # of shares outstanding. Ex: 1,000 shares out of 2,000 shares in the company => 50% ownership.

Companies sometimes go through stock splits, where they break 1 share into 2, or more.

Dividends

A dividend is a distribution of money from the company's earnings to its shareholders.

If the company pays a dividend, the value of the share should go down by the amount of the dividend per share. This happens on the Ex-Dividend Date, which is the date on which you have to be a shareholder of the company to be receiving the dividend.

Common vs Preferred Stock

Common refers to "held in common".

Common stock: dividend at the discretion of the firm, subject to legal restrictions. Preferred stock: specified dividend (which does not grow through time?) does not have to be paid, but firm cannot pay dividend on common stock unless all past preferred stock dividend are paid.

US govt. bought preferred shares in corporations to bail them out in 2008.

Corporate Charter

Basic corporate charter emphasizes that all common shareholders are treated equally. They don't have to pay dividends to them, but if they do, it has to be equal for every share. "Equity" = equality of shareholders. The firm can also repurchase shares. Shareholders elect the board.

Classes of Shares

Companies can have different classes of shares. Examples:

How Do Companies Raise Money?

Need money now to build a new factory, launch a new ad campaign and get profits later. How do you get that money? Four main ways:

Share Repurchase

Reverse of dilution, because the # of shares goes down. The % of the company you own goes up. Alternative way of paying a dividend.

Advantage is the tax treatment of share repurchases. Treated as capital gains tax, not dividend/income tax. Taxes can be postponed until shares are sold.

Price as PDV of Expected Dividends

Efficient markets idea is that the price of a share is the present discounted value (PDV) of its expected future dividends.

Value investing says invest in low P/E.

Why Do Firms Pay Dividends?

Psychological. Some people don't like to dip into the capital and live off dividends and interest. Signalling: proves to the world that you're profitable and won't go bankrupt.

\(DIV_t-DIV_{t-1}=\rho(\tau*EPS_t-DIV_{t-1})\)

\(DIV_t=\rho\tau\sum\limits_{k=0}^{\infty}(1-\rho)^kEPS_{t-k}\)

Kind of "prove" that the efficient markets theory is a half-truth… Even really high net worth investors might behave irrationally (preferring dividends).

Recessions

Recessions are psychological.

Inverted yield curve: when short-term interest rates are above long-term interest rate. Shown statistically that it's a leading indicator of a recession. Might happen because people are pessimistic. In history, central banks often started recessions deliberately when inflation was getting out of control.

"Best" leading indicator of a recession is a drop in the stock market. Bond market isn't as dramatically affected. You only know a recession is happening at that turning point when business plans are cancelled, people are getting laid off etc…

Mortgages

History

From the Latin "mortuus vadium" and French "mort gage". Word mortgage became common in the late 18th century. The verb "to mortgage" means to commit property as collateral for a loan.

Lending dates all the way back to China in the 8th century. There were fines on relatives for failing to pay.

Property law wasn't so developed. Unclear who owned what.

US History

In 1920s, 5-year term loans were common. In the 1930s, there was a decline in nominal home prices and rise in unemployment causing massive defaults. Mortgage lending industry therefore turned to longer-term annuities.

Federal Housing Administration

Established in 1934. Required 15-year loans. Nowadays, mortgages are typically 30-year. Insured the lender against loss. Raised insurance premium from 0.5% to 1.5%.

Size of Mortgages in the USA

$13.2T mortgage debt 48M mortgaged homes 10.9M of these were underwater after the financial crisis

Compared to the Treasury Rate

30-Year Mortgage Rate and 10-Year Treasury Rate are closely linked, though there is a small spread between the two. A mortgage is slightly riskier, hence the slightly higher rate. Plus additional costs of managing the loan.

