finance11
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3video_transcripts.docx1/Financial Management (video transcript)
The Netherlands, Ajax, Amsterdam: a football club with a long tradition. Large clubs go public as companies. The obligation to disclose financial information to shareholders and the public, structure of the balance sheet and techniques in financial statement analysis.
Switzerland, the telecommunication service provider, Swisscom: a large company in dynamic markets. The interaction of the flow of funds from the operational business, investments and financing. The need for cash flow analysis and cash management.
Tunisia, an investment project in a tourist region. Building a new luxury hotel. Weighing out profit and risk. Financial techniques to evaluate an investment project.
In any company, capital from a wide range of sources is tied up in various assets. The balance sheet is a momentary record of these financial structures. However, the balance sheet needs to be correctly interpreted in order to obtain sound information concerning the financial situation of a company.
The world of football fills millions of people with enthusiasm, and football has long ceased to be merely a sport. Behind the big matches and the major media events there is a huge corporate effort. Large clubs, such as Ajax, Amsterdam, run their operations as commercial enterprises with their shares increasingly being listed on the stock exchange.
The financial public, they read a different paper than the sports public, OK? And we have shareholders from both sides. So the football shareholders will look, very much, at the results of the club. The financial shareholders will look at both, but they will have more focus on the financial picture, of course. They will say are you a healthy club? Are you making the right investments? Are you not selling out? Are you doing this?
The balance sheets, in general, for every company, means that it gives you an insight in the position. Where does the company stand? I mean, what is the assets that they have in possession and how are these assets financed? In what way are they financed by equity? By, let's say, your own money, to say it bluntly. And what part is financed by going to banks or find third-parties that will finance those assets for you?
The traditional format of a corporate balance sheet reflects the symbol of scales in balance because the sum of existing assets in which the company has invested corresponds to the sum of the capital used to finance them. Outside capital, like bank loans, is placed at the disposal of the company, risk-free, for a fixed time, and at a fixed interest rate. Whereas, capital placed at the disposal of the company on a continuous basis by the owners is subject to risk, and the interest that it yields is dependent on the company's success.
This capital structure of outside and equity capital is shown on the liability side of the balance sheet. Assets are primarily categorize as current assets, such as liquid funds, or assets that can be converted into cash at short notice, and long-lived assets binding capital in the long-term, such as real estate or a stake in the stadium. The players under contract, however, also represent a balance sheet asset because they can be sold to other clubs for a transfer fee. This book value is lost when the player's contract expires.
He has, in the end, a value of zero because if nothing happens and the contract runs to an end, the player is free to go wherever he wants and you don't get any revenue from the sale of that player.
This means the players have to be written off by the time that their contracts expire, which results in the reduction of the balance sheet assets. However, it is also possible to increase the balance sheet total in the same way, for example, by developing talented new players. If they become more attractive to other clubs, and their market value increases in the form of the transfer fees that they can bring in, the balance sheet assets of the club also increase.
However, individual balance sheet items only present a limited insight into a company's financial situation and development. More in-depth information is obtained by applying the methods of financial statement analysis.
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The analysts calculate ratios or indices. This means they connect individual items from the balance sheet with other items from the profit and loss statement to enable them to interpret the company's development over the years.
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These ratios clarify the company's situation with regard to its liquidity, the solidity of its financing, and its profitability.
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Liquidity means the ability of a company to pay off debts at short notice. The most simple method to measure liquidity is the current ratio. This establishes a ratio between the liquid funds and the short-term liabilities of a company.
Liquid assets ratios can vary depending on whether only real cash items, or also items which can be converted into cash on short notice, are taken into account.
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Clearly, when the liquid funds are higher than the short-term, outside capital, the company has a strong ability to pay regarding short-term debts.
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To analyze how financially sound a company is, it is necessary to examine its capital structure by looking at its debt/equity ratio, also financing ratio, for example.
We had an equity of 230 million on a balance sheet total of about 300 million, which means that you have an equity ratio against debt on the total of the balance sheet of about 78% equity. This means, from an equity base, we are very, very healthy.
When evaluating the soundness of a company, the fixed assets to net worth ratios are particularly important. They show the ratio between fixed assets and equity capital, or capitol placed at the company's disposal long-term.
