INVESTMENT: STOCKS & BONDS This chapter examines capital markets: why do individuals, firms and governments seek to raise capital to support their productive activities
1.1 WHAT IS CAPITAL? In a simple model of the economy there are three factors of production: land, labor and capital. The first two are relatively straightforward and intuitive: land consists landed property and the natural resources contained there in, while labor is human activity. However, what “capital” is less clear. In economics, the term “capital” is often specified to refer to the type of capital under consideration. For example, buildings, equipment, and tools may be called fixed or physical capital, while money is financial capital, skills as human capital, and social networks and relationships as social capital. It is not clear that one unit of capital in the form of skills is readily equivalent to one unit of capital in the form of money or to one unit of capital in the form of technology or equipment. Therefore, when we discuss “capital markets” in the abstract, we need to keep in mind that we are sometimes conflating different things. The failure to understand confusion on the part of economists and economic thinkers as much as our own shortcomings. Unlike other basic factors of production, such as labor and land, where the units are more commensurable, capital may not. In addition, while the other factors of production are just “there,” i.e., not produced, capital must be made. For example, if I want to make a simple tool, I might combine my labor (work) with raw materials (wood, metal, etc.) taken from the land to make physical capital in the form of a hammer. If this is true, then the value of the capital (hammer) should be the simple sum of the value of the land and labor inputs. However, this is not true. There is a positive return to capital -- a positive interest rate -- that suggests there is an uncounted increment of value in capital that is not reducible to its inputs. Understanding the origins of this increment is key to understanding the operation of capital markets because it is that increment of value that creates the ability to “make money from money” through financial transactions. Since one of the key insights of economics is that there is “no free lunch” -- everything must net out -- uncovering the origins of this increment is key to understanding why economies can grow over time and the distribution of resources and income. In Marxist language, it is the “means of production,” i.e., the tools required for productive activity. Those that control the technology, money, and equipment needed for modern economic activity have power over those who bring the other factors -- labor and land -- to production. To more conservative “Austrian” economic thinkers, capital is simply the passage of “time.” The real interest rate -- the price of capital -- simply discounts the value of purchasing power between two periods of time. For example, most people would rather have $10 now than $10 a week from now. The difference is the implied interest rate, the cost of money. As a result, we pay a preimium -- an interest rate -- to borrow money to be spent in the present against money delivered in the future. To economic thinkers and moralists of the Middle Ages, this made no sense. If money is simply a measure of value, how could anyone profit from lending money: how could anyone lend an inch? The reality that we, without thinking it strange, use a variety of capital instruments -- checks, credits, automobile and mortage loans, and fiat currency defines the modern age.
2.1 STOCKS AND BONDS Stocks and bonds are two instruments for financing current consumption and investment. However, most individuals do not use either stocks or bonds to make consumer purchases or to finance major investments such as the purchase of a home or a car or to pay for a college education. Why not? Or, why do
governments, businesses, and other organizations rely on these means of financing so much? Why not simply go to a bank and take out a loan like you or I would? The first reason is that the sums that certain corporations and government wish to borrow are much greater than any single economic actor can provide. In 2011, the US government borrowed over $1 Trillion; no bank, or combination of banks, has $1 Trillion of liquid assets in its vaults, even if it highly leveraged those assets. Therefore, there is a need to borrow from multiple creditors and both stocks and bonds allow an entity to raise capital from a broad range of sources. Prior to the Industrial Revolution, capital was mostly in the form of physical capital and dispersed throughout the population. The main source of wealth was the ownership of land (hence the pre-eminent position of landed nobles) and the implied control over the individuals who occupied the land, whether through feudal obligations or slavery. The second reason comes down to control. If I borrow $100 dollars from one person, that person may want to know why I want to borrow $100 and may make an effort to ensure that the sum is repaid. However, if I borrow $1 from 100 people, there is less incentive for them to look inside the “black box” of my company, government, etc. For example, if I borrow from 100 people to finance the purchase of a house, it is unclear how each creditor claims a piece of the house if the borrower defaults. In addition, when there are multiple creditors, a borrower may be able to pit one creditor against another to renegotiate the terms of obligation. While laws generally privilege certain classes of creditors, i.e., debt holders over stockholders, multiple creditors gives the borrower more negotiating leverage. When an economic organization issues stock, it is selling equity -- ownership -- of its organization; when it issues bonds, it is selling debt. The differences can be illustrated with a simple example. Imagine a person -Winnie the Pooh -- wanting to buy a whole pizza (and in this world, pizzerias do not sell slices) that costs $8, but only has $4 on hand.
