Finance: Examples of Finance Pt 6

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. 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: An Experiment Of The Financial Market Pt 3

Here’s what happened. Mister seller ten sold to thirty six at a price of twenty. Mister seller nine sold to buyer twenty. So, nine, there is no nine. Nine sold to twenty at a price of what? Six. That’s okay. So, seller six sold to twenty at a price of twenty. We won’t ask who buyer twenty is. Buyer twenty is going to screw everything up.

So, buyer fourteen through- I can’t read this either. Buyer fourteen sold to buyer forty four for twenty, and buyer twenty sold to buyer forty for twenty two, and seller twenty four sold to buyer thirty for twenty five.

So, five people traded now which five were they? The sellers were ten, six fourteen and twenty four, the bottom five. The five buyers were thirty six, twenty, forty four, forty and thirty. So, basically forty four, forty, thirty six, thirty six didn’t buy, twenty bought instead.

So, if you look at it, so it’s not quite the way theory would have predicted, but almost. If you look at it, if you just shuffle the order and you put the sellers, instead of from top to bottom, you put them from bottom to top, you get what looks like a demand curve and a supply curve. And so, what happened? All these five people ended up selling, one, two, three, four, five, those are exactly the sellers. The price they sold for was all between twenty and twenty five and the five buyers were forty four, forty, thirty six, thirty. Twenty six didn’t manage to buy, but twenty bought. So, what is the theory of the free market? The theory of the free market says, “This chaotic situation where they had less than two minutes to decide what to do could be analyzed as if you put a demand curve together with a supply curve and there was one price that they miraculously knew.

Here it should have been twenty five. It turned out to be twenty or twenty two that all the trade took place at. At that one price you get all the trades happening. The people have the highest valuation buyers they’re the one who get the tickets. The people with the lowest valuation sellers sell it. So, the people who end up with the tickets are these red guys at the top and the blue guys at the top. All the tickets go from the people who value the stuff least to the people who value it more. So, the market has done an extraordinary thing in two minutes.

So, there was one mistake. Mister or miss twenty, whose identity we are protecting, although I’m searching the faces, mister or miss twenty got a very bad deal. She or he, let’s say he, bought at twenty when the value was twenty. That was a horrible deal. He didn’t get any extra out it. So, he should probably have only bought if the prices were lower, and then twenty six would have bought instead of twenty. So, twenty sort of squeezed his way into the market, so twenty six and twenty between them somehow there was a slight inefficiency.

But, basically with no training, no background, no practice, these sixteen undergraduates managed to reproduce – they gathered all the information in the whole economy, and they discovered who were the eight people who valued the tickets the most and they ended up with all the tickets. For me to do it and sort it out would have taken longer. The market solves a complicated problem and gets information incredibly quickly, and put things into the hands of the people who value it the most. And the marginal buyer thought it was worth about twenty five or twenty and that’s what the price turned out to be.

So anyway, we’re going to come back to this parable at the beginning of the next class.

Finance: An Experiment Of The Financial Market Pt 3 

Finance: Examples of Finance Pt 5

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. 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?

Finance: Examples of Finance Pt 5

Finance: Examples of Finance Pt 4

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

Finance: An Experiment Of The Financial Market Pt 2

So, here are the rules. I’m going to put you all together, start inching your way towards each other and try not – now, when I say go, which won’t be for two minutes you’re going to start yelling out an offer. So, if you think it’s worth fifteen and you’re a seller, you’re not going to sell it for fifteen. You’re going to say give me twenty, or give me thirty, or give me twenty five. You’re going to try and get as much as you can. You have to yell it out. The buyers are going to be making their offers.

When the two of you see that there’s a deal, you have to shake, exchange the football and leave, and tell your number to TA. Where’s the TA? You’re going to stand outside the group that way. So, once you make a deal, you just leave and tell what’s happened to TA who’s now standing back here. So, it has to be public outcry. It’s very important that you’re yelling these things publicly and all the other people can hear you, and you’ve only got two minutes. Now, two minutes sounds like an incredibly short period of time, which it is, but it’s much longer than you think, wait, quiet here.

