Economics 434: The Theory of Financial Markets Professor Burton Fall 2016 Sept 8, 2016

Readings Through The End of This Week First Six Chapters Worth reading on a daily basis – the Wall Street Journal and the Financial Times Also, the Economist magazine Sept 8, 2016

The Main Takeaway from Tuesday’s Lecture (the previous lecture) Two types of bankruptcy Liquidation of assets (Chapter 7) Reorganization of balance sheet (Chapter 11) Usually “emerge” later from bankruptcy into new company New balance sheet The terms Chapter 7 and Chapter 11 refer to sections of US Bankruptcy code (law) Sept 8, 2016

Debt versus Equity, Again Debt: usually “fixed” payments until repayment, thus the name: “fixed income” Equity: residual interest – claim of what’s left of profits after paying interest on debt Income can be positive or negative Unlimited upside, losses capped at size of investment Sept 8, 2016

Calculating Stock Returns (returns from t-1 to t): 𝑃 𝑡 − 𝑃 𝑡−1 + 𝐷𝐼𝑉 𝑡−1, 𝑡 Capital Gain (or Loss) ≡ 𝑃 𝑡 − 𝑃 𝑡−1 Dividends ≡ 𝐷𝐼𝑉 𝑡−1, 𝑡 Sept 8, 2016

Modigliani-Miller on Dividends Franco Modigliani – MIT Professor Merton Miller – his student Both awarded Nobel Prize in Economics Two Famous “Irrelevance Theorems” Dividends If no taxes, dividends are irrelevant If taxes, dividends are irrational Sept 8, 2016

Modigliani-Miller on Debt Defining the value of the firm as “liabilities plus net worth” In a world of no taxes, leverage (liabilities divided by net worth) is irrelevant…can’t increase or reduce the value of the firm In a world of taxes, optimal leverage can raise value of firm up to a point, after that increasing leverage can reduce the value of the firm. Sept 8, 2016

The History of Stock Ideas Jessie Livermore – “Reminiscences of a Stock Operator” by Edwin LeFevre Benjamin Graham – “Security Analysis” –birth of “value” investing Not much interest in diversification until Harry Markowitz in early 1950s Then comes CAPM (and APT) Sept 6, 2016

Default Free Securities – An Example US Treasury Market Bills (less one year original maturity) Notes and Bonds (one year or more original maturity) Notes are 2 year through 10 year Bonds are anything more than 10 year (20, 30) Auctioned on a regular basis Calculating yields Bills different than Notes and Bonds Sept 8, 2016

Sept 8, 2016