Finance: Logistics Pt 1

Now, the prerequisites of the course, so I want to make this clear, you don’t really need ECON 115. It would be helpful because this logic of the free market being good or bad, that was already started in ECON 115. That’s what they call it now, right? It’s still called 115. I used to teach it but I haven’t done it for years.

So, anyway, what you really need is mathematical self-confidence. It’s not going to be high math. It’s going to be simple math, but it’s relentless over and over again. And I can tell you that every year, there’s the five percent of you, five or ten out of the hundred twenty are going to just get bored doing problem after problem and you’re probably not that, you know, those ten maybe haven’t much experience doing it, don’t feel very confident doing it, stop coming to the class and then really have no idea what’s going on.

My sister is probably much smarter than I am, but she doesn’t like math. She wouldn’t take this course. So, if you’re not confident doing little mathematical problems just don’t take the course. You’ll save yourself a lot of trouble. I don’t know how to say this any better. I want to warn you not to do it. It’s easy month, but it never stops. Every week, there’s going to be a problem set. The exam – there are problem sets. The exam is doing problems just like the problem sets, but if you don’t like that, you know, to me finance is a quantitative subject. What’s so beautiful about it one aspect I really like is that you have these complicated different things you have to weigh, but at the end you have to come up with one number. What is the price you’re willing to pay for something? It’s very concrete.

I’m going to take advantage of the concreteness by turning every question into a number. I hate it when you get on the one hand and on the other hand. It’s a number. So, if you don’t like numbers, it’s not a good course to take. So, what are the kinds of things you have to know? You have to understand the distributive law of arithmetic which, I have little kids and I see that’s not easy to understand. Anyway, and then you have to understand the idea of a function which is a contingent plan, simultaneous equations; that’s what we do for equilibrium in arbitrage.

Taking a derivative, that’s marginal utility, the idea of diminishing marginal utility, a concave function that looks like that. That’s risk aversion. Bankers invented the logarithm, compound interest, so you have to know what taking a logarithm and exponential means, and you have to understand how to take probability weighted averages of things. And we’re going to use Excel for a lot of the problems which we’ll teach you. By the end of a day, you’ll be better at it than I am.

So, my office hours are four to six. My secretary assistant is Rendé, there’s an accent missing as she always tells me, Wilson. She just started three ago but I’m sure she’ll be great. There are going to be two lectures a week and a TA session. So, every Tuesday there’ll be a problem set starting this Tuesday due the next Tuesday. There will be two midterms. There’s a lot of stuff to learn and so I found, everything I think agrees who’s taken the course. If you take the midterm, it’ll focus your mind and make it a lot easier, so I give two of them so you only have half the course to study. It makes the final much easier to study for. I recognize that some of you will have problems on one of them, like especially the first midterm, and if you do vastly worse on one exam than the rest I’ll tend to ignore that, but most people don’t, by the way, do vastly worse on one exam than the rest.

So, the final’s forty, the problem set’s twenty and the two midterms are twenty percent. Tuesday to Thursday, and so all the TA sessions are Thursday to Monday so they’re going to start next Thursday. So, you see the classes are Tuesday – Thursday then the next Tuesday. There’s a long time in between here so all the TA sessions will meet there. So, they’re at the same moment in the class.

There are all these textbooks, all by the Nobel Prize winners, all by those financial greats. You can buy any one of them, but I have my own lecture notes because as I say I teach a slightly unconventional course and there’s a huge list of books on the crisis. Some of them are incredibly interesting and fun and so they’re all on the reading list you can take a look at. I mean, there’s never been a more fun time to read this stuff now.

Finance: Logistics Pt 1

Global Economic Outlook Pt 1

Okay, I think we can start. It’s my great pleasure to moderate this very, very important session which I have done for a number of years and I have always enjoyed enormously.  Whether the panellists have enjoyed as much as I have done is of course an open question. Maybe that’s why I’ve invited them backs.