= $8 Pooh’s Problem Fortunately for Mr. Pooh, he has two friends --Tigger and Piglet -- willing and able to help him with his dilemma. Each of them as $2 to contribute to purchasing the pizza. However, while Tigger wants two slices, Piglet does not. Mr. Pooh makes two different transactions. With Tigger, he sells an equity stake in the pizza; $2 for two slices. With Piglet, he sells debt. He agrees to pay Piglet $3 next week to borrow his $2 today, enabling him to purchase the whole pizza. In both cases, Mr. Pooh is able to raise the necessary capital to carry out the pizza purchase, just as a company issuing stock or debt raises capital to finance their operations or investments. However, is there any reason why, from the issuer’s or purchaser’s perspective, one should prefer stocks to bonds. In the next section, we will discuss this question. 2
2.2 STOCKS vs. BONDS The conventional wisdom regarding stocks and bonds is that they are reciprocal, but identical, bets. Bonds provide lower, but less risky returns, while stocks have more risky, but have the potential to produce greater returns on the investment. One illustration is the following through experiment. Would you rather offer or take a 10% chance of winning $90 or a 90% chance of winning $10? The traditional view of stocks and bonds was the first bet was like a debt (bond) transaction, while the second was like a stock purchase. Viewed strictly from an “expected value” (probably X payoff ) perspective, one should be neutral. The expected value of a 10% chance with a $90 payoff is $9, just as a 90% chance of a $10 payoff is also $9. They are the same bet. The only difference is one’s view of risk. If you are risk-averse, you prefer the second, if you like to take chances, you may take the first. Since bonds were considered a “sure thing,” despite modest returns, many corporate finance experts argued that capital structure should tilt toward bond issues. For buyers, bonds promised steady and secure income, ideally for those approaching retirement. However, if you want more risk and reward, you should weight your portfolio toward stocks. Since they can be viewed as flip-sides of the same wager (they are both financed by income), they should be inversely related: when stocks rise, bonds will be relatively cheap and when bond prices increase, stocks will be relatively cheap. The chart illustrates this relationship. It shows the relationship between two electronically traded funds (ETFs) focused on longterm Treasuries (government bonds) and the S&P 500 respectively. Stocks are “growth opportunities” when a positively economic outlook suggests most companies will increase in value. Bonds are a “safe haven” when the economic forecast is dim. As the market shifts from one view to another, there are arbitrage opportunities as investors lean toward one asset class against another. Over time, long-term investments in stocks and bonds have changed in relative value. For most of the 19th century, bonds proved a better investment. At the time, most stocks were railroads that frequently boomed and busted, wiping out shareholders. During the Gilded Age, the spread of monopolies and trusts promised substantial and secure profits. This resulted in a greater share of income flowing to shareholders and stocks outperformed bonds. The 1929 Crash and Depression combined with higher income taxes to support government borrowing once again saw bonds outperforming stocks. The worldwide destruction following WWII put American industries in a unique position to expand, but since the late 1960s, despite multiple stock market booms, bonds have outperformed stocks. 3
2.2.1 EQUITY vs. DEBT: THE SELL SIDE First, let us look at the tradeoff between stocks and bonds from the perspective of the issuer. In short, does the capital structure -- the share of capital composed of debt and equity respectively -- matter? In the past, the answer was yes, companies with high debt-to-equity ratios should be valued less because than companies where the capital was mainly provided by the firm’s owners because it implied large outstanding liabilities. Highly leveraged companies -firms with high debt-to-equity ratios -- have borrowed heavily against a small ownership stake. Therefore, to a prospective shareholder, a heavy debt burden would seem to lower the company’s value. Two Nobel-Prize winning economists, Franco Modigliani and Merton Miller, argued that firm’s capital structure is irrelevant. It does not matter whether it finances through stocks or bonds. They made four propositions about capital structure. First, the debt-equity ratio does not affect the firm’s market value; second, leverage does not affect the borrowing costs of the firm; third, the firm’s value is independent of its dividend (payouts to shareholders) policy; fourth, investors are indifferent to a firm’s capital structure. The basic intuition is shown in the chart to the right. At low debt-equity ratios, the required rate of return to bondholders is low, while the return to shareholders is high. As the debt-equity ratio rises, bondholders demand higher rates of return, but shareholders have lower rate of return, but the average cost of capital remains the same. Therefore, the capital structure does not impact the value of the company. Merton Miller explains the intuition: "Think of the firm as a gigantic tub of whole milk. The farmer can sell the whole milk as is. Or he can separate out the cream and sell it at a considerably higher price than the whole milk would bring. (That's the analog of a firm selling low-yield and hence high-priced debt securities.) But, of course, what the farmer would have left would be skim milk with low butterfat content and that would sell for much less than whole milk. That corresponds to the levered equity. The M and M proposition says that if there were no costs of separation (and, of course, no government dairysupport programs), the cream plus the skim milk would bring the same price as the whole milk."
In essence, this is an example of the “no free lunch” or “the whole equals the sum of the parts” propositions in economics. However, Miller suggests certain circumstances where they may not be equal. For example, if there is a relative tax advantage to debt financing, a company may choose to bias its financing toward issuing debt. Some observers note that due to the tax advantage of debt financing, many American firms are much more highly levered than in the past. In addition, if there are arbitrage opportunities created by different abilities of the firm and investors to borrow, this could affect how a company finances its operations. In the United States, where deep and liquid capital markets exists, “leveraged buyouts” may occur where one entity can borrow cheap (issue debt) and purchase shares (buy equity). In Europe (and Japan), where abundant “patient capital” exists and equity markets are relatively underdeveloped, these opportunities are relatively scarce. As a result, most European firms and banks are much more highly levered than their American counterparts. Finally, corporate governance can affect how a firm finances. If managers are compensated through stock options, they pursue policies that boost stock prices by taking on additional leverage, even if its degrades the firm’s value. The upside is captured by the managers, while the potential downside of bankruptcy are borne by shareholders. 4
2.2.2 EQUITY vs. DEBT: THE BUY SIDE When investing, one realizes a capital gain when one can purchase an asset cheap and sell it after its value appreciates. There are four basic types of investing assets: stocks, bonds (fixed-income), commodities (i.e, oil, precious metals), and real estate. While there can be bubbles in real estate and commodities, they are not primarily financial securities and are affected by supply and demand in the real economy. However, debt and equity are both financial securities and can be seen as different methods of making the same investment. If stocks and bonds are simply two means of the same wager with the same expected value, why would one prefer one to the other? As stated above, stocks and bonds can be compared as two wagers with the same expected value. A simple expected value is calculated by multiplying the risk (probability) by the reward (return). In general, bonds are low-risk, low-reward assets, while stocks are high-risk, high-reward assets. The chart below displays are range of assets and their relative risks. There are some inherent risks to different types of investment assets, but at any given time, there may be a general market opinion about risk. When most market players perceive the future to be risky, the demand for low risk assets may increase, driving up the price. When most market players have a bright economic outlook, the demand for riskier assets may rise, increasing their price. One can take advantage of these movements by investing counter-cyclically: buy the undervalued (lower demanded) asset and then sell it when others in the market drive up its price. In short, purchase bonds when the economy is booming (and sell when the economy busts) and do the reverse with stocks. This is difficult because it requires resisting the momentum of the market. Most investment experts recommend diversification or the holding a spectrum of different assets that will be able to weather secular and cyclical changes in the economy. In essence, diversification argues that one should hold both. However, this does not identify the best portfolio mix of assets with different risks and rewards. This can be estimated empirically. Since there is a lot of data on financial assets, one can find the average payoff to owning various assets and the variability (risk) of the payoff. The critical insight into “portfolio theory� was done by economist Harry Markowitz. His central idea was that it did not matter how risky individual stocks or bonds were, but how correlated they were with each other. One could compare any two assets, and using historical data, estimate how correlated they were and their return. While this worked in theory, it presented a practical problem. Computing the paired correlations of the whole universe of financial assets was beyond the ability of existing technology. Still, Markowitz’s concept helps understand how to balance assets in a portfolio. 5
We can think of all possible portfolio combinations as points on a chart with risk and reward on the horizontal and vertical axes. The graph at the right illustrates this idea. The cluster of portfolios forms a horizontal parabola. The apex of the parabola represents the least risky portfolio. The upper edge of the parabola represents the best combination of risk and reward and everything below is an inferior portfolio. Any rational investor would be indifferent to any point on the upper edge, known as the “Efficient Frontier” because they all represent equally desirable combinations of risk and reward. This model, however, is still incomplete. First, the apex does touch the vertical axis and therefore does not provide a complete set of possible portfolios. Second, it still presents an insurmountable calculation problem in practical terms. These issues were addressed later by two other Nobel-Prize winning economists, James Tobin and William Sharpe. Tobin noted that if one included the return on a riskless asset, cash, or its near substitute, a short-term, inflation-protected US Treasury Bond, one could complete Markowitz’s efficient frontier by drawing a tangent line from the return on cash -- the prevailing interest rate -- or yield on the relevant Treasury Bond, which is a point on the vertical axis, to the existing efficient frontier. Tobin also noted that one did not have to compare relative risks of different assets, but argued that a portfolio could be divided into risky assets plus borrowing and lending (cash at the prevailing interest rate). If you were risk-averse, you would lend any additional capital to those who would borrow due to their greater risk appetite.
