Finance Basics

To cover all of finance in a single chapter, we're going to have to simplify. The world consists of only two things: people and capital assets. Capital has so many different meanings that it results in more confusion than clarity. In this context I mean assets (good things) used to make money. So if you have a car you drive around in, it's an asset, but not a capital asset. The same car owned by a taxi driver, or by a business, is a capital asset.

At this level of abstraction, we're not going to worry about government. It's just another business, holding capital assets, collecting revenue, and delivering goods and services. Its pricing policy is unusual: It tells its customers how much to pay and decides for itself what goods and services to deliver in return. Nice work if you can get it.

ECONOSPEAK

I do have to warn you about terminology. The words for the things I'm going to discuss in this chapter were invented by economists. Economists are clever people who take innocent delight in defining words as exactly the opposite of their normal English meanings. We've already seen goods and services. Well, goods need not be good and good things need not be goods. A sunset is not a good because nobody pays for it. A bottle of pain reliever capsules with cyanide in it is a good because somebody does. I'm not even going to mention some of the things that pass for services in the economy.

Anyway, businesses deliver goods and services to people-excuse me, to households. Of course, households don't have to own a house or hold anything. It's just shorthand to remind us that a lot of economic activity takes place outside the money economy. If a mother gives food to her child, that's not considered an economic transaction because it takes place within a household. If you spend all weekend cleaning your house, nothing economic happened, but if you pay someone outside your household to do it, it's a transaction and counts in the statistics.

Households get money to buy the goods and services, mainly by delivering labor to businesses and receiving wages in return. The labor example I use that resonates with students is to imagine the final exam, when I'm sitting in the front of the room doing a crossword puzzle and listening to my iPod, while the students are sweating, cursing, punching calculator buttons, and writing furiously. I'm laboring because I'm being paid. They're not because they're not.

COMMERCIAL BANKS

Okay, finally we get to the finance part. Businesses make profits, meaning the revenue they receive for selling goods and services exceeds the wage income they pay out. The excess can be used to purchase assets or labor from households to increase the stock of capital assets, or it can be returned to households through payments on financial instruments. Although this is the aggregate direction of the flow, many individual households earn more money than they spend. The surplus can be used to buy more assets for consumption (this includes just hoarding the extra money) or it can be sent back to the business sector.

I'm going to omit the large part of financial services that are consumed entirely within the business sector. Banks and other financial institutions do all kinds of things to help companies do business with each other: exchange foreign currencies, write letters of credit, authorize credit lines, and so forth. Because we're flying at 20,000 feet, those business services are no different from legal or janitorial services. In that sense, finance is just another business. There is a smaller, but still important, part of finance that operates entirely within the household sector. A credit union, for example, accepts deposits from its members and makes loans to them.

For our purposes, the important part of finance is when financial intermediaries stand between households and businesses. Banks are one familiar institution. We call them commercial banks if they accept deposits from the public, although deregulation is erasing this distinction. The deposits are lent out to businesses or used to buy securities (they can also be lent out to households, as with mortgage loans, but we're ignoring that). Businesses repay (we hope) the loans with interest and the securities go up (we hope) in value, so the bank can pay depositors their money back with interest, either in cash or in the form of transaction services such as free checking accounts.

An insurance company is exactly the same thing, except that it doesn't pay its depositors back according to the amount of money they deposited. Instead, it pays based on whether they die or have automobile accidents. From a financial standpoint there's little difference. A mutual fund has a different system: It pays investors back according to how much money it makes, but again it's just a variety of commercial bank. A hedge fund is just a mutual fund that is subject to lighter regulation because it refrains from advertising itself to the public and insists that its investors be rich. Hedge funds charge much higher fees than public mutual funds, but only if they make money, and they engage in much more sophisticated investment strategies. Not all of those strategies are risky; most hedge funds pitch moderate risk approaches.

INVESTMENT BANKS

A different type of financial institution is an investment bank (although, as I said, the distinction between investment and commercial banks is fading as more and more institutions take on both characteristics). The main job of an investment bank is to provide financial services to businesses, which we ignore except for one particular service. Investment banks act as underwriters, meaning they raise new capital for businesses by creating and selling new securities.

The two most important corporate securities are bonds and stocks. There are many hybrids, variations and combinations, and some entirely different types, but if you understand bonds and stocks, you've got the basics. Bonds are loans; they make periodic interest payments and return the principal amount at a stated maturity. If the issuer (the company, that is, not the investment bank) fails to make payments, bondholders can force it into bankruptcy. In the United States, that generally means bondholders and other creditors get the main voice in how the company is run, or whether it will be sold to make partial payment on the debts. In some other countries, bankruptcy is more difficult or less creditor-friendly, making bonds of issuers in those countries less attractive to investors.