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It tells us how strongly the company is financed by equity or outside capital, or what the ratio is between fixed assets and equity capital to reveal how many of the company's long-term investments are financed in an equally long-term way.
The analysis of the financial statement also takes a close look at profitability. The most important revenue items include earnings from merchandising and sales of the numerous fan items, revenue from match tickets as well as revenue from sponsoring and from TV broadcasting rights. On the outgoing side, in addition to the normal operating expenses, the main item is payroll costs, clearly, because of the well above-average salaries the soccer stars receive. The overall company results, seen as the result of all expenses and revenues, is considered in relation to the various balance sheet items to clarify the performance capacity of the company from different points of view.
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Profitability is probably the most interesting aspect. There are many different concepts of profitability. Those mostly used are return on assets, which considers the ratio of profit to the total amount of assets. Return on sales establishes the ratio of profit to turnover. Maybe even more important is the return on equity, which looks at the amount of profit compared to shareholder's equity.
This return on equity also depends on the capital structure. If a company achieves a 20% return on its overall capital and outside capital costs only amount to 10%, higher debts result in an over proportional increase in the return on equity despite the increasing interest load.
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Taking on more debts can generate stronger earning power but also entails higher risks and increased vulnerability.
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The balance sheet analysis is essential when drawing up a financial evaluation of a company. However, many aspects that are decisive can, frequently, not be measured in figures and, therefore, cannot be reported on the balance sheet.
An asset which is really the most important one, which for Ajax has been a capability to develop players. So that's almost like intellectual capital that we have experience, processes, systems, facilities, really to scout players, to find the best talent.
The balance sheet presents the assets and capital structure as a particular moment in time. The calculation of ratios makes it possible to analyze the company with regard to its liquidity, soundness and profitability.
Still, you can only make plans and purchase and forecast. The result is down on that field. Club interest, of course, has been and always will be first the sport and second the business.
The amount of cash flowing in and out of companies varies. The movement of funds is caused by business activities, financing activities, and investment activities. To see a company safely into the future, this movement of funds needs to be kept under constant control. The instrument used is the cash flow analysis.
Swisscom, the Swiss telecommunication services provider, has a turnover that goes into billions. But even large, profitable companies can encounter a temporary shortage of liquid funds if they fail to monitor their cash flow closely enough.
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It is possible for companies to generate negative cash flow even when they are making a profit. In such cases, neglecting their cash flow and failing to analyze it can even cause a company to slip into a state of insolvency.
Ever or not, sufficient liquid funds available at all times to cover overhead, such as salaries or energy, or to pay suppliers, sooner or later the company will face huge problems independent of its size or its earnings position. This means that maintaining solvency is a [FOREIGN PHRASE] for every company.
Companies have three different types of cash flow. Operative cash flow refers to the cash flow from business activities. Investing cash flow covers cash paid out for investments and money coming into the company from dis-investments, while financing cash flow encompasses funds coming in that are related to company financing. The cash flow is positive or negative depending on whether more money is coming in or going out.
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Operative cash flow records the difference between the overall cash flow that we receive from our clients during the year and payments made to suppliers. As a rule, this cash flow should be positive. In other words, the company should generate positive cash flow from its current business.
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The flow of funds from investment activities refers to the funds required for the acquisition of installations or participation in other companies.
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This is usually negative. The difference between cash flow from business activities and from investment activities has to be filled by the third measurement, financing activities.
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In this sense, filling means taking out a bank loan or raising money from the shareholders. Or if, as can also be the case, the entire cash flow is positive, money can be repaid to the bank or distributed to the shareholders in the form of dividends.
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The sum of all funds from business, investment, and financing activities produces the company's cash assets or liquid funds.
These cash assets must always be high enough to cover the current operating costs. Longer term liquid funds must also be available for investments, to meet interest payments, and to pay dividends arising from financing activities. The ideal situation is when all expenses can be covered by funds from the operative cash flow, which obviously means that it must be positive in the first place. Cash requirements need to be forecast in detail to make it possible to raise any additional funds necessary in time, or to invest funds that are temporarily not required on the capital market.