Sharpe solved the problem of infinite possible portfolios by noting that there was one obvious portfolio on the efficient frontier: the whole market. Most stocks rise and fall together and the strength of this correlation is a gauge of the variability of individual stocks. Instead of comparing pairs of portfolios, one could compare all portfolios against an index of the market. Sharpe argued that all the risk related to specific investments could be captured by its deviation from market volatility. This deviation is known as beta; the higher a security’s beta (β), the greater the risk (and reward) that could be expected. The conclusions of Tobin and Sharpe lead to the belief that an index of the market is the best portfolio for general investors because it not only was efficient, but reduced transaction costs of investment to a minimum. 6
3.0 BONDS This section will discuss bonds in greater detail. In addition to addressing how they function, sold and priced, it will discuss the process of securitization and its role in precipitating the recent financial crisis.
3.1 BONDS AS POST-DATED CHECKS Bonds are fixed-income security that exchanges money now for money later. In a bond transaction, one person has a need for more money than their current income permits, while the other has more income than they need to satisfy current needs. Let us unpack this concept. Like an ordinary bank loan, an individual borrows money and takes on the obligation to repay a debt. However, unlike a loan, the amount of the debt is fixed; a bond will never be worth more than the par value of the bond and matures in a fixed period of time. In addition, a bond is a security, meaning it is a financial instrument that can be bought and sold repeatedly and is secured against a specific income stream or collateral. Government bonds are secured against tax revenues; corporate bonds are secured against corporate property and income. However, the best way to conceptualize bonds is a post-dated check like the one below.
Imagine a situation where I want to vacation in Cabo, but do not have the ready funds to finance this trip. Fortunately, I know that I have future income that could pay for the cost of the trip and rather than contract a loan from a bank or use consumer credit (credit card), I decide to auction the personal check above to the highest bidder. I would gain whatever the highest bidder would offer for this promise of payment. However, the bidder would not be able to collect on the check until April 25, 2019. How much should someone bid on this future promise to pay? Obviously, no one should bid the full face value of this post-dated check, but how much less than the face value should they offer? First, how are bonds priced differently than other securities or debt obligations.
The cost of a loan is the principal -- the amount borrowed -- plus an interest rate; the cost of a bond embeds the cost of capital in its par value and the rate of interest can be inferred by the difference between the face value of the bond and the price paid for purchase of the bond. As the value of a bond increases, it becomes closer to its par value, shrinking the yield. The inflation rate affects both bonds and loans since they are typically contracts stated in nominal terms and inflation can reduce the real yield and the interest rate and the principal borrowed. 7
3.2 PRICING BONDS There are four basic considerations when pricing a bond: issuer credibility, the prevailing interest rate, time to maturity and inflation. Each relates to a specific risk that the bond’s value will diminish or not be honored by the issuer. Three -- the interest and inflation rates and time to maturity -- of them can be precisely quantified, the fourth is measured by a rating system that provides a summary statistic to assess the issuer’s willingness and capacity to repay its debt obligation. In a world of small, face-to-face transactions, individuals could make their own judgments regarding the issuer’s credibility, but in large, anonymous credit markets, investors must devote resources to monitoring the issuer’s credit status whether through a ratings agency or their own efforts. Still, the calculation of a bond’s price is largely mechanical, since three parameters are objective and available to all, leaving only one judgment -- the issuer’s credibility -- to be determined.
3.2.1 INTEREST RATE RISK Cash is a near substitute to bonds and therefore when the “price” of cash -- the interest rate -- changes, it affects the demand for bonds. Holding cash has some clear advantages relative to bonds: there is no risk of default and it is liquid and can be used directly to purchase goods and services. Therefore, if the “price” or return on cash rises, investors will prefer to hold cash instead of bonds, lowering the demand and price of bonds. The purchase and sale of bonds is the main channel central banks use to control the interest rate. By changing the composition of their balance sheets, they inject or withdraw cash from the economy. Cash and short-term government bonds are near substitutes and cash can be thought of as a short-term bond. When a central bank sells a bond, it withdraws cash from circulation; when it buys a bond, it puts cash back into the economy. This makes cash relatively plentiful or scarce, moving the interest rate. These actions not only affect the price of government bonds, but bonds in general.