The issues that are in front of us are of enormous interest and importance.  Before I introduce the panellists, not that I think they need much introduction, I will just say very briefly where I think of what my sense of worth of where we are in this World Economic Forum and the issues we will have to address, thinking about 2012, what might happen to the economy and the big policy questions.  The agenda is very long.  We will do our best to cover it and we will certainly leave some time for questions and answers.

My sense of the mood in Davos is that people are feeling relief in the way that somebody would just be reprieved from hanging fields of relief.  That instead of facing the imminent prospects of catastrophe, there is a sense that things have been done which have eliminated, very substantially, the immediate risk of disaster particularly in Europe, particularly because of the activities of the European Central Bank but not exclusively so and that therefore we can start thinking about the slightly longer term which is at least a few months and perhaps even longer but at the same time as the IMF reminded us this week, the prospects for this year  look pretty bad, they have downgraded global growths and developed country growth in particular very significantly, if I remember correctly down to 3.3 percent and with the Euro Zone now expected to be in recession.

So the long story of difficulty particularly in the developed world,  which is now following a financial crisis but again 4 and a half years ago, remember how long  we have been in this and nobody can say that we are through it so this is..we’re not even clear that we’re through the halfway.  This is an incredibly long process we’ve been in  with the current crisis a now increasing concern of course about sovereign debt quite particularly in the Euro Zone where the crisis have been very, very extreme.

But that’s one part, the downgrading of growth as a result of what I think Madame Legarde  has referred to as  self-inflicted wounds by the developed countries and we all know what she is referring to.  At the same time, I would just like to remind  you one or two statistics, the developments in the rest of the world,  the bubble in the emerging world have been quite  staggering.  If you go back to the Sept or October 2011 World Economic Outlook and you look at the IMF’s forecast of 2012 and converted this  back to a 2007 base,  so that’s when the world economy was just moving  into crisis and what has happened to the economies of the world as the IMF forecast for 2007 and 2012, you will discover that according to the IMF’s forecast, over that period, China’s economy will expand by 60%.  The Asian developing and emerging countries, which is, I would remind you, half of the world’s population, will expand by 50%.  The emerging world well over by 35% and the developed world by essentially 0.

So this five years have seen the most  extraordinary and unprecedented speed of transformation of a relative weight  of countries.  In addition to this great deliveraging, there is this great convergence.  These two processes are shaping our world.  So with that little introduction, let me just introduce you to the panellists starting on the far left is Robert Zoellick, President of the World Bank Group.  The World Bank has been a frequent member of this panel.  Next to him is Governor Mark Carney of the Bank of Canada who is also now Chairman of the Financial Stability Board  responsible for the regulation of financial systems.  Next to him is Deputy Prime Minister Ali Babacan  who is of course responsible for the economic policy in Turkey for a long time.  Next to him is Christine Lagarde  who has been previously on this panel as Finance Minister of France, of course she is now the Managing Director of the International Monetary Fund.  Next to her is Mr. Donald Tsang, Chief Executive of Hongkong.   Next to him George Osborne, Chancellor of the UK and finally Minister Furukawa who is Minister for National Economic Policy  of Japan.

For some reason I cannot even begin to imagine  there is no representative from the Euro Zone government on this panel and I certainly don’t take it personally.  So I am going to start off then with you Christine Lagarde if you could set out how you and the Fund now see the world and how concerned you remain despite some of the things, the improvement in terms about the world economy in 2012 and the issues that confront us.

Davos 2012 – Global Economic Outlook Pt 1

Finance: Examples of Finance Pt 3

So, I want to give you my money, a billion dollars, I want to get these superior returns you seem to earn, but you have to guarantee that you don’t lose me a penny. I don’t want any risk. I want a principal guarantee that when I give you a hundreds dollars, you’ll always return my hundred dollars and hopefully much more, but never less than a hundred dollars.” So, is there any way to do that?