The investors who buy a company's stock get to elect a board of directors to oversee the running of the company (as long as it stays out of bankruptcy court). In principle, the board acts to maximize shareholder wealth, although we could spend the whole book discussing the complexities in that arrangement. The shareholders are entitled to the residual earnings of the business, after all expenses and bondholders are paid. The company could send shareholders checks (called dividends), use the extra money to buy up shares in the market (which increases the value of the remaining shares, sort of like an automatic, tax-free dividend), or reinvest the money to make the business larger. Some stocks pay high dividends; others, no dividends at all (in which case, the price better go up or holders will be unhappy).

EXCHANGES

The third important type of financial institution is the exchange. Examples are the New York Stock Exchange and the Chicago Board of Trade. This is where households and businesses can come to buy and sell securities like stocks and bonds, and also things like commodities, foreign currencies, and entirely made-up securities called derivative contracts. Not all exchanges are physical buildings where traders gather face-to-face. Most trading these days is done electronically, either directly from institution to institution (this is called the interbank or dealer network, also over-the-counter trades) or through private companies that set up exchanges as for-profit businesses.

I want to highlight two particular kinds of derivative-two of the simpler ones-because I discuss them a lot in this book. A call option is the right, but not the obligation, to buy a specific thing for a specific price at (or sometimes at or before) a specific time in the future. The thing is called the underlying, the price is called the strike or exercise price, and the time is called the expiry. For example, a call option might give you the right, but not the obligation, to buy 10 ounces of gold (the underlying) for $4,000 (the strike price) at or before January 1, 2007 (the expiry). A put option is the same thing except it gives the right to sell the underlying at the strike price.

One person creates the option, which is called writing it. She always receives money; the option buyer or holder always pays. The amount the option sells for is called its premium. The premium is paid at the time the option is written and is never refunded, whether or not the option is exercised.

The curious thing about this third sector is that it seems unnecessary. All the other financial institutions collect money from households, send it to businesses, and return the profits, less expenses, back to households. But pure trading just moves money from one entity to another without obvious economic effect. If I buy a stock on the New York Stock Exchange, the issuing company doesn't get the money; another investor does. If I enter into a long cattle futures contract and cash out three days later, I'll make or lose money, but the cattle I owned-or had economic exposure to, anyway-for a few days won't be any different as a result; in fact, they were never specifically identified.

This view was largely true until the settlement of the American West. Exchanges were minor economic afterthoughts, more often associated with disaster or scandal than useful function. But in the dynamic self-organized network economy that emerged a century and a half ago, the exchange became the core institution. The trading characteristics of a security became more important than its underlying economics. The virtual economics began to drive the physical economy rather than the other way around. How and why that happened, and what it means today, is the subject of this book.

THEORY

A half century ago, finance was a purely descriptive field, like biology before the theory of evolution. Students learned what a letter of credit was and what documents were needed to issue a corporate bond, but there was no meaningful theory. A group of professors-most notably Franco Modigliani, Merton Miller, Jack Treynor, John Lintner, and Harry Markowitz-began trying to change that. The work with the broadest application was Markowitz's Modern Portfolio Theory, called MPT in the business.

The hard part about teaching MPT today is explaining why it is not obvious. That's an impressive testament to its success. All it says is that investors care about the statistical properties of their portfolios. Today no one would think of buying a mutual fund without thinking about its expected return and standard deviation of return. More sophisticated investors examine other statistics such as the Sharpe Ratio and beta.

However, a little thought will indicate that most things people buy are not evaluated by statistics. If you can measure or estimate the value of something accurately enough, its statistical properties don't matter much. Even if that's not true-say, when you choose a career or a spouse-there aren't a lot of statistics that can help.

So when Markowitz asserted that investors care about statistical properties, he was really making two statements, one negative and one positive. First, that research and analysis could not produce value estimates reliable enough for decision making. Second, that there were enough high-quality data for useful statistical analysis. These things were just beginning to become true in the mid-1950s. Before the 1930s, there was enough nonpublic information available that research could unearth good and bad values. Investors wanted inside information to bet on sure things, not statistics about historical returns. After the reforms of the 1930s, it took about 20 years to build up enough statistics to understand the market. It also helped that computers were becoming available to do the job.

The other half of MPT is that investors think at the portfolio level. They don't look for good individual securities; they look for securities that fit well with the rest of their investments. Some people buy a shirt because they like it; other people think about the other clothes they have that it would go with and for which they don't currently have the right shirt. Markowitz said that investors shop for a wardrobe, not a shirt. But he didn't say that investors match their portfolios to broader life assets, such as careers, houses, and spouses. MPT says that financial investments are evaluated in connection with all other financial investments, but not with everything else.

MPT does not require that markets be efficient. Every investor could have her own views on security prices and select the appropriate portfolio, given those views. Investors can be wrong about the statistical properties. Securities can be mispriced. Therefore, MPT can never be proven right or wrong, except in the irrelevant sense as a statement about investor psychology (in which case it's clearly false-investors care how much money they made or lost, not about abstract statistical properties). MPT is important because important features of the market are explained most simply if it's true. In other words, security prices move as if investors care about the statistical properties of their portfolios, even though investors don't.