Kinds of Mortgages

Private Mortgage Insurance (PMI)

Companies, such as MGIC, insurance Fannie & Freddie against losses on their mortgages. Both Fannie & Freddie require that mortgagors buy mortgage insurance if down payment is less than 20%. Controversy: with recent real estate price increases, LTV has declined below 80% for many homeowners still paying for mortgage insurance. The PMIs don't notify them. Looming failure of PMIs, PMI Group Inc. declared bankruptcy in 2011.

Collateralized Mortgage Obligations (CMOs)

A pool of mortgages sold to investors. CMOs divide the cash flow of a mortgage pass-through security into a number of tranches in terms of prepayment risk. Sequential-pay CMOs (first created in 1983): first tranche received first principal payments, after is is paid off the second tranche receives principal payments. Allows to get Triple A-rated investments out of mortgages.

Collateralized Debt Obligations (CDOs)

Similar to CMOs but don't need to hold only mortgages, can hold any kind of debt. Hold securities, typically mortgage securities as their assets. Typically subprime mortgages. CDos divide cash flow into a number of tranches in terms of default risk. Created the CDO debt crisis of 2007. Criticism of rating agencies for not downgrading them.

Post-crisis Regulation

In Europe, a mortgage originator must hold 5% of the mortgages they issue. Dodd-Frank copies this idea in the USA, but Qualifying Residential Mortgages (QRMs) are exempt.

Requirements for QRMs (as of 2014)

Commercial Real Estate Vehicles

Limited Partnership

Real estate partnership is an example of a direct participation program (DPP). For accredited investors only. DPPs are "flow-through vehicles", investors report earnings and losses on their personal taxes. Therefore, no corporate profits tax.

General partner runs the business, no limited liability. Must own >1%. Limited partners are passive investors, with limited liability.

REITs

Real Estate Investment Trusts. Created by the US Congress in 1960 to allow small investors access to real estate investments. Flow-through vehicles, REITs don't pay much corporate taxes.

Restrictions
The 3 REIT Booms

Excess Reserves

Many banking crises in history where banks are subjected to a bank run. During a bank run, everybody goes to the bank and demand their money at the same time. Depositors lose faith in the bank, and the bank runs out of money. Banks can't handle this.

Regulators in the US and other countries imposed reserve requirements. Banks have to keep a certain amount of cash in reserve to meet any sudden increase in demand from their depositors.

Excess reserves are the reserves that banks hold beyond what they're required to hold by regulation. Banks typically don't like that as it means they're getting 0% interest. But starting from the Great Recession (2008), central banks cut interest as much as they could (to 0% or even negative). Regulation has also made it more difficult for the banks to make risky loans. Therefore, banks started increasing their excess reserves.

The Real Estate Bubble and Origins of the 2008 Financial Crisis

Overoptimistic mortgage lending. People thought prices will go up forever. Speculative bubble that preceded and led to the financial crisis.

As population is rising, there's a higher need for homes, especially since people like to establish themselves in cities, where there are jobs. But offsetting that is the technology, we can mass produce more and lower the costs of building homes.

Bubbles are social. People talk to each other, reminding themselves of good news and forgetting about bad news. Bubbles could be called "epidemics".

Regulation

Most regulation in the past has been to protect individuals from abuse (microprudential regulation). More recently, there has been macroprudential regulation to prevent big crises affecting the macroeconomy.

Business Wants Regulation

Without regulation, people are forced to do things in a competitive system that they think are bad for society. Analogous to sports, players hate referees when they go against them, but without them they know the game would turn ugly.

Within-firm Regulation

The Board of Directors acts like a regulator. Directors are usually from outside the company, representing a broader community. Usually a part-time job so companies don't put too much burden on them.

Tunneling

Tunneling = tricks people use in companies to steal money from the company

How Tunneling is Achieved
Director's Duties to Prevent Tunneling

Trade Groups

An example of a trade group is the stock exchange (Buttonwood Agreement, 1792). Was basically a collusion that they would not charge lower than 0.25% commission.