3.2.2 INFLATION RISK Inflation reduces the value of cash holdings. Since bonds swap money now for money later, inflation could affect the terms of the exchange by reducing the value of money later. This can be a problem because bonds transactions are stated in nominal terms, where $1 = $1, regardless of what the $1 can buy. Inflation makes the real interest rate lower than the stated nominal rate and further reduces the real price of the bond. For corporate bond transactions, inflation is an exterior risk because neither party can control the inflation rate. However, since governments do have the ability to influence the level of inflation, government may use inflation to reduce their real borrowing costs. There are “inflation-protected” bonds, such as the Treasury InflationProtected Securities (TIPS) that are indexed to inflation, which typically have lower yields (higher prices) than their non-indexed counterparts and the difference is an implied measure of inflation. 8
3.2.3 TIME TO MATURITY Bonds realize their full face value only after a set term. A 20-year bond takes 20 years before the buyer can redeem it at par value. However, between the time of issuance and redemption, the bond can be traded. If I want to purchase a 20-year bond five years after its issuance, how does the time affect the bond’s value? Time to maturity involves more or less risk; less time, less risk; less risk, higher price. So, one could price a 20-year bond with 5 years elapsed as a 15-year bond. As time passes, long-term bonds resemble newly-issued shorter-term bonds. While interest rates and inflation represent shifts in price to concrete and discrete changes in markets (availability of substitutes, value of money, etc.), the adjustment due to the maturity term is about uncertainty. The more time, the more unpredictable events could occur that could affect the bond’s ultimate payout. Since not every buyer may have the patience to wait until the bond fully matures, some bonds have “coupons,” the operate similarly to stock dividends, that make smaller, scheduled payouts of the bond’s value. This is useful when there is doubt about the issuing entity’s existence when the bond matures. For example, no matter how creditworthy, few banks would make a 30-year mortage to a 65-year old individual. Similarly, firms on the brink of bankruptcy or nations near default or defeat in war may issue their bonds with coupons to attract buyers. To the right is a 1927 bond issued by China’s Nationalist government under Jiang Jieshi (Chiang Kai-Shek) to finance his “Northern Expedition” against comepting warlords. The long-term future of the nationalist government was unsecured and the bonds were issued with coupons that could be clipped and redeemed for payment in installments. Once coupons on bonds are clipped, they depreciate the value of the bond to all future holders of the bond, and therefore, the bond would command a lower price. However, coupons make bonds more liquid because it allows holders to convert its value into cash to be used for other transactions.
3.2.4 ISSUER CREDIBILITY The final consideration is the issuer’s credibility. Credibility consists of two judgments: the willingness and capacity to honor the debt obligation. “Credit” and “credibility” come from the Latin word for trust. In faceto-face situations, establishing trust is easier because one can monitor and observe other’s resources, behavior, and intentions, but in a large, anonymous market, individuals need to rely upon indirect systems to guarantee trust and give information on credibility. We trust that the meat we purchase at a grocery is safe because the USDA inspects and grades it; we trust doctors, teachers, and other professionals because they must pass state examinations and earn licenses. We trust the structural integrity of a bridge or the operation of an elevator not because we have tested it, but because an engineer inspects it. the same is true of pruchasing a bond. 9
There are three major agencies that rate bond issuers: Moody’s, Fitch, and Standard & Poor’s. They rate both governments and corporations regarding their creditworthiness. With minor variations, they range from “AAA” indicating a low risk of default, to D, indicating a state of default on debt obligations. These credit ratings are analogous to individual credit scores. These low-grade bonds are sometimes call “junk bonds” or more euphemistically “high-yield” bonds. The more creditworthy the issuer, the higher the price (and lower the yield) on the bond. However, some investors gamble on low-rated bonds, because they can can purchase them on the discount, betting that they will make good. Although it has lost the highest credit rating from some agencies, recently, US government debt is considered the most creditworthy asset, as evidenced by the “flight-tosafety” into US Treasury Bonds during the 2008 Financial Crisis. This preeminent status is due to the US dollar’s status as the world’s reserve currency and that, unlike virtually every other nation in the world, the US has never officially defaulted on its debt obligations. However, the divergence between market-based estimates of risk and agency credit ratings show the potential problems of relying on ratings. As information has become more transparent, the market yield suggests investors’ collective faith in a government’s ability to repay. Investors can buy insurance against defaults and the “spread” between the capital costs for different countries can provide relative measures of riskiness. However, governments can undergo crises of confidence as investors “chain-gang” with “hot money” in and out of different countries precipitating financial crises. Some types of bonds have a higher defaults risk than others; the chart to the left ranks bonds from high to low risk. Governments and corporations have an inherent advantage in their ability to pay over individuals for one simple reason: they have no fixed lifespan. Individuals, even under the best circumstances, only have 30 to 40 productive years to generate income to finance debt. Governments and corproations have a potentially infinite time horizon. As a result, they can “roll over” debt in perpetuity, simply by covering the interest payments on the amount borrowed. For example, the US only recently finished paying off the bonds used to finance the Louisiana Purchase -- after nearly two centuries. 10
3.3 SELLING BONDS Government bonds have inspired some of the most interesting sales campaigns in history. Jay Cooke made his fortune selling bonds to finance the American Civil War; WWI and WWII produced a plethora of memorable posters. In addition, many children receive government bonds as present from doting grandparents, aunts, and uncles. Why the attraction? Why not buy someone $100 worth of stock instead of $100 savings bond? First, unlike stocks, the face value of a bond is always greater than the purchaser paid. The receiver may think they received $100 present, but it only cost the giver $85. Second, when purchasing a stock to hold, the appeal is relatively narrow: the future prospects of the company. Bonds prove to have a broader appeal as the posters below suggest.
The diversity of potential buyers, from large to small, across the spectrum of backgrounds make bonds a popular investment vehicle. Appeals to humor, patriotism, security, playfulness, and the “American Dream� have all been used. 11
3.4 MORTGAGE-BACKED SECURITIES AS BONDS Bonds are one type of fixed-income security. The term “fixed-income” refers to securities that return stable and steady sterams of income at fixed internvals over time. Stocks can fluctuate significantly over short intervals, alternatively booming and busting, generating large gains one period and losses the next. Bonds and other fixed-income securities are thought to be more stable because they are tied to regular payments to generate their income, whether it is corporate revenues, government taxes, or loan payments. In short, they are “secured” against a collateral flow. This section will discuss the process of securitization or the creation of fixed-income securities and apply the previous section’s comments on bond pricing to explain several dimensions of the 2008 Financial Crisis. In particular, it will discuss Mortgage-Backed Securities (MBS) as a type of bond, how they became widely used in the mid-2000s, and why the system fell apart.
3.4.1 MORTGAGE FINANCE: A BRIEF OVERVIEW In the past, home mortgages were a local affair. Local savings & loans and banks would take deposits and make home loans in their communities. As a result, they had the ability to assess the borrower’s credibility and capacity to take on debt. In addition, these local financial institutions would hold on to the mortgage, generating income as mortgage payments were made over time. This relationship encouraged lenders to make only prudent loans, because mortgage defaults would eliminate their main source of income and also put pressure from depositors (who often were the same people taking out mortgage loans). However, if a region was poor or experienced bad economic times, this could produce a vicious cycle. Banks in poorer areas would not be able to source capital to support productive projects, including home construction. In addition, if the local economy went sour due to a factory closing or a poor harvest, a series of defaults could put pressure on the bank as individuals draw down their savings (and the demand for loans). To address these problems, the Federal Government created two agencies -- Fannie Mae (1938) and Freddie Mac (1970) -- to bundle and securitize mortgages.