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Cash is, on the one hand, very, very important for a company. But on the other hand, it is a variable which is very difficult to budget. This means that there are three main requirements. First, cash planning must be extremely precise, and the closer in the future we plan, the more precise it must be. Why? The more precisely we plan, the better we are protected against unexpected developments in cash flow or unexpected cash deficits.
The planning of the movement of funds is based on the parameters of strategic management. The financial situation of a company, however, in turn, imposes certain restrictions on strategic goals.
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Strategic planning is the basis for budgetary planning. Strategic management monitors whether the budgetary planning will be achieved, whether the goals of the strategic planning will be met. This means that if certain variances are observed, appropriate corrective action needs to be taken for the current business activities, or the budgetary planning has to be adjusted.
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Second, it follows that the company must have optimum cash management. Optimum cash management means that the cash a company has at its disposal is controlled as carefully as possible, employed as efficiently as possible, and yields the highest possible level of interest.
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It also requires the regular and strict examination of the cash flow to ensure that there are always adequate liquid funds to cover the financing requirements of the company, thus, safeguarding the company's standby liquidity. The cash flow analysis is the basis for budgetary planning, and cash management is the daily implementation of budgetary planning.
If a company does not monitor its cash flow closely enough, it may have more cash available than planned or less.
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The result could be problems in the company's ability to pay. In other words, we may have too little money to finance our current business activities or our investment activities.
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A consequence of this could be a temporary postponement of our investments and this could, in turn, mean that we are too late getting innovative products on the market.
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As a countermeasure, we could establish cash reserves in the sense of setting aside a percentage of the funds from business activities, of the funds required to meet interest payments, and funds that we want to invest.
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To avoid the risk of a liquidity squeeze, attention must be paid, for example, to the maturity of funds when planning and financing investments.
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This would naturally pose a serious problem if the bank could call in a loan on short notice forcing us to find new funding for this investment.
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This means we try to align the maturity of investments with financing resources. There's a simple reason for this. We don't want to run the risk that funds that can be called in at short notice may threaten a long-term investment.
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The amount of a company's disposable cash is highly volatile. To ensure that the strategic goals can be achieved, the cash flows must be planned and monitored precisely.
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Investors expect a certain continuity, A, in the financial management of the company and, B, in the return they receive from a company.
Investments increase the economic performance potential. Building new production facilities or founding completely new companies are the key to economic growth. But how are investment decisions taken on the level of individual companies?
Tozeur, an oasis town in the southern part of Tunisia. The boom in the tourism industry was already extended this far into the desert where numerous new hotels have been built. One of them is the five star hotel, Dar Cherait. It is a family-run business.
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Southern Tunisia is virtually new ground. Those investing in this region have the advantage of being pioneers. It is easier to make an impression in a region if you discover virgin terrain, if you have a good idea and a good project.
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Regardless of whether you are talking about individual capital goods or an entire new hotel, an investment project is always characterized by long-term considerations. Capital is tied up long-term and bad investments are virtually impossible to reverse. Moreover, fixed costs accumulate irrespective of the actual capacity utilization. Evaluating an investment project is, indeed, a complex task.
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The main characteristics of investment projects are the high initial outflow of liquid funds and the fact that the, usually, positive cash flow they generate is often only achieved after many years.
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In this context, the future cash flow is hard to predict both with regards to time and the actual revenue.
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To evaluate an investment project, all the revenue and expenses generated by the project must be compared with one another. In this context, it is primarily the cash flow that is relevant rather than the profit.
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The most complex aspect is forecasting the cash flow. For a hotel, your forecast will depend on the season, the success of the region, the number of guests, occupancies, and meals sold. What is required is a forecast.
To make forecasts, you have to analyze the competition, for example. Who are your competitors? And how much market share can be gained? You also have to analyze the general market trends. The more growth the market is showing, the more optimistic the project evaluation will be.
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Ten years ago, a mere 3,000 beds were available in Southern Tunisia. Today, there are 10,000 beds in Tozeur alone. Including the up-market hotels, there are about 75 luxury hotels in this tourist region. This has led to excellent results because the region has continued to develop year-after-year.
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To make a financial forecast for a project development, various techniques can be applied.
