Archive for the ‘Finance’ Category

Looking over your General Finances

Posted by admin on December 3rd, 2010 | Comments Off

The New Year is almost upon us, which means the time for reflection is upon us. Many of us set New Year’s goals whether they are financial or more personal in relation. If you have never thought about setting financial goals in the past, now is a good time to start. With the amount of debt the average US citizen has, especially in the middle class, it is time to see what can be done about it. What can you do to lower your debts next year? What are you willing to sacrifice to gain a better handle on your personal debts?

Finance is managing your funds, as well as how to secure new funds. In the world of general finance you have to prepare for how you can make your situation better. If you have dealt with payday loan direct lenders, but know that you need to stop this type of lending practice, you have to prepare to get out of the cycle. Likewise if you have credit card debt, you will need to consider how you can get out of debt and how quickly this will happen.

There are plenty of things you can do in order to get yourself out of debt. It just depends on what you are willing to do. Let’s take a look at how you might decide to finance next year.

One option open to you is to talk with a couple of banks to determine if you can obtain a personal loan or secured loan to reduce your monthly payments and interest. If you have equity in your home you may want to remortgage or get an equity mortgage to pay off your larger interest debts. Paying out 15 percent or more on a debt is unnecessary if you are in a position to get an equity loan or personal loan for 7 percent APR or less. There are products like this out there. So, now is a good time to search for them.

Also consider debt consolidation. With debt consolidation you may be able to pay off certain debts by cutting them in half. Companies like credit cards and are willing to settle for a lower payment if it means getting money from you. Debt consolidation can be the way for you to settle some of the more unseemly debts and get back on a financial track that helps you save for your retirement.

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Risk Neutrality (and Risk Aversion Preview)

Posted by admin on June 11th, 2009 | Comments Off

Fortunately, the expected value is all that we need to learn about statistics until we will get to Part III (investments). This is because we are assuming—only for learning purposes—that everyone is risk-neutral. Essentially, this means that investors are willing to write or take any fair bet. For example, you would be indifferent between getting $1 for sure, and getting either $0 or $2 with 50% probability. And you would be indifferent between earning 10% from a risk-free bond, and earning either 0% or 20% from a risky bond. You have no preference between investments with equal expected values, no matter how safe or uncertain they may be. If, instead, you were risk-averse—which you probably are in the real world—you would not want to invest in the more risky alternative if both the risky and safe alternative offered the same expected rate of return. You would prefer the safe $1 to the unsafe $0 or $2 investment. You would prefer the 10% risk-free Treasury bond to the unsafe corporate bond that would pay either 0% or 20%. In this case, if I wanted to sell you a risky project or bond, I would have to offer you a higher rate of return as risk compensation. I might have to pay you, say, 5 cents to get you to be willing to accept the project that pays off $0 or $2 if you can instead earn $1. Or, I would have to lower the price of my corporate bond, so that it offers you a higher expected rate of return, say, 1% and 21% instead of 0% and 20%. Would you really worry about a bet for either +$1 or −$1? Probably not. For small bets, you

are probably close to risk-neutral—I may not have to offer even one cent to take this bet. But what about a bet for plus or minus $100? Or for plus and minus $10,000? My guess is that you would be fairly reluctant to accept the latter bet without getting extra compensation. For large bets, you are probably fairly risk-averse—I would have to offer you several hundred dollars to take this bet. However, your own personal risk aversion is not what matters in financial markets. Instead, it is an aggregate risk aversion. For example, if you could share the $10,000 bet with 100 other students in your class, the bet would be only $100 for you. And some of your colleagues may be willing to accept even more risk for less extra money—they may have healthier bank accounts or wealthier parents. If you could lay bets across many investors, the effective risk aversion would therefore be less. And this is exactly how financial markets work: the aggregate risk absorption capability is considerably higher than that of any individual. In effect, financial markets are less risk averse than individuals. 

We will study risk aversion in the investments part of the blog. There, we will also need to define good measures of risk, a subject we can avoid here. But, as always, all tools we learn under the simpler scenario (risk-neutrality) will remain applicable under the more complex scenario (risk-aversion).

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Why is the Yield Curve not Flat?

Posted by admin on June 5th, 2009 | Comments Off

There is no necessary reason why capital should be equally productive at all times. For example, in agrarian societies, capital could be very productive in summer (and earn a rate of return of 3%), but not in winter (and earn a rate of return of only 1%). This does not mean that investment in summer is a better deal or a worse deal than investment in winter, because cash in winter is not the same—not as valuable—as cash in summer, so the two interest rates are not comparable. You could not invest winter money at the 3% interest rate you will be able to invest it with 6 months later. 