3.4.2 SECURITIZATION Securitization is the process of bundling ordinary loans -- mortgages, automobile loans, student loans -- and marketing them to creditors as a single security. By securitizing ordinary loans, one can source capital froma wider range of sources, lowering the price of borrowing, and defray risk for lenders by packaging good and bad loans together. Similar to the portfolio model developed by Markowitz, Tobin, and Sharpe described above, securitization allows one to “buy the market” by holding a diverse spectrum of assets in one security. The prospects of one mortgage failing are uncertain -- one cannot put a specific number on it, but the prospects of a bundle of mortgages failing is risk -- we can estimate the chances of its failure. This relieves the issuing bank from the risk of individual mortgages and lowers the cost of borrowing by expanding the market. Now that risk can be quantified, one can set a price on the insurance against default and buy insurance against this possibility through “credit default swaps.” In addition, by then selling the insurance to a wide array of people, one can defray the risk of loss. What went wrong? First, risk was transferred from local lenders who made the original lending decision. As a result, no longer liable for default risk, they were much more willing to issue mortgages to marginal borrowers. This should not have been a problem, because the risk was (theoretically) being taken on by the purchasers of the mortgage-backed securities. However, the purchasers had little way to monitor the creditworthiness of the borrowers, except through the ratings given to the securities they purchased. This was their guide to the “credibility” of the borrowers, just as we use transcripts, USDA ratings, and professional licenses to guide us to make trust decisions we cannot observe. 12
3.4.3 CREDIBILITY GAPS Several problems arose through the process of securitzation. First, when bundling the mortgages together, they mixed mortgages of varying quality. For example, they split first payments on mortgages from later payments (even with a poor credit risk, most people make their first payments), they mixed mortgages issued under different lending standards. Intuitively, one would think that the risk of a bundle of assets is simply the weighted average of its components. For example, a securitized asset that has AAA mortgages and B mortgages should be rated somewhere in between. However, many were rated AAA. Why? In part, because they purchased insurance against the default of these riskier assets. For the purposes of paying-out, an insured bad asset can be represented as a good asset. This passed the risk to the insurers, like the company AIG. In retrospect, it is clear that many of the actors in the financial sector understood the problems with this at the time. Why would seemingly intelligent and talented individuals engage in such a risky enterprise? The first is that there is a market for “safe,” “investment-grade” -- AAA-rated -- assets. Many institutional investors, especially those in the public-sector, can only hold assets of high-quality, defined as the asset-rating by rating agencies. They are risk-averse by statute, and, as a result, they tend to settle for lower returns on their investment. However, the creation of AAA-rated assets from high-yield components (lower credit risk = higher interest rate = higher notional income) seemed to provide a low-risk, high-yield security. Therefore, seemingly conservative, but credulous, investors ended up chock full of toxic securities, just as a little-old lady going to a store and buys Grade-A prime chuck only to open the package to discover mystery-meat sausage and get foodpoisoning. The other reason is liquidity. If one thinks of bonds and other types of fixed-income as a near substitue for cash money, it can be used as collateral, like income, revenue, or taxes, that can be used a security for a loan. To finance other financial transactions, especially those that required a high degree of leverage or scale, the “promise” of income from mortgage-backed securities provided a ready source of liquidity. In essence, what developed was a ponzi scheme to service a gambling habit. The rewards accrued to those who successfully won their gambling bets, while the “suckers” of the ponzi scheme bore the risk. 13
The third dimension of this was “savings glut” created by export-oriented growth strategies of developing countries, mostly in Asia. In order to maintain their export advantage, these nations try to keep their own currency weak relative to their foreign markets. The main way to do this is to raise the value of the US dollar by buying safe dollar-denominated assets. Ordinarily, this means buying US Treasury Bonds, but the same goal came be served by purchasing US mortgage assets; securitization allows this to do be done on scale. All of these developments made determining the credibility of the borrower more difficult, whether by parsing risk from reward, willfull ignorance, or the complexity of the transactions themselves
3.4.4 INTEREST RATES & THE FED The second force setting up the 2008 financial crisis was the abnormally low interest rates in the early-2000s followed by a rapid rise of rates thereafter. The graph below shows base interest rate levels during the 2000s. In late 2000-2001, the Dot-Com (NASDAQ) bubble burst, prompting the Federal Reserve to lower interest rates to cushion the aftermath of the burst bubble. Shortly thereafter, the potential of an economic ripple following the 9/11 attacks convinced policymakers to keep interest rates low to prompt investments and spur consumption. However, low interest rates made two other related developments possible. First, low interest rates also meant low mortage rates, making it easier for individuals to take out loans to purchase houses, creating demand for houses. This lead to rising home prices and investment in home construction. In addition, it lowered the yields (raised bond prices) on all fixed-income assets, such as governemnt and corporate bonds. This pushed financiers to take on more risk to produce the returns on investments that investors had come to expect. There is a measure, called the “Taylor Rule,” developed by Stanford economist John Taylor, to predict where the Federal Reserve Funds Rate should be given the levels of inflation and unemployment. The graph below shows the Federal Funds actual rate compared to a simple Taylor Rule (dotted line) during this period. As you can see, the Federal Funds Rate, which governs the nominal short-term interest rate, was below what the Taylor Rule would predict, implying that the Fed’s actions were inflationary. However, the relatively sharp rise from 2004 to 2006 was equally problematic. Many individuals who had taken our “sub-prime” or adjustable rate mortgages, suddenly found they were unable to keep up with the mortgage payments. Not only was this fortunate for these homeowners, but this dramatically increased the default rate for the securitized assets that contained them. As these assets depreciated, it created a liquidity crunch throughout the financial sector, blowing a hole in their balance sheets. 14
4.0 RISK v. UNCERTAINTY Earlier, we distinguished stocks and bonds as examples of high and low risk investments. However, this is not quite accurate. The main difference is not “high” versus “low” as much as the difference between “risky” and “uncertain” investments. Risk is quantifiable; uncertainty is not. When I roll a die, there is a 1/6 chance of a four; when I flip a coin, there is a 1/2 of the result being a heads. If I were to wager $10 on these outcomes, I know that a fair bet would be $5 ($10/2) on a coin flip and $1.67 ($10/6) on the die roll. The expected value is a precise number. However, if the gamble was what are the chances that I will become a doctor, precise odds cannot be determined. The possibilities are not simply “doctor” and “not-doctor,” but doctor, lawyer, teacher, police officer, environmentalist, and so on. The future is indeterminate, and as a result, estimations of future events are indeterminate and we estimate them subjectively. A second reason for the uncertain nature of stocks is inherent randomness. By definition, a random event is not predictable. A good analogy is a drunkard’s walk as he teeters and waddles from side to side. If he walked the double yellow line divider, his average position (the double yellow line) suggests he would not be hit by oncoming traffic. However, as shown by the picture to your right, his first wobble leads him into the traffic, killing him, so he never realizes his “average” position. This is what the economist J.M. Keynes meant when he observed that “markets can stay irrational longer than you or I can remain solvent.” The drunk’s wobbles can be described as the “heads” and “tails” flips of a fair coin. Even the most unlikely events, provided enough chances, will occur with certainty. On average, the probability of lightning striking the same place twice is low, but given enough lightning strikes, it will occur with 100% certainty. Finally, the movement of stock prices are contingent. Standard theories of probability often assume that events are independent, the outcome of one does not influence the outcome of another. For example, if I flip a coin, getting heads on the first flip does not affect whether the second flip will be heads or tails. However, this is not true for stocks. A good historical example is the fate of the VHS and Betamax Videocassette players. At the time, Betamax was the superior product, but VHS had the larger initial market share. As a result, VHS was able to control the market in this product. Another complex system is weather, where small disturbances can create large effects, such as the twitch of a butterfly’s wings creating a hurricane. Similar things can occur in equity markets through network effects, information cascades, and interaction of perceptions. All of these factors suggest that the risks of stocks is non-linear and cannot be quantified as a fraction (i.e., one chance out of three). While stochastic calculus allows some to model some of these factors, this goes beyond our discussion.