The US outlawed fixed commissions in 1975.

Local Government Regulation

In the US, banking regulation belonged to states until the National Banking Act of 1863. In 1934, the US federal government set up the Securities and Exchange Commission (SEC).

Blue Sky Laws

Laws made during the progressive area (1900s-1920s).

National Government Regulation

Local Regulation Failed

SEC was initially viewed as a radical, almost socialist, institution. Peculiar that it started in the US, imitated by other countries.

Goal was to submit standardized forms about what public firms are doing. Need to be easily available. Nowadays it's on the Internet, on SEC.gov's EDGAR.

Public vs Private Securities
Hedge Funds
SEC Rules
Insiders vs Outsiders
Examples of Insider Trading Caught by Market Surveillance

IBM Secretary

Emulex Corporation

Front Running and Decimalization
Financial Accounting Standards Board (FASB)
Earnings Definitions
Brokerage Insurance
Goodbody & Co. Failure, 1970
Securities Investor Protection Corporation (SIPC)
The 2008 Financial Crisis as a Result of Regulatory Failure
Dodd-Frank Act of 2010
European Supervisory Framework of 2010

International Regulation

Bank for International Settlements

"Central bank for central banks"

Basel Committee
G7 Countries

Canada, France, Germany, Italy, Japan, United States, UK

G20 Countries
Financial Stability Board
Final Thoughts

Derivatives

Forwards and Futures

Introduction

Spot market = market for immediate delivery. Forwards and futures market = contracts with future delivery. Different price with different delivery date.

People usually don't really know about derivatives markets. Therefore, there is a public distrust towards derivatives markets.

Forward Contract
FX Forwards and Forward Interest Parity
Forward Rate Agreements

\(\text{Settlement}=\dfrac{(L-R) \times D \times A}{(B \times 100)+L \times D}\)

Futures Contract
Rice Futures

First futures market: Osaka

CBOT Rough Rice Futures (GBX)

2,000 hundredweights (CWT) (~91 metric tons) Deliverable Grade: US No. 2 or better long grain rough rice (with lots of specifics about the quality) Pricing Unit: Cents per hundredweight Tick Size: ½ cent per hundredweight ($10.00 per contract) Contract Months/Symbols: January (F), March (H), May (K), July (N), September (U) & November (X)

Wheat Futures

When a harvest is coming, they dump it on the spot market and the price fall. Just before the harvest, there might be a shortage and it is reflected in the futures price.

Mini-sized Wheat Futures Contract Spec

Contract Size: 1,000 bushels (~27 metric tons) Deliverable Grade: #2 Soft Red Winter or #1 Soft Red Winter at a 3 cent premium Pricing Unit: Cents per bushel Tick Size: 1/8 cent per bushel ($1.25 per contract) Contract Months/Symbols: March (H), May (K), July (N), September (U) & December (Z)

Buying or Selling Futures
Daily Settlement
Example: Farmer in Iowa
Fair Value in Futures Contract

\(P_{future}=P_{spot}(1+r+s)\)

Future price is normally above cash price (contango) (otherwise "backwardation")

Arbitrage Enforcing Fair Value

Oil Futures

Current oil futures prices are in contango (upward sloping). Around fair value because of interest rate and cost of storage.

Nature of Oil Storage

Most stored oil is "moving through the pipeline" (figuratively) of oil tankers, refiners, distributors and retailers. No point in pumping out oil and storing it. In consequence, there's not really a spot price for crude oil. When oil is quoted, it's usually the nearest futures market price.

Pegging of Oil Prices by Texas Railroad Commission

OPEC

First Oil Crisis, 1973-4

Second Oil Crisis, 1979-80

Collapse of OPEC Cartel, 1986

Government Oil Reserves

Persian Gulf War, 1990-91

Second Gulf War Oil Spike

Volatile Oil Prices after 2008 World Financial Crisis

Stock Price Index Futures
Federal Funds Futures Market

Options

An option is a contract. A call option gives the right to buy. A put option gives the right to sell.

