All right, so this is too hard for you to read, so let’s do this. So, let me just give you a few examples here of the kinds, just so you realize there’s something to the Standard Theory. There’s a lot to it. So, I’m going to give you ten examples very quickly of the Standard Theory. So, these are things that I’m guessing you’ll have, at least some of them, trouble figuring out how to answer now, but by the end of the course, this should be totally obvious to you.
So, suppose you win the lottery, forty million dollars, it’s a hundred million dollars, the lottery. Now, they always give you a choice. Do you want to take five million a year over twenty years or just get forty million dollars right now? Which would you do and how do you think about what to do?
So now, you get tenure at Yale at the age of 50, say. You’re making a hundred fifty thousand dollars a year and you think professors – it’s going to go up with the rate of inflation, and that’s about it for the next twenty years until you retire. So, that’s twenty years of that and then you’re going to live another twenty years when you’re going to be making nothing. So, much of the hundred fifty thousand and let’s say inflation is three percent, and what you’d like to do is consume inflation corrected the same amount every year after you retire and before you retire, and so how much of the hundred fifty thousand should you spend this year and how much should you save? You’ll learn very quickly how to do a problem like that.
Now, President Levin wrote a few months ago, the end of last year if you remember, he said that, “Well, the crisis was bad. Yale was going to weather it, but Yale had lost twenty five percent, probably, of its endowment. That’s five billion dollars almost of the twenty three billion dollar endowment. So, much should he choose to cut? It’s his decision. How much should Yale reduce spending every year? The total spending at Yale is a little over two billion. So, the endowment goes down by five billion what cuts should you take to the budget. Should faculty salaries be cut, be frozen, should you get three TAs instead of four TAs? What should you do? How big a cut should you take? Now, the same question faced Yale in 1996 or so. I’ve forgotten exactly the year. Ten or twelve years ago, the previous president, Benno Schmidt, he suddenly noticed that there was deferred maintenance, as he called it, a billion dollars to fix the Yale buildings. That’s why, incidentally, every year another college gets fixed.
They decided there was deferred maintenance of a billion dollars. A hundred million dollars every year for ten years had to be spent. The whole endowment then was three billion, and now we had a one billion dollar deferred maintenance problem. The budget was about one billion then. So, how much should you cut the Yale budget at that time? So, Benno Schimdt said, “I’m firing fifteen percent of the faculty.” He announced he was firing fifteen percent of the faculty. That was on the front page of the New York Times, “Yale to fire faculty.” Well, did he make the right decision? Rick Levin took over as president three months later, so probably not. What mistake did he make in his calculations? What was the right response? We’re going to talk about it. It’s not that hard a problem.
Now, let’s take a slightly more complicated one. You’re a bookie. The World Series is coming up. The Yankees are playing the Dodgers, let’s say, and you know that the teams are evenly matched and you’ve got a bunch of friends who you know every game will be willing to bet at even odds on either side because they think it’s a tossup. Well, one of your customers comes to you and says, he’s a Yankee fan, he’s sure the Yankees are going to win the series. He’s willing to put up three hundred thousand dollars to bet on the Yankees.
So, if the Yankees win he gets two hundred thousand, but if the Yankees lose, he loses three hundred thousand. So, 3:2 odds he’s willing to bet on the Yankees winning the series. Well, you say, “This guy’s sort of a sucker here. I can take big advantage of him. On the other hand, it’s a lot of money, two hundred thousand I might lose if I have to pay off and the Yankees win.
Finance: Examples of Finance Pt 4
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