4.1 NEWTONIAN & BROWNIAN MOTION Much of economics derives from the application of physics to describe social phenomena. Initially, this meant applying the insights of Isaac Newton (both the Laws of Motion / Thermodynamics and the mathematics of calculus created to describe them) that students learn in introductory physics and calculus courses. Crudely, this assumes a world that is orderly, rule-governed, linear, and predictable. In other words, it describes the social and physical world as a large, mechanical clock. Once the components of the clock are understood, one only needs to push on the proper gears to make it work as desired. Newton’s second (inertia: objects at rest tend 15
to stay at rest) and third (for every action, there is an equal and opposite reaction) Laws of Motion manifest in economics as the concepts of equilibrium and “no free lunch.” Newtonian physics and conventional economics presume relationships are general, universal, and deterministic. While this is a simplification, it is also a good description of how bond and fixed-income markets work in practice. However, modern physics -- the physics that derives from the work of Einstein, Heisenberg, Mandelbrot and others -- transcends this model of how the world works. Einstein’s Law of Relativity (E = mc2), Heisenberg’s Uncertainty Principle, and Mandelbrot’s fractal geometry all suggest a different way to look at how complex systems operate. They are probabilistic, not deterministic; they are relative, not general; they emphasize uniqueness, not universality. The best example of this are clouds. The basics of how clouds form is well known, but it is nearly impossible to predict the shape of any specific cloud formation. Similarly, DNA -- parents and children look similar, but not the same -- and snowflakes -- all have similar crystalline shapes, but different details -- are examples of these types of processes. In terms of economics, the economy -- and in particular the stock market -- seem to have regular cyclic undulations, but predicting the movement of any individual stock is difficult. Movements in the stock market seem to be random, unpredictable, and contingent: how can one accurately predict how one should invest?
4.2 RANDOM WALKS & STOCKS The goal of investing in stocks is to purchase a stock at one price and sell it at a higher price, pocketing the difference as a capital gain. However, the listed price of stock is the price at which half of the market participants think it will go down (sellers), while the other half think it will rise (buyers). This is because, in the short-term, for every stock purchased another stock must be sold. Therefore, the likelihood of each possible event is 50-50; in essence, a coin flip. Half of the market bets on the possibility of heads/stock rising, while the other half bets on the possibility of tails/stock falling. This has several implications. First, it suggests that stock transactions are zero sum: the winners must equal the losers. Second, the movements of individual stock prices are random fluctuations akin the flips of fair coins. They are like static or “noise” that vary around the true signal of the stock’s worth. Therefore, there is no talent or ability in picking the best stocks, or, more precisely, picking the correct stocks is not an indicator of talent or ability anymore than correctly picking heads or tails on a coin flip is a matter of talent or ability. Third, while the overall value of the stock market may grow (because the underlying asset, the value of firms, increases in value) and individual stocks do rise and fall, one may not be able to identify these events in a fair and competitive market. The similarity between coin flips and stock market movements has been made by several economists as suggested by the charts below. The one on the left is created by simulated coin flips; one on the right is from the real movements of a stock. In short, stock movements are indifferentiable from randomness.
As a result, economists suggest that professional brokers can do little to improve the performance of your portfolio and their “success” is simply luck. One would be better putting your money in an index fund that mimics the movements of the market as a whole than trying to guess what is the next stock to boom. 16
This may also explain the common caveat made by stockbrokers: past performance is no guarantee of future success (although they try to convince you that their past performance is meaningful). It also implies that the more one tries to see a pattern in a stock price, the worse one will do predicting future movements. Studies have shown that a monkey throwing darts at a wall can perform better in stock-picking than professional brokers. “Mindless” wagers -- “beginner’s luck” -- may do better anticipating a random pattern than a more informed judgment. It also suggests the more one trades -- the greater number of transactions -- the worse will be your final return on investment. For most, every trade entails a fee charged by a broker to execute the trade, whether or not it is wise or prudent. Brokers (and brokerages) make their living on the volume of stock market trades, not whether the market goes up or down. As a result, they have incentive to promote investments in equities. Just as a casino may comp “high-rollers” to encourage them to play more, brokers may entice individuals to speculate in the stock market.
5.0 THE STOCK MARKET Although the most reported economic news are the daily movements of stock markets, economists generally have a dim view of its operations. It is not seen as a major source of investment leading to productivity and it does not lend itself to general theories or predictions. This view is perhaps best summarized by the economist J.M. Keynes, who noted: Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation. When capital development of the country becomes a by-product of the activities of a casino, the job is likely to be ill-done. In addition, Nobel laureate Paul Samuelson observed that the stock markets have predicted nine of the last five recessions suggesting it is not even a good indicator of the health (or ill-health) of the economy. However, some believe that the stock market is a good indicator of future expectations of economic growth and advocated that central banks buy equities to help stabilize the business cycle. In this final section, we will identify some of the major exchanges, describe some common strategies used (and abused) to “beat the market” by investors, and conclude with a discussion of “call” and “put” options.