History
Why Have Options?

Theoretical Reason

Behaviourial Reason

Options Exchanges
Terms of Options Contract
Moneyness

https://en.wikipedia.org/wiki/Moneyness

In-the-money (ITM)

A call option is in the money if the stock's current market price is higher than the option's strike price.

Out-of-the-money (OTM)

An OTM call option will have a strike price that is higher than the market price of the underlying asset. Alternatively, an OTM put option has a strike price that is lower than the market price of the underlying asset.

Options Value
Call Options

Example of a call option of exercise price $20 on the last day. If the stock is worth less than $20, the option is worthless. But if it's "in the money" on the last day (exercise day) the option is worth the difference between the stock price and the option price. If the stock price is $25, you would definitely exercise because you pay $20 to exercise it and you can sell the stock immediately for $25.

Put Options

For put options, you would only exercise if the stock price is below the exercise price.

Put-Call Parity

Put-Call parity arbitrage:

All those formulas are equivalent, just written differently.

For European options, this formula must hold (up to small deviations due to transaction costs), otherwise there would be arbitrage opportunities.

Options for Hedging

To put a "floor" on one's holding of a stock, one can buy a put option on the same number of shares.

Options Pricing

https://en.wikipedia.org/wiki/Black%E2%80%93Scholes_equation https://en.wikipedia.org/wiki/Feynman%E2%80%93Kac_formula

Cliquet options

https://en.wikipedia.org/wiki/Cliquet_option

Resources
Options, Futures, and Other Derivatives

by John C. Hull

Option Volatility & Pricing: Advanced Trading Strategies and Techniques

by Sheldon Natenberg

The Concepts and Practice of Mathematical Finance

by Mark S. Joshi

Financial Calculus: An Introduction to Derivative Pricing

by Martin Baxter

Stochastic Calculus for Finance I & II

by Steven Shreve

https://en.wikipedia.org/wiki/Delta_neutral
https://en.wikipedia.org/wiki/Greeks_(finance)
https://en.wikipedia.org/wiki/Binomial_options_pricing_model

Investment Banking

They do no accept deposits. They are not members of the Federal Reserve System. Investment banks underwrite securities rather than make loans.

Bulge Bracket Firms

Underwriting of Securities

Two Basic Kinds of Offerings
Underwriting Process
Initial Public Offerings (IPOs)

An initial public offering (IPO) is an offering of shares in a company for the first time publicly. Public shares are shares that are regulated for the general public.

Rating Agencies

An agency that publishes its information publicly. Rating is usually given using letter grades. AAA being the best rating.

History

History

Glass-Steagall Act of 1933

The modern concept of "Investment Bank" was created in the Glass-Steagall act (Banking Act of 1933). Glass Steagall separated commercial banks, investment banks and insurance companies.

Democrats believed that commercial banks securities operations had contributed to the crash of 1929.

Same act created the FDIC.

Repeal of Glass-Steagall Act

Other countries (Germany, Switzerland…) have always allowed universal banking. In the 1990s, regulators nibbled away at the Glass-Steagall Act by allowing commercial banks to engage in certain securities operations. President Clinton in November of 1999 signed the Graham-Leach Bill which rescinded the Glass-Steagall Act of 1933.

Mergers among Commercial Banks, Investment Banks & Insurance Companies
Volcker Rule Goes Into Effect in Oct 2011

Paul Volcker (former Fed chariman) proposes in 2009 that we restore the Glass Steagall Act in the sense that commercial bank to no longer be allowed to own hedge funds or do proprietary trading. Incorporated into Dodd Frank Act Section 619.