But although seasonal effects do influence both prices and rates of return on agricultural com-modities, and although the season example makes it clear that capital can be differently produc- tive at different times, it is not likely that seasonality is the reason why 30-year Treasury bonds in May 2002 paid 5.6% per annum, and 6-month Treasury notes paid only 1.9% per annum. So why is it that the yield curve was so steep? There are essentially three explanations: 

1. The 30-year bond is a much better deal than the 1-year bond. This explanation is highly unlikely. The market for Treasury bond investments is close to perfect, in the sense that we have used the definition. It is very competitive and efficient. If there was a great deal to be had, thousands of traders would have already jumped on it. So, more likely, the interest rate differential does not overthrow the old tried-and-true axiom: you get what you pay for. It is just a fact of life that investments for which the interest payments are tied down for 30 years must offer higher interest rates now. 

It is important that you recognize that your cash itself is not tied down if you invest in a 30-year bond, because you can of course sell your 30-year bond tomorrow to another investor if you so desire. 

2. Investors expect to be able to earn much higher interest rates in the future. For example, if the interest rate r0,1 is 2% and the interest rate r1,2 is 10%, then r0,2 = (1 + 2%) · (1 + 10%) ≈ 1 + 12%, or r2 = 5.9%. If you graph rT against T , you will find a steep yield curve, just as you observed. So, higher future interest rates can cause much steeper yield curves. 

However, I am cheating. This explanation is really no different from my “seasons” explanation, because I have given you no good explanation why investment opportunities were expected to be much better in May 2032 than they were in May 2002. I would need to give you an underlying reason. One particular such reason may be that investors believe that money will be worth progressively less. That is, even though they can earn higher interest rates over the long run, they also believe that the price inflation rate will increase. Inflation erodes the value of higher interest rates, so interest rates may have to be higher in the future merely to compensate investors for the lesser value of their money in the future.

However, the empirical evidence suggests that the yield curve is not a good predictor of future interest rates, except on the very shortest horizons (a month or less). So, the expectation of higher interest rates is not the most likely cause for the usually upward sloping curve in the real world. 

3. Long-term bonds might somehow be riskier than short-term bonds, so investors only want to buy them if they get an extra rate of return. Although we have yet to cover uncertainty more systematically, you can gain some intuition by considering the effects of changes in economy-wide interest rates on short-term bonds vs. long-term bonds. 

The empirical evidence indeed suggests that it is primarily compensation for taking more risk with long-term bonds than short-term bonds that explains why long-term bonds have higher yields than short-term bonds. That is, investors seem to earn higher expected rates of return on average in long-term bonds, because these bonds are riskier (at least in the interim).

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Investments, Projects, and Firms

Posted by admin on May 29th, 2009 | Comments Off

 

As far as finance is concerned, every project is a set of flows of money (cash flows). Most projects require an upfront cash outflow (an investment or expense or cost) and are followed by a series of later cash inflows (payoffs or revenues or returns). It does not matter whether the cash flows come from garbage hauling or diamond sales. Cash is cash. However, it is important that all costs and benefits are included as cash values. If you would have to spend more time to haul trash, or merely find it more distasteful than other projects, then you would have to translate these project features into equivalent cash negatives. Similarly, if you want to do a project “for the fun of it,” you must translate your “fun” into a cash positive. The discipline of finance takes over after all positives and negatives (inflows and outflows) from the project “black box” have been translated into their appropriate monetary cash values. 

This does not mean that the operations of the firm are unimportant—things like revenues, operations, inventory, marketing, payables, working capital, competition, etc. These business factors are all of the utmost importance in making the cash flows happen, and a good (financial) manager must understand these. After all, even if all you care about is cash flows, it is impossible to understand them well if you have no idea where they come from and how they can change in the future. 

Projects need not be physical. For example, a company may have a project called “customer relations,” with real cash outflows today and uncertain future inflows. You (a student) are a project: you pay for education and will earn a salary in the future. In addition, some of the payoffs from education are metaphysical rather than physical. If knowledge provides you with pleasure, either today or in the future, education yields a value that should be regarded as a positive cash flow. Of course, for some students, the distaste of learning should be factored in as a cost (equivalent cash outflow)—but I trust that you are not one of them. All such non-financial flows must be appropriately translated into cash equivalents if you want to arrive at a good project valuation! 

A firm can be viewed as just a collection of projects. Similarly, so can a family. Your family  may own a house, a car, tuition payments, education investments, etc.,—a collection of projects. This blog assumes that the value of a firm is the value of all its projects’ net cash flows, and nothing else. It is now your goal to learn how to determine these projects’ values, given cash flows. 