You know that you’ve got a great strategy, but of course it’s risky. You could lose money. You’ve lost money a bunch of times before. So, how can you guarantee the guy that he’ll get all his money back and still have room to run your strategy? Well, it sounds like you can’t do it, but of course a lot of people want to invest that way, so there must be a way to do. So, you’ll figure out – we’ll learn how to do that.

So, three more short ones. A scientist discovers a potential cure for AIDS. If it works, he’s going to make a fortune. He started a company. He’s a Yale scientist, he’s – medical school, started this startup company. Yale, of course, is going to take all his profits, but anyway it’s his startup company and if his thing really works, he’s going to make a fortune. If it doesn’t work, it’s going to be totally zero. You calculate, and let’s say you believe your calculation, that the expected profits that he’ll make if it works, the probability of it working times the profit, that expected profit is equal to the profits of all of General Electric.

Should his company be worth more than General Electric, the same as General Electric, or less than General Electric since it’s got the same expected profits? Well, I can tell you the answer to this one because I think most of you would think, first you’d think, “Well, maybe the same.” Then you’d say, “Well, this AIDS thing, it’s so risky. It’s either going to be away up here or nothing. And that’s so risky, and General Electric is so solid, probably General Electric is worth more.” But the answer is the AIDS Company is worth more. So, how could that be?

So, another question, suppose you believed in this efficient market stud and you rank all the stocks at the end of this year from top to bottom of which stock had the highest return over the year. It’s 2010, let’s say 2010, this year’s a weird year. So, let’s say you do it in 2010. All the stocks the highest return to the lowest return. Now, suppose you did the same thing in 2011 with the same stocks? Would you expect to get the same order, or the reverse order, or random order? Now again, if you believe in efficient markets and the market’s really functioning the prices are fair and all, I’ll bet most of you will say, you won’t know, but you might say it should be random the next time because firms only did better or worse by luck, but that’s not right either. So, you’re going to know how to answer that question by the end of the class.

One last one, the Yale endowment over the last fifteen years has gotten something like a fifteen percent annualized return. A hedge fund, that I won’t name, has gotten eleven percent over the last fifteen years counting all its losses and stuff like that. So, is it obvious that the Yale endowment has done better than the hedge fund? Would you say that the Yale manager is better than the hedge fund manager? Its return was fifteen percent. The hedge fund only got eleven percent. So, I’m asking the question, and I would say that David Swensen would think about it the same way I think about it.

So, suppose I even told you that the Yale hedge fund had lower volatility – the Yale hedge fund? – the Yale endowment had lower volatility than the hedge fund, which it surely does, would that convince you now that the Yale endowment made been managed better than the hedge fund? Well, we’re going to answer this question again, and you’re going to see that the answer’s a little surprising. It won’t be so surprising – I wouldn’t have brought it up otherwise. But anyway, that’s the kind of thing that in finance you’re taught to think about.

Finance: Examples of Finance Pt 3 

Intro to Chemical Engineering Lecture Pt. 6

Some may go as high as a quarter million barrels a day.  One refinery up in Venetia, where the ships come in and unload directly into the refinery and they process it.  They don’t even have storage for it.  Can you imagine running a business like that when the boat doesn’t come in? Or it hits something.  You are in bad shape.  But things like that don’t happen very often.  So they make gasoline, jet fuel and monomers.  So where does all the jet fuel from San Francisco airport comes from?  It comes from these refineries but you don’t see trucks coming in.  There are pipelines that go under the bay that carry jet fuel from the refinery directly to the airport, puts into underground tanks and the jets are fueled.  Jet fuel is really nothing more than kerosene basically; it has a certain boiling fraction of crude oil.  That means it boils at a certain temperature and jet engines are designed to accept that certain kind of fuel.

We can also make monomers and monomers are basically small molecules, say like ethylene and if you start attaching them to one another and many ethylene molecules together, what do you think you get?  Polyethylene.  You don’t get the bottles right away but you get the polyethylene which you then cast or mold or blow mold into bottles, milk cartons or whatever.