A few years later, Eugene Fama made an essential advance to put finance on a sound basis. He investigated the results of assuming that security prices incorporate all information-in other words, that you cannot use any information to predict future security price movements. Without the Efficient Market Hypothesis (EMH), you can explain anything as a disagreement among investors. He sold stock A to her at $50 because he thought it was worth less than $50 and she thought it was worth more. Stock A went to $52 because more investors wanted to buy it. If you can explain anything, you explain nothing. Whatever happens, your theory covers it, so it never has to be changed. Of course, it also cannot predict; anything is possible in the future.

So Fama asked, "What happens if all investors agree about statistical properties of securities and try to form good portfolios?" Then he checked to see whether security prices moved according to that prediction. It's important to realize that no one thought the market was efficient; it was just a way to study things rigorously. If Fama could document the deviations from efficiency, there would be something to study, hence the possibility of learning. It came as a massive surprise that markets were so close to totally efficient that it was questionable whether there were any deviations at all. There are some anomalies, which could be inefficiencies, or could be data errors, or could reflect the need for more sophisticated theories. But no one ever found an anomaly without starting out with EMH. People criticize efficient markets all the time, but no one has come up with an alternative way to study finance. If you like to argue opinions forever with no possibility of data to resolve the issue, you hate EMH. If you would like to make some progress and actually figure things out, learn things, then you need EMH. Whether or not you believe the market is efficient has nothing to do with that.

William Sharpe, John Lintner, Jack Treynor, and Fischer Black independently came up with versions of the Capital Asset Pricing Model, or CAPM (pronounced "Cap Em"). There are dozens of other versions, which I had to memorize for my finance PhD qualifying exam at the University of Chicago. Lintner was probably first, although Sharpe's version was communicated more clearly and was the most influential. Treynor's and Black's version, based on equilibrium, turned out to be the most useful.

All three versions give a formula for relating the expected return on any asset to its systematic risk, known as beta. Systematic risk means risk related to broad market movements, as opposed to idiosyncratic risk that affects only some companies or industries or sectors. CAPM says that only systematic risk is rewarded by increased expected return. This is important because it says risky projects do not need higher expected returns to be chosen over safer projects, unless the risky project requires the stock market to go up to succeed. If a company is choosing between a high-risk and a low-risk research project, it should not penalize the high-risk one, because the success of a research project is not related to the market. But if it is choosing between two marketing projects, one of which is riskier and will do better only in economic good times, at the same expected return the company should prefer the safer project. However, if the riskier marketing project does better in bad economic times, it would be preferred to a safe project.

FINANCIAL CHALLENGES

One of the reasons I wrote this book is to try to attract a broader range of people into finance. I think it's a great field, but it needs new blood. The advantages are well known-high pay, interesting work, and if you make a mistake, well, it's only money; nobody dies. Too many people are entering the field for the safe money, and not enough for the challenges. At the moment the field has far more than its share of opportunities for breakthroughs, including ones that can make you rich, others that can make you famous, and still others that would do immense social good.

♦ We fail to provide even minimal financial services for at least half the world. This includes poor people, independent people, and even most rich people. Middle-class conformists are well served, but that's not everybody. Better financial services could make huge progress toward alleviating the miseries of poverty and social ostracism, and could make wealth concentrations more productive.• We lack a basic theory of corporate finance. We don't know why firms organize as they do, nor do we know how they should be financed or overseen. A better theory could help businesses do a better job for employees, customers, investors, and communities. I don't think we do such a terrible job of corporate finance now, but it's all based on traditional knowledge.We don't really understand risk. We know it sometimes causes disasters but that it's essential for all the good things in life. We have some rough ability to tell good risk from bad risk. But a deeper understanding is needed.♦ While our financial models have become very good at pricing securities, they require assumptions that clearly conflict with how security prices actually move. This creates some minor technical problems, but people have learned to ignore the underlying inconsistency. I think this has to be addressed eventually, and when it is solved it will reveal hidden worlds of opportunity.

The new techniques of finance can be applied productively to areas of human interaction that have resisted money exchange. I don't mean by putting a money value on everything and trading it; I mean by integrating insights from gift and gambling exchange to the mathematical machinery of modern finance. The possibility for increase in happiness from this is far greater than from anything else I know.We have little control over the economy. I do not believe that monetary or fiscal policy help. It is reassuring that there seems to be persistent, unlimited long-term growth, but it would be nice to know why, especially in case it stops. Also there are areas in which that might not be the best policy. Humans should be able to choose how much and what type of growth they want. On the darker side, there seems to be persistent, growing inequality among and within groups of people. Again, we should be able to choose the degree of inequality we consider acceptable. No doubt others would have different lists. My point is that finance is at a very exciting time when a relatively small insight can trigger a massive realignment of thought. This in turn could lead to the solution of an age-old problem or the creation of an incredible, unimagined opportunity. You want to be in a field at a time like this. Even if it doesn't work out, you will meet lots of other talented, interesting people. They'll go out and find the next set of challenges and invite you along for that adventure; or if you find the right place first, you'll have lots of allies to join you.

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