5.1 STOCKS, RATIOS & BEAUTY CONTESTS As stated above, the goal of investing in stocks is to choose one that one thinks will increase in value. In other words, you want to pick a stock whose value is greater than its current price. Simply picking a good company is not enough, because if that opinion is shared by many, the price is likely to be close or exceed its current price. For example, Apple may be a good, well-run company marketing an attractive product, but is it worth buying its stock at any price? One way to answer this question is to look at the PE (Price-Earnings) Ratio. This ratio divides the stock price by the earnings per share. While there is no general agreement on what ratio indicates a properly valued stock, a PE Ratio between 10 and 20 is considered reasonable, below 10 is underpriced, and over 20, overpriced. There are variations of these ratios, such as the Graham Ratio, named after famous “value investor” Benjamin Graham, the Q-ratio, which compares the market price of compares to the book value of their capital assets, and the PE10, which uses 10-year average of earnings. The charts on the facing page show some of historical values of these ratios compared to stock indices. As you see, high PE ratios are associated with stock bubbles that preceded crashes. A second way to view the value of a stock is to look at the (inter)subjective evaluations of investors. It is not 17
important what the “real” intrinsic value of a company is, but what investors perceive its value to be. The price of stocks go up because perceptions change, not underlying value. However, every investor’s perception and actions interact with the price, which should be the point where half believe it will go up and the other half down.This makes a Keynesian “beauty contest.” Two examples illustrate the difficulty in correctly picking a stock. Imagine that one had to pick the most beautiful face in a set and the “most beautiful” is defined by what the majority select as the most beautiful. Picking correctly entitles you to a share of the prize. Your choice changes the correct answer and every other contestant faces the same problem, so you are guessing not only at what is objectively the most beautiful, but what others believe is the most beautiful. However, they know you are taking their intentions into account, and adjust according. For those preferring popular culture, the dialogue betweeen Vizzini and Westley in the movie The Princess Bride illustrates this problem. You win only if 1) you correctly choose 2) what the majority believes 3) the majority will pick as 4) the winner of a subjective contest. Like the board game Apples to Apples, the winner is not what the best match is, but what the judge decides is the best match according to whatever criteria they arbitrarily choose. Another way of understanding this problem is to think of the following situation. Imagine a group was asked to pick a number between 1 and 10 with the correct answer being 2/3 of the average guess. If the guessers could not coordinate, every guess would move the average and the correct answer. If you believed the average guess would be 5 and adjusted 2/3 from there, the correct answer would be less and everyone else who did the same would make the answer lower and lower as individuals adjusted their guesses to their expectation of others’ intentions.
5.2 STOCK EXCHANGES There are several large markets for equities or indices of the major publicly traded companies in each country. In the US, the major indices are the S&P 500, the Dow Jones Industrial Average, and the NASDAQ. Broadly speaking, the Dow Jones and the S&P 500 draw from the same type of firms, with the Dow Jones consisting of a small sample of 30 “blue chip” companies, while the S&P 500 is a larger sample of somewhat smaller firms. The NASDAQ differs insofar as its components tilt heavier toward “new economy” companies, 18
including “tech” companies. Despite these differences, most of the time, these indices move in tandem with each other. Other major exchanges/indices around the world include the FTSE (London), Nikkei (Tokyo), DAX (Germany), CAC (Paris), and the Hang Seng (Hong Kong). Running parallel to these stock exchanges are commodity exchanges such as the NY (NYMEX) and Chicago (CME) Mercantile Exchanges that trade in key commodities such as precious metals, oil, raw materials, foreign exchange, and futures contracts that often impact on and interact with the equity-stock exchanges.
5.3 HOW TO BEAT THE MARKET In a fair and competitive market, there should be no profit (producer surplus) because it has been competed away. This suggests that no one should be able to make money over the long-term by playing the stock market. However, clearly, some people do. How is this possible? This section describes some of the strategies that allow some to have an advantage in investing. Before continuing, let me state that this is not investment advice and its only purpose is to explain how the empirical phenomenon of stock market profits can be understood within economic theories. A good analogy for the strategies outlined below is the game of poker. Poker is a game of chance, suggesting that no one should have a long-term advantage over other players. However, good poker players exploit certain advantages and strategies that allows them to make money over the long-term. When one bets in poker, one wagers that the cards they hold are better than the cards their opponent holds, just as when a stock is sold, one party believes the price will increase, while the other thinks it will decrease.
5.3.1 MONOPOLY & MARKET MAKING One assumption of fair and competitive markets is that all participants are price takers, not price makers. In short, their actions cannot influence the market price. However, in the real world of investing, there are certain players who control enough assets to move the price of these assets, such as (some) hedge funds, mutual funds, large financial institutions, and pension funds can manipulate market prices to their own advantage. Arguably, some public agencies, like the Federal Reserve, can also exert monopoly power by controlling the flow of money in the economy or lower the borrowing cost for the government by purchasing government debt. To make the analogy to poker, this is akin to betting against someone with a much larger stack of chips. They can put other players “all in” and force them to chase poor hands or fold. Instead of receiving a “fair price” for 19
the cards they hold, they can effectively bluff others. Another dimension of this advantage is that some financial actors have privileged positions within the financial system. A broker who places the stock investments for other investors can keep track of the flow of decisions and bet accordingly, violating their fiduciary obligations. Or, they could see that a bubble is forming and time their investments to take the greatest advantage of other investors’ expectations.