If I take polyethylene which is nothing but carbon, carbon, carbon with hydrogen hanging from them, then replace every other hydrogen with a chlorine atom.  I’ll get polyvinyl chloride.  If I replace everyone with a benzene ring, I get styrene.  If I replace all the hydrogens with fluorine, I get Teflon.  So it is kind of cool, isn’t it?  I mean this is how you get all the things you hear about all come from these monomers which get attached to each other like chains or railroad in a railroad car.  And polyethylene is up there.  Cute.  I can see now why.  (Laughter)

So silicon crystals, you probably don’t realize that Intel — who do you think Intel hires?  What kind of disciplines?  EEs, wrong.  There are more Chemical Engineers working at Intel than there are EEs.  In fact, Andy Grove was a classmate of mine and he was the president of Intel for many years.  Why on earth did I not go with him?  He’s living up here, big house.  I live down here, in a drain gutter.  I mean it is so awful.  But Andy Grove understood things like diffusion, reaction and chemistry and was able to help develop the technologies to grow very large, up to now 12-inch pure silicon crystals that are then cut into wafers under which you impress the architecture that results in the transistors that are basically collected together.  That of course, the EEs don’t make.  The EEs, if you will, are sort of the architect of what’s getting imprinted.  The Chemical Engineer provides the framework on which these can be drawn and does the cooking.  In other words, these things have to doped, and they have to be chemically reacted in order to get a chipset out of it.

Inorganic materials which are basically non-carbon containing materials result in such things as ceramics, and other raw materials such as glucose or sugars can be converted through biological means using microorganisms into things like pharmaceuticals and fine chemicals.  This is becoming a very, very huge industry particularly since Recom and DNA happened in the early 1970s where we now have control over the genome and we can take microorganisms that are surviving out there and the dirt and we can coax them to into making chemicals that otherwise, they wouldn’t have made because they just didn’t evolve to make those things, but we can use them as basically little engines, little machines and we can grow trillions and trillions of them in a test tube, you can generate a lot of production capacity.

Many of our students now go into besides refining or petrochemicals which is polymers production, which is still a very robust industry is protecting and improving the environment.  One, after you destroy the environment, and then you come and fix it up.  So there are two things that you do want to know.  The first thing is don’t destroy in the first place, but if you happen to, chemical engineers are very much involved in what is called remediation. One of the things that we have real problems with is that people have, over the years, sort of hawked down on the ground or punch a hole in the ground and they dump everything in it that they don’t want and lo and behold, it gets mixed up in the groundwater.

Introduction to Chemical Engineering Lecture Pt. 6
chemical engineering expert witness

Finance: Why Study Finance???

So, the crisis of 2007, which we’re going to spend a longtime talking about, I just want to get back to that subject. So, that list of questions were the kinds of things that I used to teach for years before I was confident about my theory of crises, and this is the kind of questions you have to face all the time in hedge funds, and decisions you have to make and things you have to tell investors, and so that’s the basic part of the course, but I want to say more.

So, I want to talk about the crisis of 2007-2009. It started as a mortgage crisis. Now, how could it be that everything goes wrong in mortgages? I mean, they’re four thousand years old. The Babylonians invented mortgages.

What is a mortgage? You lend somebody money. They put up collateral. They don’t pay, you take the house or you take the guys life, he’s a slave or something, but it’s the same thing. You borrow money and the guy promises you can confiscate something if he doesn’t pay. Four thousand years and we screwed it up. How could that be? And why should a screw up in the mortgage market have such a big effect on the rest of the economy? Were a sub-prime mortgages a terrible idea? Was there some logic to it?  And how did we get out of the crisis?

How is it that everybody was saying this is the worst crisis since the Depression, maybe another Depression and things seem to have turned around. What is it that we did to get things to turn around? I don’t think we’re out of it yet, but things are a lot better than they were a year ago. So, what is it that the government did to turn things around? It didn’t do nearly enough, I think, but it did something. What exactly did it do?