There are two important specific kinds of projects that you may consider investing in—bonds and stocks, also called debt and equity. As you will learn later, in a sense, the stock is the equivalent of investing to become an owner who is exposed to a lot of risk, while the bond is the equivalent of a lending money, an investment which is usually less risky. Together, if you own all outstanding bonds (and loans) and stock in a company, you own the firm: 

Entire Firm = All Outstanding Stocks + All Outstanding Bonds and Loans . 

This sum is sometimes called the enterprise value. Our blog will spend a lot of time discussing these two forms of financing—but for now, you can consider both of them just investment projects: you put money in, and they pay money out. For many stock and bond investments that you can buy and sell in the financial markets, we believe that most investors enjoy very few, if any, non-cash based benefits.

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The Goal of Finance: Relative Valuation

Posted by admin on May 23rd, 2009 | Comments Off

Finance is such an important part of modern life that almost everyone can benefit from understanding it better. What you may find surprising is that the financial problems facing PepsiCo or Microsoft are not really different from those facing an average investor, small business owner, entrepreneur, or family. On the most basic level, these problems are about how to allocate money. The choices are many: money can be borrowed or saved; money can be invested into projects, undertaken with partners or with the aid of a lender; projects can be avoided altogether if they do not appear valuable enough. Finance is about how best to decide among these alternatives.

There is one principal theme that carries through all of finance. It is value. It is the question 

“What is a project, a stock, or a house worth?” To make smart decisions, you must be able to assess value—and the better you can assess value, the smarter your decisions will be. 

The goal of a good corporate manager should be to take all projects that add value, and avoid those that would subtract value. Sounds easy? If it only were so. Valuation is often very difficult. 

It is not the formulas that are difficult—even the most complex formulas in this blog contain just a few symbols, and the overwhelming majority of finance formulas only use the four major operations (addition, subtraction, multiplication, and division). Admittedly, even if the formulas are not sophisticated, there are a lot of them, and they have an intuitive economic meaning that requires experience to grasp—which is not a trivial task. But if you managed to pass high-school algebra, if you are motivated, and if you keep an open mind, you positively will be able to handle the math. It is not the math that is the real difficulty in valuation. 

Instead, the difficulty is the real world! It is deciding how you should judge the future—whether  your Gizmo will be a hit or a bust, whether the economy will enter a recession or not, where you can find alternative markets, and how interest rates or the stock market will move. This blog will explain how to use your forecasts in the best way, but it will mostly remain up to you to make smart forecasts. But there is also a ray of light here: If valuation were easy, a computer could do your job of being a manager. This will never happen. Valuation will always remain a matter of both art and science, that requires judgment and common sense. The formulas and finance in this blog are only the necessary toolbox to convert your estimates of the future into what you need today to make good decisions. 

To whet your appetite, much in this blog is based in some form or another on the law of one price. This is the fact that two identical items at the same venue should sell for the same price. Otherwise, why would anyone buy the more expensive one? This law of one price is the logic upon which almost all of valuation is based. If you can find other projects that are identical— at least along all dimensions that matter—to the project that you are considering, then your project should be worth the same and sell for the same price. If you put too low a value on your project, you might pass up on a project that is worth more than your best alternative uses of money. If you put too high a value on your project, you might take a project that you could buy cheaper elsewhere. 

Note how value is defined in relative terms. This is because it is easier to determine whether your project is better, worse, or similar to its best alternatives than it is to put an absolute value on your project. The closer the alternatives, the easier it is to put a value on your project. It is easier to compare and therefore value a new Toyota Camry—because you have good alternatives such as Honda Accords and one-year used Toyota Camry—than it is to compare the Camry against a Plasma TV, a vacation, or pencils. It is against the best and closest alternatives that you want to estimate your own project’s value. These alternatives create an “opportunity cost” that you suffer if you take your project instead of the alternatives.

Many corporate projects in the real world have close comparables that make such relative valuation feasible. For example, say you want to put a value on a new factory that you would build in Rhode Island. You have many alternatives: you could determine the value of a similar factory in Massachusetts instead; or you could determine the value of a similar factory in Mexico; or you could determine how much it would cost you to just purchase the net output of the factory from another company; or you could determine how much money you could earn if you invest your money instead into the stock market or deposit it into a savings account. If you  know whether you should build it or not. But not all projects are easy to value in relative terms. For example, what would be the value of building a tunnel across the Atlantic, of controlling global warming, or of terraforming Mars? There are no easy alternative projects to compare these to, so any valuation would inevitably be haphazard.

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