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

2. 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

3. 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

4. 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

5. 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

6. 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

7. 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

8. 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

9. 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

10. Sept 8, 2016