STOCKS & BONDSFOR INDIVIDUALS, GOVERNMENT & CORPORATIONS,

CURRENT EXPENSES OFTEN EXCEED THEIR CURRENT INCOMES / REVENUES . . .

PEOPLE TAKE OUT LOANS TO ATTEND COLLEGE, BUY HOMES, OR START SMALL BUSINESSES . . .

GOVERNMENTS & BIG BUSINESSES NEED MORE CAPITAL FOR LONGER PERIODS THAN ANY BANK CAN PROVIDE

SELL OWNERSHIP: EQUITY IS THE RIGHT TO COLLECT PROFITS. ISSUING STOCK MORE CAPITAL, BUT OWNERSHIP IS DILUTED

» STOCK = EQUITY = OWNERSHIP

» CITIZENSHIP = EQUITY / OWNERSHIP IN GOVERNMENT; KINGS SOLD “SHARES” (DEMOCRATIZED) TO RAISE FUNDS TO FIGHT WARS (16TH TO 18TH CENTURIES)

SELL DEBT: BONDS EXCHANGE FUTURE CAPITAL FOR CURRENT CAPITAL

» IOU: BUY THIS FOR ME NOW, I WILL PAY YOU BACK LATER

STOCKS & BONDSSTOCKS PRICES & BOND YIELDS TEND TO BE

INVERSELY RELATED WHEN STOCKS GO UP, BONDS GO DOWN

STOCKS 10% CHANCE TO WIN $90BONDS 90% CHANCE TO WIN $10

BONDS = “SAFE HAVEN” WHEN ECONOMIC CONDITIONS WORSEN & GROWTH PROSPECTS FOR FIRMS LOOKS DIM

STOCKS = “GROWTH OPPORTUNITY” PREFERRED WHEN COMPANIES EXPAND THEIR MARKET OR PRODUCTS

RATIONAL COMPANIES SHOULD ISSUE STOCKS WHEN THE ECONOMY RISES & BONDS WHEN IT FALLS . . . BUT TEND TO BE PRO-CYCLICAL, NOT COUNTER-CYCLICAL IN FINANCING

BONDSBOND: PROMISE TO PAY A CERTAIN AMOUNT AT A

FIXED POINT IN THE FUTURE – A POST-DATED CHECK

GOVERNMENTS / CORPORATIONS AUCTION BONDS TO THE HIGHEST BIDDER

– LOAN: PRICE = PRINCIPLE + INTEREST RATE– BOND: PRICE = PAR VALUE – YIELD

BONDS ARE SUPERIOR TO LOANS BECAUSE :1) DEBT SOLD TO MANY DIFFERENT BUYERS (WAR BONDS)

2) THEY CAN BE BOUGHT & SOLD CONTINUOUSLY – PRICES RISE & YIELDS DECLINE AS BOND MATURES

PRICING A BOND

ISSUER CREDIBILITY: CAN & WILL THE ISSUER OF THE BOND MAKE GOOD ON THEIR PROMISE?

• AGENCIES GRADE BONDS FROM “AAA” – HIGHLY RELIABLE – TO “D” – DEFAULT OR “JUNK BONDS” / SIMILAR TO CREDIT SCORES

• TIME HORIZON – UNLIKE INDIVIDUALS, GOVERNMENTS / CORPORATIONS CAN “ROLL OVER” DEBT IN PERPETUITY

• SAFEST = US SHORT –TERM TREASURY BOND• LOWER CREDIBILITY LOWER PRICE HIGHER YIELD

INTEREST RATE: HOW DO BONDS COMPARE TO OTHER “SAFE” INVESTMENTS?

• BOND YIELD > INTEREST RATE BETTER TO BUY BONDS• AS INTEREST RATES INCREASE, YIELDS SHOULD INCREASE,

DECREASING BOND PRICES

TIME TO MATURITY:• BOND YIELDS NORMALLY DECREASE AS THEY APPROACH MATURITY• COUPONS – SOME BONDS INCLUDE “COUPONS” THAT BEARERS CAN

REDEEM FOR MONEY BEFORE MATURITY

BONDS, SECURITIES & SUB-PRIMEBONDS = FIXED INCOME SECURITY BOND OWNER ENTITLED TO

INCOME “SECURED” BY THE ISSUER’S COLLATERAL– GOVERNMENT BONDS TAX REVENUES – CORPORATE BONDS CORPORATE ASSETS– MORTGAGE BACKED SECURITIES MORTGAGE PAYMENTS

FANNIE MAE & FREDDIE MAC CREATED TO “SECURITIZE” MORTGAGES INTO COLLATERALIZED DEBT OBLIGATIONS (CDOs) OR MORTGAGE BACKED SECURITIES (MBS)