Now, Shiller would talk about the whole thing was irrational exuberance. I’m going to say it’s all the leverage cycle, but anyway so that’s the mortgage crisis. Now, are free markets good? I want to talk about the argument.

The argument was first made by Adam Smith about the invisible hand. The modern mathematical argument is Ken Arrow’s, my thesis adviser. And of course, everybody knows that monopoly and pollution and things like that interfere with the free market and they have to be regulated. But, the financial markets, there’s no monopoly. As long as there’s no monopoly and there’s no pollution should the free market function there? So, I want to go over that argument and show you what was missing in it, as I said before.

And then lastly, we’re going to talk about Social Security and how could that system be going bankrupt. I mean, it just seem shocking. There’s a two trillion dollar trust fund that’s going to run out in 2024 or something and after that the system will be broke. So, how did it happen? Why is it broke? What can we do to fix it? So, George Bush said, “Well, it’s terrible. Even if we manage to sort of get the trust fund rehabilitated, young people like you are going to get a two percent rate of return. If you put your money in the stock market even allowing for the last crash, over the long haul, the returns have been six percent. So, it’s terrible Social Security. Something’s wrong with the system. We should privatize it and let young people like you put your money in stocks instead.”

Well, Gore, in the debate in 2000 said, “You can’t do that because then the old people who are expecting their money can’t get paid.” And both of them agreed that it was all the baby-boomers’ fault. People like me, we’re getting old, we’re going to retire. That’s why the system’s going to get broke. So, that’s the conventional wisdom. All three of those things are wrong, so we’re going to find out why.

So in summary, why study finance? It’s to understand the financial system, which is really part of the economic system. It’s to make informed choices. Is privatizing Social Security a good or bad thing? Is regulation of financial markets a good thing? The language that you learn is the language that’s spoken on Wall Street, and was created by professors and yet practitioners use it. For me, it’s incredibly fun, all these little puzzles. As J.P. Morgan said, “Money’s just a way of keeping score.” You have to figure out what something’s worth in the end and if you get it right, you’ve solved the puzzle right and it’ll help you make good financial decision in a pensioned career. That’s the standard reason to take Finance as a course.

Finance: Why Study Finance???

Finance: Examples of Finance Pt 2

The fact is it’s such a big number I’m a little worried about that.” So, what do you do? So, what can you do? You’ve got these friends who are willing to bet at even odds. Each game by game, so how much money – presumably the first night you’re going to bet with one of your friends. You take the guy’s bet, the customer, you take his three hundred thousand. You promise to deliver him five hundred back if the Yankees win and to keep it if the Yankees lose. What should you do with your friends? Should you bet on the Yankees with your friends?

Should you bet on the Dodgers with your friends and how much should you bet at even odds the first night? So, the answer is, well, I don’t want to give all the answers now, but so there’s a way of skillfully betting with your friends and not betting two hundred or three hundred thousand the first night with your friends at even odds. You bet some different number than that, which you’ll figure out how much to bet so that if you keep betting through the course of the World Series, you can never lose a penny. How do you know how much that is? Well, that’s the kind of clever thing that these finance guys developed and you’re going to know how to do.

So, let’s do another example like that. I’m running out of time a little bit, but an example. Suppose there’s a deck of cards, twenty six red and twenty six black cards. Somebody offers to play a game with you. They say, “If you want to pick a card and it’s black, I’ll give you a dollar. If it’s red, you give me a dollar.” So, if I’m picking, I’m in the black, I get a dollar, it’s in the red I lose dollar, I have to throw away the card after I pick it. The guy says, “By the way, you can quit whenever you want.” So, should you pick the first card? It looks like an even chance of winning or losing.