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The most usual technique, but not necessarily the most simple, based on simulations which take various scenarios as a starting point. An optimistic scenario in the case of the hotel, for example, would be to assume that it will have an occupancy rate of 80% to 90% on opening, and then you take medium and pessimistic scenarios.
For every probable scenario regarding the occupancy rate trends for the hotel, a detailed pre-investment analysis is conducted. The variables of a pre-investment analysis are, first of all, the investment amount, which encompasses all expenses incurred by the project. The benefit is the forecast revenue, which extends over the planned effective life. After expiration of the latter, it is usually possible to realize liquidation proceeds which, like the imputed rate of interest on the face capital, also have to be taken into account. To draw up a financial evaluation, there are static techniques available.
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The most simple is the payback technique. This takes into account the initial investment and the inflow of cash that is predicted from the investments made. If I were to invest ITL 10 billion into a hotel, and this investment produced a return of ITL 2 billion a year, I would regain my initial investment within five years.
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This very simple method can serve as a rough guide to determine whether a project's amortization period is reasonable.
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A second indicator that is still quite elementary is to calculate the average accounting rate of return. Here you need to recalculate the earnings ratio as the quotient of the average annual revenues over the average annual expenses.
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These static techniques, however, do not enable you to reach a precise result because they do not take into account the current value of money. The value of $1,000 in two year's time will be less than it is today.
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If I get $1,000 today, I can invest it for two years and also get interest on it. If I just have the $1,000 paid back to me in two years time, I miss out on the interest.
The dynamic techniques of pre-investment analysis take the current value of money into account. The current outflow of funds and the future inflow of funds due to investments can only be compared in a precise way if both are compared with identical current values. This means that the cash flow must be discounted at its current value. The higher the required rate of return chosen, the lower this actual current value will be.
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Determining the rate of interest to discount the cash flow is probably the decisive element of this technique. It is very difficult to determine and it basically reflects the, so called, opportunity costs of the investments.
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Instead of building a hotel, the entrepreneur could just as well put his money in fixed interest investments on the capital market. The increased financial risk must, therefore, result in a higher return for the entrepreneur and reflect a risk bonus.
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This will be the discount rate I use to update the flow. The rate must reflect the degree of the risk.
In order to evaluate investment projects, the entire flow of funds resulting from the project must be compared at the same current value. The prevailing interest rate takes into account both the opportunity costs and the investment risk.
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I think, in the case of a hotel, the extent of a financial commitment at the site of the investor is clear.
2/Fundamental Concepts in Financial Management (video transcript)
Financial managers are concerned with every aspect of a company's activities. Their decisions, along with the decisions of marketing, production, and other areas of the company, are important in determining how a company is to grow and profit.
The growth of assets has its risks. Can the company successfully expand current production or move into a new product market? What are the risks involved in investing in one asset versus investing in another? What are the expected returns of these assets? In every financial decision, there are elements of risk that must be measured and controlled.
Risk can be defined as the chance that something bad may happen. You have the risk of having a car accident on your way home or of losing your wallet. These are not pleasant things to think about, but we must take precautions to reduce the risk of these bad events happening.
The same is true for financial managers and for all investors. Everyone should understand how to minimize risk so that losses are minimized.
The stock market closed up a little bit yesterday, its first gain after five straight losses. But investors describe the trading as volatile, and losing stocks outnumbered gainers two to one. So what's an investor to do? Jerry Berg is a financial planner and radio talk show host at KFNN in Phoenix, where he joins us this morning. And in Boston, Peter Lynch, the former portfolio manager for the Fidelity Magellan Mutual Fund, one of the most successful in history. Good morning, gentlemen.
Good morning, Harry.
Peter, let me start with you. Do you think the so-called correction is over?
You never know. I mean, we've had 93 years this century, and we've had 50 times the market's declined 10% or more. At the bottom, yesterday, Harry, the market had done one of those 10% declines. So about once every two years, the market falls about 10%. We always have reasons for it. The market has gone up 12 years in a row, so we are due for some kind of correction.
There are so many reasons. People have talked about the little uptick in the interest Rate But there are so many other reasons. Everything from the potential trade wars in Asia, and who knows what all else. What do you blame this on?