ISSUER CREDIBILITY RATING AGENCIES OVERRATED CDOs & MBS AS “AAA” SECURITIES

INTEREST RATE RATES LOW AFTER 9/11, BUT INCREASED AFTERWARD INCREASED YIELDS & REDUCED PRICES

TIME TO MATURITY MBS “SLICED & DICED” INTO TRANCHES (COUPONS) BY MATURITY / RISK & SOLD TO DIFFERENT BUYERS

***SUB-PRIME / JUNK BONDS – SECURE SPECULATIVE***

NEWTONIAN & BROWNIAN MOTIONNEWTONIANDETERMINISTICUNIVERSALITYGENERALITY

F = M x A

CLOCKSMACHINES

RISK ------

BONDS

BROWNIANPROBABILISTIC

RELATIVITYUNIQUENESS

E = MC2

CLOUDS DNA

SNOWFLAKES

UNCERTAINTY -----

STOCKS

STOCKS & BEAUTY CONTESTSSTOCK MARKET = BETS ON PUBLIC OPINION’S GUESS

WHAT THE MAJORITY WILL CHOOSE TO WIN A BEAUTY CONTEST

YOU WIN IF . . .

1) YOU BET 2) WHAT THE MAJORITY BELIEVED 3) WHAT THE MAJORITY WOULD PICK 4) AS THE WINNER OF A SUBJECTIVE CONTEST

. . . BUT THE PRICE OF THE BET INCREASES AS MORE PEOPLE MAKE THE SAME BET AS YOU

Ex. BOARD GAME: APPLES TO APPLES

STOCKS & RANDOM WALKSFOR EVERY STOCK BOUGHT, ONE MUST BE SOLD . . .

STOCK PRICE = HALF THINK THE PRICE WILL INCREASE & HALF DECREASE RANDOM COIN FLIP

THEREFORE, STOCK PRICES MOVEMENTS IN A FAIR, COMPETITIVE ARE RANDOM OR UNSYSTEMATIC “NOISE”

EXPECTED VALUE OF A STOCK MARKET TRANSACTION = ZEROHALF WIN / HALF LOSE

IMPLICATIONS: – ONLY BROKERS (TRANSACTION FEES) & INSIDERS (CHEATERS)

CAN PROFIT OVER THE LONG RUN; STOCK MARKET = CASINO – A MONKEY THROWING DARTS WILL DO BETTER THAN ANY

EXPERT INVESTMENT STRATEGY (BEGINNER’S LUCK)– PAST NO INDICATOR OF FUTURE SUCCESS; PICKING LOSERS >

PICKING WINNERS

BEATING THE STOCK MARKETFAIR, COMPETITIVE MARKETS NO PROFIT . . .

. . . SO HOW DO PEOPLE MAKE MONEY ON WALL STREET?

MONOPOLY / PSYCHOLOGY / INSIDE-INFORMATION / LEVERAGE / RENT-SEEKING / MATHEMATICS / DIVERSIFICATION

– MONOPOLY – INSTITUTIONAL INVESTORS – HEDGE FUNDS, MUTUAL FUNDS & INVESTMENT BANKS – HAVE MARKET POWER PRICE MAKERS

– LEVERAGE – MATHEMATICS IDENTIFIES MARKET FRICTIONS & PROVIDES PRECISE PROBABILITIES EXPLOIT BY LEVERAGE

– INTERPERSONAL / INTRAPERSONAL PSYCHOLOGY – READ “HERD” PSYCHOLOGY & CONTROL “ANIMAL SPIRITS”

“VALUE INVESTING”

– PROPRIETARY RESEARCH & STRATEGIES: MARKET RESEARCH & SECRET STRATEGIES

– DIVERSIFICATION: BET ON MANY DIFFERENT COIN FLIPS SIMULTANEOUSLY

OPTIONS & FUTURESONE CAN TRADE THE RIGHT TO BUY OR SELL STOCKS,

BONDS, OR COMMODITIES CALLED OPTIONS CALL OPTION: BUY THE RIGHT, BUT NOT THE OBLIGATION, TO PURCHASE AN ASSET AT A CERTAIN PRICE ABOVE PREVAILING PRICE PROFIT: IF ASSET RISES ABOVE “STRIKE PRICE,” BUYER POCKETS THE DIFFERENCE, OTHERWISE, LETS OPTION EXPIRE. “BULLISH”PUT OPTION: BUY THE RIGHT, BUT NOT THE OBLIGATION, TO SELL AN ASSET AT A CERTAIN PRICE BELOW THE PREVAILING PRICEPROFIT: IF ASSET FALLS BELOW “STRIKE PRICE,” BUYER POCKETS THE DIFFERENCE, OTHERWISE, LETS OPTION EXPIRE “BEARISH”