Let’s say you pick the first card, it’s black, you win a dollar. Now, the guy says, “Do you want to do it again?” You picked a black one so there’s twenty six red left and twenty five black. So now, the deck is stacked against you. Should you pick another card?  Well, it doesn’t sound like you should pick another card. But, you should pick another card and I can even tell you how many cards to pick. Even if you keep getting blacks, you should keep picking and picking. So, how could that be? It sounds kind of shocking. Well, it’s going to turn out to be very simple for you to solve halfway to the course.

So, a more basic question. There are thirty year mortgage now you can get over for five and three quarter percent interest. There are fifteen year mortgages you can get for less, like five point three percent interest. One’s lower than the other. Should you take the fifteen year mortgage or the thirty year mortgage? How do you even think about that? Why do they offer one at a lower price than the other?

One more example, suppose you’re a bank and you hold a bunch of mortgages. That means the people in the houses, you’ve lent them the money and they’re promising to pay you back. And you value all those mortgages at a hundred million dollars. The interest rates go down. The government lowers the interest rates. Half of them take advantage to refinance. They pay you back what they owe and they refinance into a new mortgage. So now, you’ve only got half the people left. Let’s say all the people had the same mortgage and everything. Half the people are left.

That shrunken pool, half as big as the original pool, is that worth fifty million, half of what it was before or more than fifty million or less than fifty million? How would you decide that? Again, this is a question which might be a little puzzling now, but actually you should be able to get the sign of that today even, and we’ll start to analyze it. So, that’s what mortgage traders have to do. They see interest rates went down. A bunch of people acted. The people who are left in the pool are different from the people who started in the pool. Now, we’ve got to revalue everything and rethink it all, so how should we do that?

Let’s say you run a hedge fund and some investor comes to you and says, “Oh, things are terrible. Look at all the money you lost for me last year. I know you’re doing great this year and you’ve made it all back that you lost last year, but I don’t want to run that risk.

Finance: Examples of Finance Pt 2

Finance: An Experiment Of The Financial Market Pt 1

When does this end, ten of or quarter of?

Ten of.

Ten of, so we have 13 minutes. I want to end with one experiment. I want to end with one experiment. So, this is something we’re not going to have time to figure out the answer to. So, I need sixteen volunteers. How about the first two rows? Why don’t you just volunteer. You’ll survive and I know it’s a drag but you’ll do it.

What I’m going to do now is I’m going to run an auction. So, please stand up and eight of you go on this side and eight come over here. That’s okay, you’ll be okay. I know everyone is reluctant to do this. So, I only need sixteen, TA, help me count them. Two, four, six, eight, you guys have to come the other way. The TAs aren’t going to participate. You’re not in this, right?

No.

Two, four, six, eight, so we only need eight, you both sat down. So, would you like to participate? Come on. We could use another woman here. So, can you mix these up? There are going to be eight sellers and eight buyers. So, shuffle them up and hand on to each.

So, we’ve got eight, and these are the football, they’re selling. So, we’ve got eight sellers and eight buyers, and I don’t know whether you’ve ever seen this experiment before, but shuffle them, right?

They’re all sellers, though.

They’re all sellers, but you’ve got to shuffle them. On the other side there’s a number. So, we’ve got eight sellers here and eight buyers. So, each seller knows what his football ticket is worth or hers, so please take one.

You should be one short. Here’s an extra. So, there are eight sellers and eight buyers. They’ve got the football tickets. Each of them knows what the football ticket is worth to her. So, these are the “hers.” She knows exactly what it’s worth to her. So, say it’s fifteen. The football ticket’s worth fifteen. Now, if she can sell it for more than fifteen, she’s going to do it. She’s going to make a profit. If she sells it for less than fifteen, she’s not a very good trader. She’s not going to do that. She is going to say, “If I can get more than the football ticket is worth, I’m going to sell it. If I can’t get more than its worth, I won’t sell it.”

So, everybody knows what the football ticket is worth to herself. All these guys, they know what the ticket is worth to them. So, say someone thinks it’s worth thirty that guy’s going to say, “If I can get it for less than thirty, like for fifteen, I’m going to get it. That’ll give me a profit of fifteen. If I can only get it for forty, I’m sure not going to do that because I’m paying more than I think it’s worth. So, you all got that? You have a reservation value yourself. You don’t want to pay more than it’s worth because then you’re losing money, and they want to sell it for more than they think it’s worth because then they’re making money.