Well, I think in the last couple of years, we've had a perfect environment. The economy's been getting better. We've had profits going up. And all of a sudden, our chief warrior about inflation, Alan Greenspan, put his foot on the brake. In the last month, he said, two big steps in interest rates are going up. He's worried, he's paid to worry about inflation, and he's trying to slow down the economy.
And people are saying to themselves, will we have a very strong economy in '95, '96, and get back to double-digit inflation? If that's going to happen, the stock market's going to go lower. And no one knows. No one's going to find out until--
Is there anything out there that would even begin to suggest double-digit inflation? No!
None at all. Right now it's been the slowest economic recovery since World War II. We have 500,000 workers in the manufacturing sector than we had three years ago. Oil's low. There's no signs. It's just people spooked about the future.
All right. I'm going to come back to you in a second, Peter, and talk about what you would do with your money. Because there were so many-- what? We've got one in four people in America now in mutual funds. A lot of people in the stock market.
Let's talk to Jerry Berg out of Phoenix. What are people talking about on the phone? Your phone must be ringing off the hook on the talk show.
It is, in a lot of ways, Harry. We're hearing a lot about uncertainty. And the average person who used to be able to pick almost anything during the last five years and make a profit is finding it a lot tougher today. The profits just aren't there on a day to day basis, and you have to have a long term horizon.
And so what kinds of advice are you meting out, and for the experts that you have called in, what's your short term advice? Especially for folks in mutual funds, because so many Americans are these days.
Well, a lot of people in mutual funds went in there with specific goals in mind and specific desires and aims. And if they were in there to set up a plan for their children's education, or they were able to set up a plan, or were looking to set up a plan for retirement, then if those plans are long-term, they have to stay with those plans. And they certainly should take advantage of the long-term horizons that the market has generally developed over the past decades. Time's going to cure all of the ills, and I have no doubt that a lot of people are going to make a lot of money down the road if they stay in right now and don't jump ship.
So have you heard anything, have you heard jittery folks out there on the phone saying, well, gee, we all heard we were supposed to get mutual funds the last couple years, and I just saw, I'm worth less money now in mutual funds than I was a year ago?
Well, that's happening, Harry, but that's because we don't have an economy that goes straight up. There are lots of different ways to take advantage of it. Certainly short-term investments right now, whether it be municipal bonds, whether they be money market accounts, or even some of the annuity contracts with the deferred values are starting to look a lot more attractive when you can go and have a split annuity which gives you income on a regular basis and guarantee the return of principal.
But on the short term, what is your advice? What are you telling folks here?
For a short term, if they're not used to being in the marketplace, I'm telling them, let's look at money markets, let's look at municipal bonds certainly the shorter intermediate term variety, and other types of investments like that that are going to keep you in the economy, let you keep up with inflation, but still, at the same time, make a few dollars.
All right. Peter. The long haul.
Well, behind every one of these stocks is a company. And if the profits go up-- Johnson & Johnson's profits have gone up a hundred fold over the last thirty years, and stock's gone up over a hundred fold. You have time on your side in the stock market. I bought a couple funds yesterday.
I think it's-- I'll listen to an audience, about a thousand people in the audience, and I'll say, how many people out there are long-term investors? Everybody puts their hand up. I've never seen anybody say they're short term investors. We find out, when the market goes down, who the short-term investors are. They're going to lose. They're going to put the money in when the market's at an all time high, they're going to take it out three weeks later and say, I'll never go back in-- we really test it out. You have to find out what your stomach is for this. The brain is not the key organ here. It's the stomach.
OK. Peter, Jerome, thank you so much. Do appreciate it, gentlemen.
The markets for stocks and bonds are very volatile. Changes in interest rates and other factors can have a huge effect on rates of return on investments. Investors must be aware of the risks that they are taking whether they are investing in stocks or bonds of companies.
Risk can be thought of in two ways. One, as risk of an asset that stands alone, or two, as risk of many assets held in a portfolio. The risk of holding just one asset is called standalone risk.
Let's say you invest in just one asset-- a store. Your entire fortune is tied up as the ownership of your store. In other words, you own the equity stock in your store. How well you profit from your investment depends on how many people come into your store on a given day. When you invest in this store, you expect to receive a lot of money from your investment. Therefore, you have a high expected return.