Professional Money Managers and their Influence

Assets of US Households (Table B-101)

$101T About a ÂĽ of that is real estate, almost equal are pension funds

Liabilities of US Households (Table B-101)

$14T Most loans are mortgages

Net Worth

$101T-$14T=$87T (per capita: $270k)

Typical household of 4 people is worth >$1M

The Prudent Person

Employment Retirees Income Security Act (ERISA, 1974)

Fiduciaries must act with the care, skill, prudence and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims

Dodd-Frank Act (2010)

Dodd-Frank never refers to the "prudent person" but does refer to "prudential standards" 34 times. The new idea is not to rely on fiduciaries to use their own judgment as to what is prudent, but to impose regulatory standards

Financial Advisors
National Securities Markets Improvement Act (NSMIA, 1996)
Financial Planners

Mutual Funds and ETFs

Mutual Funds History
ETFs vs Mutual Funds

Exchanges, Brokers and Dealers

Brokers

*B*rokers act on behalf of *O*thers as their *A*gent for which they earn a *C*ommission

Dealers

A *D*ealer always acts for *H*imself, in other words as a *P*rincipal in the transaction for which he makes a *M*arkup

Broker-Dealers

Exchanges

The Traditional Four Markets
Limit Order Book

List of buy (bid) and sell (ask) orders, with # of shares and price (to the cent).

High Frequency Trading
Kinds of Orders

Payment for Order Flow

When your broker doesn't send your order to the exchange directly, but to someone else who pays for it. Illegal in Canada, not in the US.

Public Finance

Government Debt and Default

Government Involvement in Corporations

Example of Fukushima Disaster
Bankruptcy Laws Make Govt a Shareholder in All Businesses
Personal Bankruptcy

Municipal Finance

Basic Motivation of Municipal Debt
Deficit Spending
Revenue Bonds

Government Social Insurance

Origins of Social Insurance
Social (Governmental) Insurance

to compensate against job-related hazards

Income Taxes

Failure of First US Income Tax
Withholding of Income Taxes
Survivors Insurance

Conclusion

Nonprofits, Cooperatives, Philanthropy

Nonprofits

Percentage of Workforce in Nonprofits by Country in 2013
  1. Israel 12.7%
  2. Australia 11.5%
  3. Belgium 11.5%
  4. New Zealand 10.6%
  5. United States 10.2%
  6. Japan 10.0%
  7. France 8.9%
  8. Norway 8.2%
  9. Portugal 4.4%
  10. Brazil 3.7%
Nonprofits Give Bonuses Just as For-Profits
Why Set Up a Nonprofit?
Human Impulse to Hoard

Cooperatives

A business that may distribute profits. 1 member = 1 vote.

Alternative Forms

Benefit Corporation
The Future of Philanthropy

Finding Your Purpose in a World of Financial Capitalism

Critics of Modern Finance

Adair Turner, Between Debt and the Devil, Oct 2015

Corporate debt is a kind of "economic pollution" that needs to be taxed

Rana Foroohar, Makers & Takers, May 2016

Democratization of Finance

Finance for the People
Crowdfunding

Investment bankers don't always get innovative ideas. Allows you to get funding directly from the people / potential customers.

Finance and War

There will be Wars & Chaos
Finance Survives Changes in Government, Religion
Of Course, Wars Can Disrupt Finance

Finance and Population Growth

An Essay on the Principle of Population 1st edition in 1798, 6th and last in 1826

by Thomas Malthus (1766-1834)

"That population, when unchecked, goes on doubling itself every 25 years or increases in a geometrical ratio." "In the next 25 years, it is impossible to suppose that the produce could be quadruples. It would be contrary to all our knowledge on the qualities of land." "No possible form of society could prevent the almost constant action of misery upon a great part of mankind, if in a state of inequality, and upon all, if all were equal."

The Importance of Financial Theory

Mathematical Finance
Behavioural Finance

Wealth and Poverty

Your Career and Finance

Desire for Perfect Career
The Next Few Decades
Dramatic Change in Finance, our Economy
Risk and Change over Careers
Human Capital, Positioning and Meaning