So, nobody knows anybody else’s valuation. The information is distributed completely randomly across the class. Now, this is a famous experiment. I’m not the first one to run it, although I’ve done it for ten years. I do it in my graduate class, in my undergraduate class, the undergraduates, by the way, always do better than the graduate students. So, this knowledge is distributed in the whole environment, and we’re going to see what happens when I start a chaotic interaction between all of these sixteen people. What’s going to happen? And you would think it’d be total chaos and nothing sensible is going to happen.  And if that does happen, it’ll be very embarrassing for me. But, what the efficient markets guys would say is, “Something amazing is going to happen. The market is going to discover what everybody thinks it’s worth and figure out exactly the best and right thing to do and that’s what’s going to happen.

Now, it’s hard to believe that with this little preparation that you’ve had, zero, zero training, zero experience, and you’re only going to have two minutes to do this. So, see the class has got eight minutes to go. You’re going to miss the grand finale. Anyway, we only have eight minutes to go. So, with only two minutes of training, they’re going to get to a result, which if I had to do it myself and read all the numbers and sort them out and sort through them would take me much more than two minutes, and all this is going to happen in two minutes. It’s hard to believe. It probably won’t happen this time.

Finance: An Experiment Of The Financial Market Pt 1

Intro to Chemical Engineering Lecture Pt. 5

This guy is Peter Wilson.  He is actually Edwin Drake’s druggist and apparently this is a picture of the one of the very first drug deals.  You see his pants are quite full of something here and we’re not quite sure what’s going on.  Then there are these three stooges back here.

This is a derrick.  What happened to Pennsylvania is that people have noticed a sort of black stuff coming to the surface of the ground.  They also found out that if they lit it with fire, it would burn.  So he went poking around to see where this stuff was coming from and that was the first oil well.  And this was of course, in a sense, the beginning of chemical engineering.  Because chemical engineers originated, if you will, as a species that is to basically take oil which is a very, very complex set of nasty molecules and refine them into liquids and gases that are of use to society.  It could be methane, propane, ethane, butane, pentane and finally when you get to heptane and on up, this stuff becomes liquid at room temperature and they found out that if you took this stuff and boiled it, you could fractionate it into liquids and gases.  The gases could be used as fuels and the stuff that is really nasty, the tar could be put on to roads and this gave rise to this profession of chemical engineering as the people who refine oil.

Now, I have to tell you that probably in the last 20 years, not one of our undergraduates has gone into the oil business.  This is how it started, but we’ve transcended it.  It’s not that we do not refine oil anymore, we do, but we put in much figured out how to design oil refineries, essentially using software and computer programs that have imbedded in them the smartness to handle a variety of crudes and to produce products over the year that meet the market demands and so as you will learn on Friday, during the summer, the refineries are making heating oils for the winter and during winter, they are making gasolines for the summer.  And so the crude oil stream gets in and it gets changed molecularly into products that meet the market demand.  So it is not to demean refineries or to say that it’s a bad idea to go work for an oil company, but few of our graduates tend to do that.  I will talk about some of the other places where they do go. But that is for historical purposes.

What is Chemical Engineering?  It really is taking basis sciences: Physics, Math, Chemistry and now Biology, and applying them to the conversion of raw materials into valuable products.  It started out with crude oil into valuable products.  Doing it with a respect for the environment, which I can tell you was not in the picture for many, many years.  In fact, we are still litigating and I do participate in litigations of people who behave poorly in how they disposed of materials, even as latest as 1980s and early 1990s. Thinking that the world is a waste basket that can sup up anything we throw into it, but it is simply not the case anymore.