However, the actual return can be very different from your expectations. Later, we will contrast these two with the required rate of return.
The expectations of returns based on estimates of risk is called the risk-return tradeoff. It measures if the return on an asset is high enough to compensate us for the risk that we are taking when we invest in that asset.
For example, you expect your store to perform in one of three ways on any given day: great, OK, or poorly. You estimate that there is a 30% chance that the store will perform great, and you will get a 100% return on your investment. There is a 40% chance that it will perform OK, and you will receive 20% on your investment. Finally, you estimate that the store has a 30% chance of performing poorly, and you will lose 70% of your investment.
These chances are called probabilities. All of these probabilities are only estimates that you have made as to how the store will perform. You have also only estimated how much you might get in return depending on each estimate of the store's performance.
By calculating these probabilities and expected rates of return, we can estimate the overall expected rate of return of the store, k-hat. k-hat is equal to the probability of 30% that the store will perform well and earn 100% return, plus the probability of 40% that the store will perform OK and earn 20%, plus the probability of 30% that the store will perform poorly and lose 70% of your investment. Your expected rate of return is then 17%, which is an average of all expected probabilities and rates of return for each scenario.
Let's examine the 17% average rate of return. First, you'll notice that there is a high probability that you will receive a high return if the store does well, but also a high probability that you will lose almost everything if the store performs poorly. This investment appears to be very risky.
There are three methods that you can use to measure the standalone risk of an investment. The measures are the standard deviation, the coefficient of variation, and beta. All three methods use probabilities and expected rates of return as the basis of analysis.
Let's assume that you don't only owned stock in your store, but you own stock in several stores. With each store that you have ownership interest in, you have an expected return on your investment. The expected return, k-hat of each, would be calculated as we did your store: the estimated probability times the estimated rates of return.
You then have a portfolio of stocks in the various stores. The portfolio has a certain risk associated with it different from owning only one store. The return that you expect on your portfolio is based on a weighted average of the individual returns of each store's stock.
In our example, all of your money is invested in only your store. You risk losing almost all of your investment if the store fails. With one investment, you have two types of risk: diversifiable and non-diversifiable risk. Diversifiable risk is the risk that happens to only one company. An example would be a fire at your store. This risk can be diversified away by spreading out your investments in more than one stock. The more stocks you own, the closer you come to lowering your risk to the market average. You have a well-diversified portfolio.
In other words, the risk that is left in the well-diversified portfolio is the risk that cannot be diversified away-- market risk. Examples of market risk are changes in economic factors, such as interest rates and inflation, or changes in tax laws that affect all companies. With a diversified portfolio, you can measure the risk of one investment, such as adding stock in another store, with the risk of the entire portfolio, or an average of all stocks as represented by an index of market returns, like the Dow Jones Industrial Average or the Standard and Poor's 500 average. Financial managers and analysts use the beta coefficient as the third measure of a risk of a stock to determine how closely the stock returns of one company follow market returns.
So far, we have looked at estimated returns based on probabilities of events occurring, and we've looked at three measures of risk with estimated returns. How can we decide if the estimated return is high enough to compensate us for the risk we are taking? Each investor has an idea of the required rate of return that he or she wants from an investment. They will need to compare the expected returns with required rates of return.
In finance, we use the security market line, or SML, as a measure of the risk-return tradeoff. The security market line is plotted on a graph using beta as the risk measure and k to represent all levels of rates of return. The SML shows how the required rate of return increases as beta increases. The market rate of return, km, always correspondents to beta equal to 1. If our store is riskier than the market, than our store will have a beta of greater than one and a required rate of return above the market rate.
Now suppose you are a financial planner for a large company. You have the job of deciding which stocks to invest in and to determine the estimated risk and return of each. How would you estimate the three risk measures that we've discussed: the standard deviation, the coefficient of variation, and beta? What do these measures tell you, and how can they be of use? The information that you learn in this chapter will help you to understand the potential risks and returns of investing in all types of assets.
You have to decide if you want to receive $1,000 today or $1,150 two years from now. Which would you choose?
Your uncle wants to give you money for school. He wants to know how much to deposit in the bank account now to help you over the next two years. What do you tell him?
You have to decide whether to buy one type of computer or another. What financial techniques do you use to decide?
