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Diversifies Risk
Defining Risk
In an uncertain worlds, we cant state anything with certainty, only with degrees of probability.
There is a 45% chance that it will be 35 degrees tomorrow
Probability Distributions
More generally, uncertainty is characterized by a probability distribution Expected value (mu) refers to the most likely event. Standard Deviation (sigma) refers to the spread of possible events. It is equal to the expected value of squared differences from the mean.
Statistics
Expected value is equal to the sum of each possible event multiplied by its probability. Prob(35) = .45 Prob(25) = .55 E(Temperature) = .45(35) + .55(25) = 29.5 Variance is equal to the expected value of squared differences from the mean. Variance (Temp) = .45(35 29.5)^2 + .55(25-29.5)^2 = 24.75 Standard Dev. (Temp) = SQRT(24.75) = 4.97
Diversification
Suppose the chance of a cold winter is 40% (the chance of a warm winter is 60%). You own an oil company. In a cold winter, you earn $100 in profit. In a warm winter, you lose $50.
E(Profit) = .40($100) + .60(-$50) = $10 Variance (Profit) = .4(100-10)^2 + .6(-50 10)^2 = 5,400 Standard Deviation = 73.5
Diversification
Now, suppose you buy stock in Disney. If its warm, your stock appreciates by $20. If its cold, Disney stock falls by $10. You pay $15 for the stock. E(Profit) = .4($100 - $10 - $15) + .6(-$50 + $20 - $15) = $3 Variance (Profit) = .4(75 - 3)^2 + .6(-45 - 3)^2 = 3,455 Standard Deviation = 58.8
Adding uncorrelated (Corr = 0) variables to a portfolio lowers the risk attached to that portfolio
US Stocks International
In Dec. December 2001, Enron declared bankruptcy one of the largest corporate failures in history. While Enron did a lot of things wrong, what did it do right?
Enrons core business was to become the middleman in energy markets this helped manage risk and improved liquidity.
Characteristics of a Good Financial System Diversifies Risk Creates Liquidity Provides/Communicates Information
Asymmetric Information
Adverse Selection
Prior to a transaction taking place, one party is missing vital information about the other party (cant tell the good eggs from the bad eggs!)
After the transaction takes place, one party cant observe the others actions (the good eggs might become bad eggs!)
Moral Hazard
Suppose you are shopping for a new car. There are 10 cars on the lot. 8 Cars are good (P = $1000) 2 Cars are Lemons (P = $100) What price do you offer? (You cant distinguish lemons from good cars) Solution: Signaling or Regulation!
Suppose a company has one bondholder ($100) and one stockholder. The company has two possible projects to invest in:
Project A: $100 profit with certainty Project B: 50% chance of $0 profit, 50% chance of $200 profit.
Project B (Risky)
Bondholders: 50% chance of $0, 50% chance of $100 E(B) = .5(100) + .5(0) =$50
Why Do We Care?
With a financial system, your consumption expenditures are no longer restricted to equal your income (i.e., the financial system efficiently transfers income between households) Financial Markets Transfer Savings from households to firms for the purpose of financing investment projects S = I + (G-T) + NX
Black Tuesday
On Tuesday, October 29,1929, the Dow Jones Closed at $230 Down 23% from its opening of $299 with huge volume (16,410,030 shares)
The October 29th drop was only the beginning of a 89.7% collapse over the next 714 days.
The Dow make it back to its pre 1929 highs until 1954.
Black Monday
On Monday, October 19,1987 The Dow fell from $2246 to $1738 22.6% of its value
However, unlike the 1929 crash, the market quickly recovered by September 1989, the Dow returned to its pre-1987 levels
The Players
Securities Market Institutions Contractual Savings Institutions (40%) Investment Institutions (25%) Government Institutions (10%) Depository Institutions (25%) _______________________________ $30 Trillion in Debt and Equities
Securities market institutions match up buyers with sellers. (provide liquidity) Securities market institutions also provide information and analysis to help buyers and sellers of assets Primary Markets Secondary Markets Investment Banking Brokers Dealers Exchanges
Contractual Savings
Contractual Savings Institutions are by far the biggest participant in financial markets ($12 Trillion in assets) Specialize in writing contracts to protect policyholders from financial loss associated from specific events.
Insurance
Companies
Pension
Funds
Investment Institutions represent the fastest growing segment of financial markets The key service provided is low cost diversification Mutual Funds Money Market Funds Hedge Funds (LTCM) Venture Capital Funds
Provision of Liquidity
The distinguishing characteristic of a depository institutions is the acceptance of deposits and the creation of loans.
Commercial
Evolution of the Financial System Financial Innovation Integration and Globalization Regulation Competition