Chemical engineers design and manufacture useful products and this is done through chemical reactions, making and breaking bonds.  Usually when I get to this point, when I talk about catalysis, accelerating chemical reactions, separating and purifying things, people get scared.  They ask me, “Is there any Chemistry in this class?”  My answer to this is, “What don’t you understand about the word Chemical Engineering?”  I mean it is sort of taking an English class and learning Spanish.  Yes, we are going to talk about chemistry in here.  Is it deep chemistry?  It is not going to be deep chemistry.  It is something that you can all handle if you got three fully simultaneously functioning neurons at any given point in time.

So what do I mean by converting raw materials into products?  I will give you some examples.  We talked about crude oil.  There are refineries in the North Bay, up by Martinez, if you are familiar in that area.  There is also a big one along Highway 80 just north of Berkeley.  These will deal with around 100,000 barrels a day of crude oil coming in and running 24 hours a day.

Do anyone know how many gallons in a barrel?  55 in the kind of barrel that you normally see.  But unfortunately, that is not a barrel of oil and don’t ask me where it came from, but it’s 42 gallons. So if you look at the 100,000 x 42, in terms of how many gallons a modern refinery will handle.

Introduction to Chemical Engineering Lecture Pt. 5
chemical engineering expert witness

Finance: Examples of Finance Pt 1

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. So, even though I think that my expected profit is positive, because he’s putting up three hundred thousand to make only two hundred when they’re even odds.

Finance: Examples of Finance Pt 1

Finance: Collateral in the Standard Theory Pt 2

What else can we get out of these numbers? I just want you to notice a couple other things. So, these numbers are all very interesting. If you’re mathematical, these are the sorts of things you pay attention to. So, these efficient markets guys, they looked at the change in price every month. So, there’s a lot to say for their theory. They said, “Look, it goes up and down randomly.”

In fact, we’ll see that there are all kinds of tests about whether you can predict it’s going to go up tomorrow on the basis of how it did yesterday and the answer’s no. It’s very difficult to predict whether the stock market is going up or down. It seems to be random. Well, it’s random and they used to think it was normally distributed. A lot of people argued it was normally distributed, but it’s hard. You never get these gigantic outliers if things are normally distributed. They’re just way too unlikely to happen.

So, Mandelbrot, who was a Yale professor who retired a couple years ago, although he wasn’t when he formed his theories, the inventor of fractals, he said this couldn’t possibly be a random walk in the traditional Brownian motion sense of the word because you’d never get these big outliers, but he offered no explanation for why they might be there, and I don’t know if Shiller has an explanation either. I mean, is it that people suddenly get shocked one day and then the next week they changed their mind and things aren’t so bad after all. But, you’ll see that the theory of collateral and margins does explain these kinds of things.

Now, let’s just look at the Dow. We just looked at the Dow. Let’s look at another, the S&P 500. Here’s the S&P 500 data. Here’s the history of the S&P 500. It looks very similar to the Dow, except we have longer history back to 1871. So, I just want to point out one more thing in the S&P 500. So, this is an average of five hundred stocks, not just thirty, but it’s more or less the same.

But, let’s look at the same thing taking the logarithm and check for inflation. So, you see here that there are these four cycles. Things seemed low in 1871. They go up and they go down. Then you’ve got another up and a down. Then you’ve another up and a down. Four times the same thing has happened. Now, this could be just meaningless accidents, but it will turn out that the demography of the country, the baby boom cycle, we haven’t had just one baby boom, we’ve had four of them. So, this cycle of stock prices, which they’re each time a generation long, happens to correspond exactly to the rise, the different age distribution in the population.

So, another theory of the stock market, which wouldn’t have been entertained by these original financial theorists, is that demography has something to do with the stock market, not information about profits and returns but the distribution of ages in the population. So, I’m not saying this theory is correct, although I was one of the proponents of it, but it shows that there’s a room, I think, in finance for economic things, for demography to matter, for leverage to matter and not just for expectations about for future profits.

 

Finance: Collateral in the Standard Theory Pt 2