The technique that you would need to answer these questions is the time value of money, or TVM. The time value of money helps you measure the value of money today versus the value of money in the future. Say you have a chance of receiving $1 today versus $1 in one year. Considering that you could invest the $1 now and earn, say, 5% over the next year, it will be worth $1.05 in one year. Then the dollar received today is worth more to you than the dollar received in one year, since you can invest the dollar today and earn a return over the year.
For example, how much money do you need to invest now to have a comfortable retirement in, say, forty years?
At 30 or 40, it's not too early to start planning your retirement. And if you're 60, it's not necessarily too late. Money magazine has some advice in its June issue. And joining us this morning is senior editor Eric Schoenberg. And good morning to you.
Good morning, Paula.
How much money do you need have socked away to retire?
Well, it's less than you might think. That's one of the pleasant surprises about retirement planning. If you have retirement income equal to about 80% of your pre-retirement salary, than you can probably count on living as well in retirement as you did before you retire.
But you've got to make up the difference somehow. There's 20% that's missing in there.
Well, no you don't, no you don't. It works like this. You can get by and live at the same standard with somewhat less in retirement because a lot of expenses you have when you're working go away when you retire.
Commuting expenses, for example?
That's right. And when you're not working, you don't have to pay social security taxes, you're collecting social security benefits. At least half of that portion of your income is free of income tax.
And give us an idea of the other sources of income you might want to think about having as you plan your retirement.
Well, I think that if you're an average person, you shouldn't expect social security and your pension combined to make more up more than about half of your pre-retirement salary. So the rest of the income that you need in retirement has to come out of your own savings.
How much do you need to save? Particularly if you don't know what kind of medical expenses you're going to have down the road.
Well, there are ways to figure it out. It depends on how much you make, and how much you expect to live on in retirement. It depends on how much you've already got saved up. And it depends most of all on how far you are from retirement.
Let's give the example of someone making $30,000 a year. And we're actually going to chart it out for our viewers this morning, so they can look at the figures were talking about.
OK. We're talking about someone who makes $30,000 a year now. They plan to retire at 65. So they need about $24,000 a year in retirement deliver that same standard of living. That's 80%. We're assuming that that person will have $60,000 from their pension and social security, so there's an $8,000 gap that they have to make up out of their own savings.
Let's run through some other examples, too, if a person doesn't find themselves in that exact situation.
OK. Well, let's say this person is 40 years old, and let's say, furthermore, that they've got $20,000 already salted away. That person has to have $153,000 by the time they retire to make up that income gap, year after year, in retirement.
Now that's based on the same formula you talked about earlier.
That's right, that's right. It's a pretty good chunk of change. But remember, this is money that is going to have to support you for maybe 30 years in retirement, in face of implacable inflation, without your working.
Now we've made another example, if you're at the age of 50, and sort of what kinds of figures you'll be looking at then?
All right. Now the 50 year old also has to have $153,000 saved up by the time of retirement. But you see, in this case, he has to save $5,000 a year to make that goal. That's the difference. As opposed to $3,000 a year for the 40 year old. That's the difference it makes to have a 10 year head start. That's why it's so important to start early in retirement planning.
That's a big chunk of change you're asking people to save. How do you suggest they go about saving that kind of money? Particularly with the economy the way it is.
Well, retirement is a long-term goal. You have to worry about what the economy's going to be next year. We're talking about 10, 15, 25 years off for a lot of people. So anyone who's that far from retirement should have at least half of their money in the stock market, whether directly in stocks or in stock mutual funds. Yes, the stock market can go down. Yes, you can lose money in stocks. In fact, from year to year, your chances of losing money in stocks are about one in three-- one in every three years, the stock market goes down. But we're talking about long-term. And over 10, 15, 20 years, the stock market is very predictable, and has a very good chance of outperforming every other kind of asset.
Let's reinforce that, actually, with another graph to give people ideas of the mix of investments they can to sock away this kind of money you're talking about now.
OK. As I said, you should have at least 50%. In this example, we're saying 60%. This is for someone who is at least ten years from retirement.