5.3.2 LEVERAGE Although leverage is another advantage of size, it is not strictly dependent on size, but on the ability to borrow and the ability to identify and arbitrage small differences (frictions) in the operation of markets. In the 1980s and 1990s, many professional investors hired mathematicians and physicists (“quants”) to model market processes. Using these complex models, financial engineers were able to identify assets that were slightly mispriced. While these market imperfections may only yield a fraction of a cent profit, if one repeated the transaction a million times, this quickly becomes significant money. If one is able to borrow large sums of money -- leverage -- to arbitrage these market imperfections, one could magnify one’s gains (and losses). One economist compared this process to “picking up nickels in front of a bulldozer.” Two types of leveraged investing can illustrate the process. The first is to take advantage of under and overvalued currencies. For a variety of reasons, various countries over and under price their currency to promote exports or to facilitate imports. An investor could take advantage of this by borrowing money in the cheaper currency and investing it in a market denominated in a more expensive currency, pocketing the difference in currency value irrespective of the value of the actual investment. This is sometimes called the “carry trade.” Another example is, prior to the creation of the Euro, the trade between the future price of the Euro and the current price of various European currencies. Investors knew that eventually that these two prices would have to converage with the creation of the Euro, but at any given time the current price of the currency could fluctuate and they could arbitrage the difference using leverage. Recently, large American financial institutions have been able to borrow money from the Federal Reserve at low rates and then purchase government debt at a higher rate of return, pocketing the difference with no risk. A second type is high-frequency trading or algorithmic trading done by computers. Some have observed that more than half of the trades executed in exchanges are done by high-frequency traders (computers) and that the average length of time a stock is held might be as short as a few minutes or even a few seconds. This is not investing as ordinarily understood. What is occuring is that a computer, programmed with the right algorithm, can instantly spot a mispriced asset, purchase it and sell it before a human investor can act. Once again, to return to the poker analogy, this is like counting cards. If one knew the probabilities of drawing a particular card and had sufficient money (and patience) to play enough hands, over time this ability would be profitable. This is why casinos do not allow players to count cards.
5.3.3 INVESTOR PSYCHOLOGY In investor jargon, an investor who generally thinks stock will increase is called a “bull,” while one who generally thinks they will decrease is termed a “bear.” If one is able to gauge the mood of the market, one 20
could invest as a contrarian and buy when others are bearish and sell when others are bullish. The noted and successfull investor Warren Buffett has said that one reason he chooses to live in Omaha, Nebraska is that it insulates him from the mood swings of the market. In addition, those who are actively involved in financial activities may be better able to understand where the market will move next through their interactions with other professionals. They may have an advantage compared to someone who must devote their time to other occupational demands on their time and attention. To make the parallel to poker, this skill is the ability to read the “tells” of other players and being able to conceal one’s owns “tells.” If I can infer whether or not you are holding good cards or not, I will be better able to determine how much I should wager against you.
5.3.4 PROPRIETARY RESEARCH & STRATEGIES Investors spend large sums of money in research. They research individual firms, macroeconomic trends, government policies, and the prospects of various economic sectors. In short, they tend to be much more informed than the average person. One assumption of fair and competitive markets is that information is free and shared by all participants. However, if one party is much more informed than others, there is an information asymmetry. For example, a used car salesman knows the value of a used car than a potential buyer and can price accordingly. A doctor knows much more about a patient’s health (and the value of different procedures) than the patient. As stated above, brokers, simply by placing the orders of their clients, is able to know something that is not available to all investors. In its most extreme form, this can be considered “insider trading” where individuals take advantage of privileged information to make investments. While this is illegal, it probably occurs more than is acknowledged and depends on an agency to enforce these rules. Once again, in poker, this would be as if I could see my opponents cards, but they could not see my own cards. This would give me a clear and unfair advantage is deciding when and how much to wager.
5.3.5 DIVERSIFICATION Diversification has been called the only “free lunch” in investing. In essence, diversification takes advantage of the “law of large numbers.” If I bet on enough independent events, the losses and gains can be hedged, insuring against large losses. For example, if I bet on enough coin flips or poker hands, probability says that I will win a certain percentage of these bets. This basically makes a prospect plague by “uncertainty” into one that has manageable and predictable “risks.” The trick is to identify two assets that are truly independent of each other, i.e., assets whose joint probability is low. While there are general rules of what should and should not be correlated, in a market that is interconnected and interrelated, there are almost always connections that we will not anticipate. However, if one could correctly identify diversified assets, one would be able to do better than one who did not have a diversified portfolio of assets.
5.4 OPTIONS & FUTURES Futures and options are two interesting methods of investing. Unlike other types of investments discussed here, where one receives a tangible security, futures and portfolios only provide conditions for future 21
transactions. A futures contract allows one to buy or sell a fixed quantity of a commodity or security at a set price. In other words, you are not buying oil now, but oil 30 days in the future. This can be useful, even essential, to certain industries that experience volatile and uncontrollable price fluctations. For example, a farmer may not know the value of his harvest and may want to “lock in” sufficient revenue to cover his costs and needs, while allowing others to profit (and bear the risk) of price and quantity fluctuations. In addition, sectors like transportation may want to control fuel costs to plan effectively. “Call” and “put” options allow investors, for a fee, to purchase the right to buy or sell a stock at an agreed price. This is similar to an “over/under” wager where one side bets that a number will be over, and the other under, a certain threshold. For a long time, it was difficult to determine how one should value or price an option, but work by the economists Robert Merton, Myron Scholes and Fisher Black provided a formula for valuing options, allowing them to be bought and sold on open exchanges.
5.4.1 THALES & THE FIRST OPTION CONTRACT Thales of Miletus was one of the first known philosophers of Ancient Greece. He was also one of the first scientists, but is known today mostly for his theory that the basic substance of the universe was water. Legend tells that one day his friends wondered what was the use of his abstract philosophy and his pure science researches, since they did not seem to make him rich. To demonstrate the uses of science and philosophy, he arranged one of the first known options contracts. Using his scientific talents, he was able to determine whether the coming olive harvest would be plentiful or not well before the owners of the olive orchards could. Then, before the harvest, he went and contracted with the owners of the olive oil presses. For a nominal sum, he purchased the exclusive use of these presses during that year’s harvest. When the bountiful harvest he predicted arrived, all the olive growers were obliged to use the presses that Thales controlled and he was able to charge them monopoly rates and earn a tidy profit on his investment. Having proved his point about the usefulness of pure science and philosophy, he returned to his researches.
5.4.2 CALL OPTIONS A call option buys the right, but not the obligation, to purchase an asset at a certain price above the currently prevailing price at fixed time in the future. If the asset rises above the “strike price,” the buyer of the option can purchase the asset at the agreed upon price and sell it at the higher market price. If the asset does not rise above the strike price by the agreed upon date, the buyer allows the option to expire, losing only the price of the option contract. This is a “bullish” investing position. 22
5.4.3 PUT OPTIONS A put option is the right, but not the obligation, to sell an asset at a certain price below the prevailing price by a specified time in the future. If the asset falls below the the strike price, the holder of the option can purchase the asset at the lower market price and then sell the asset at the higher strike price, profiting from the difference in prices. If the asset does not decline in value as expected, the holder of the option allows it to expire, losing only the cost of the option. This is a “bearish� position because it the purchaser of the option believes that the asset will decline in value.
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