You shouldn’t trade – I’m giving you valuable advice, you shouldn’t trade in the first ten or fifteen seconds because you have to hear what everybody else is offering. If you trade right away, you’re probably doing something really stupid. Two minutes, though, it sounds short, is actually a very long period of time. So, be patient. Try to get the best possible price and we’ll see what happens. Any questions about what you’re doing? And now, in the heat of the moment, you might be so frustrated that you can’t sell when you think it’s worth fifteen that you sell it for ten. I’m going to expose you in front of all these people if you do that, so keep track of what you think the thing is worth. All right, any questions, anybody about what is going on? So, you have two minutes. Is there a second hand there? I can’t see it? No.

It’s on the ten, or coming to.

Where is it?

Now, it’s on the three. It’s moving.

It’s on the three. I think I see something. When it gets to the four we’re going to start. So, start, go.

(Students calling out prices)

Come out and tell TA. If you made a deal, tell TA. How much time is left? One minute left, plenty of time, one minute. Any other deal made? Write down the price and the two, what price they agreed. How much time? Twenty five seconds, stay cool. How much time? Fifteen. Stay cool. Don’t make any mistakes, ten, five, four, three, two, one, stop. Did you get all the numbers?

(Students discussing sales)

Give me back the tickets.

Was this designed to make us look bad on camera?

Give me back the tickets. No, you you’re going to look great on camera, you are. Give me all the tickets back. All tickets, I need them all back, all the stuff. God, you’re big folders here. These tickets have lasted ten years until you guys took over. They’re all crumpled up. All the ticket, I need them all back. You can sit down now. Everybody’s reported in? Now, let’s see what happened.

So, here’s what happened. Here, were the numbers. So, we have five minutes just to look at this. So, all the buyer prices are in blue, forty four, forty, thirty six, you should recognize these you buyers, and the red ones were the sellers. So, you notice that every seller, for everybody there’s a seller who’s underneath. So, it could have happened that thirty eight sold to forty four, and thirty four sold to forty at thirty seven, and twenty eight sold to thirty six at thirty two. You could have had eight trades. So, what did happen? Nothing’s like that happened. You had five trades, five pairs of people traded and there are those three poor schlumps, pairs of people at the end looking despondent, hopeless, unable to trade, worried that they were on camera.

Now, let’s see, who are the people who traded? So, name the buyers who bought. The prices.

The seller got it for nine and managed to sell it for twenty dollars. It was all quick, so I don’t have everybody’s name, because they were all rushing.

Finance: An Experiment Of The Financial Market Pt 2

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 

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

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 1

So, I took on in my theoretical work, finance and economic theory on its own terms. I didn’t think like Shiller to introduce psychology into economics, I just take it on in its own terms, in its own mathematical terms. And what I found was that there are two things missing in the Standard Theory.

One is that, it implicitly assumes you can buy insurance for everything. It’s the assumption called complete markets. And secondly, it leaves out collateral entirely so you’ll never see almost in any single economics textbook, the idea of collateral or leverage. And those, I think, the idea that you can’t get insurance for everything and that you need collateral, you know, you have to be able to convince someone you’re going to pay them back if you borrow money and collateral is the most convincing way of persuading him he’s going to be paid back, the lender. Those two things were missing from the Standard Theory. So, I built a theory around incomplete markets and leverage, which is critique of the Standard Theory.

So, in a way, Shiller and I have been vindicated by the crash. I mean, so let me just show you a picture here. Well, maybe I will, you know, how bad the crash was. So, let’s look at the Dow Jones. The Dow Jones is an average of thirty stocks and what their value is. We’ll talk more about it later. But here it is back to 1913, moving along breezily going up and up and up, you know, there are a few blips which we’ll come to later like this one in 1929, and then, but look what happened lately. Look at that.

The Dow Jones was up at 14,000 and it dropped to 6,500, something like that. More than a fifty percent drop and now it’s gone fifty percent up again. So, if you believe these finance professors, you’d have to say that everybody realized that future profits in America were going to be less than half what they thought they were going to be before and that’s why the stock market dropped. And then miraculously when it hit a bottom, everybody figured, “Oh, my gosh, we misunderstood things.”

Actually it’s not nearly that bad and things are fifty percent higher because now people think that profits really weren’t going to go, you know, didn’t drop in half, didn’t drop by fifty percent, they only dropped by twenty five percent. And that was the only way according to the old theory to explain what happened. Now, Shiller would just say, “Well, everybody’s – they’re crazy. They got this into their head that the world was just going to be great and then some rumor started and things were so high and the narrative changed and they thought things were terrible,” and that is his story. And I’m not sure how he gets it to go up again. They changed their mind again.

Finance: Collateral in the Standard Theory Pt 2