Also, you wouldn't want to have all your money in stocks. This is an important financial principle that's called not putting all your eggs in one basket. We suggested 20% in bonds and 20% in cash investments, like money market funds, treasury bills, and bank accounts. These even out the year to year fluctuations in stocks, and make it easier for you to get high returns and still sleep at night.
And if you do that, you really do end up with the kind of security that you've been talking about.
That's the name of the game.
Eric Schoenberg, thanks for joining us this morning.
As you can see, the longer you wait to start saving for retirement, the more money it takes to invest each year. The key factors here are time and rates of return.
We will use time values and interest rates to determine the values of money invested now to be received in the future. We will begin with a discussion of timelines, then we will discuss future and present values of lump sums and of payments over time. You will see that all of these concepts are closely related to each other.
A timeline represents a length of time. We divide the line into segments starting at zero, with each segment representing a certain period. Here each segment represents a year. Each year, cash flows are added to our account. The amount of these payments will depend upon our initial investment at time zero and the interest accumulating. Timelines are an important aspect of finance, since they help us to see financial problems and solutions.
This brings us to another important concept: future value. Future value is used to answer our earlier question of, what is the investment worth to us at some point in the future, n? In the time value of money, we use an equation where future value equals an amount invested today-- the present value plus accumulated interest over time, n.
The term 1 plus the interest rate raised to the n power is important. It is called the Future Value Interest Factor, or FVIF. Let's assume that you're planning for retirement in three years. You invest the lump sum of $100 now at time 0. This $100 is the present value of our investment. It is considered an outflow. Therefore it has a negative sign. Interest is accumulated over the three years, so we show the five percent over the line in the first period. You receive $5 at the end of year one, $525 at the end of year two, and $5.51 at the end of year three. The total amount in year three is $115.76. This amount is an inflow back to you, so it is shown as a positive number. This is the future value of our investment.
Using the future value equation, future value equals the present value of $100 plus the accumulated interest i at 5% three years, n. Future value is $115.76. The present value grows to the future value because of the compounding effect of interest. Interest accumulates on the $100 in the first year. In the second year, interest accumulates on the $100 again, and on the interest from the first year. In the third year, interest again accumulates on the $100, plus the interest already received in years one and two.
This example demonstrates why it is important to start saving for retirement early, so that you can take advantage of compounding over a long time period. If there were no interest paid on the $100, if i equals 0, then $100 today would be worth $100 in three years. There would be no interest added, and therefore, no compounding.
Now, let's look at the opposite question from above. What is $115.76 three years from now worth to us today? To answer this question, the concepts of future value can be applied in reverse to solve for present value. Present value is the value today of receiving money in the future. In other words, if we need $115.76 in three years for our retirement, then how much do we need to invest today at a 5% rate of interest?
In our example, $115.76 three years in the future is worth a present value of $100 to us today if we received 5% interest on the money for three years. We call this discounting to the present, the opposite of compounding to the future. If we look at the future value equation again, we can see how present value is the opposite concept of future value. Future value equals present value times 1 plus the interest rate raised to the number of time periods n. Using our example, the present value of $100 is equal to the future value of $115.76 divided by 1 plus the interest rate of 5% over three periods.
The term 1 over 1 plus the interest rate raised to the nth power is an important calculation. It is called the present value interest factor, or PVIF. There are tables at the end of the text where these values are calculated for you using different interest rates i and time periods n. You can also use your calculator to find these values.
If we know the present value and the future value, then we can use either the future value or present value equations to solve for the interest rate or time. For example, we might ask, what interest rate will make $100 grow to $115.76 in three years? Or how long will it take for $100 to grow to $115.76 if the interest rate is 5%?
These equations are used often in finance. You will see them in one form or another in many applications, such as bond and stock valuations. Usually when we invest. we don't simply put down a lump sum like $100. Instead, we make payments over time, continually adding new cash flows into our account, along with the accruing interest. These can be in a series of equal payments, say, $25 per year. These could be annuities and perpetuities, or these could be a series of uneven cash flow payments. We will start with annuities.
Let's assume that you now invest a series of equal payments over time, say, in years, toward your retirement. You then invest in an annuity, or a series of equal payments over a specified time period. This would be like adding money to your savings account. The timeline begins at zero and goes out for n years. The payments begin at the end of the first year and continue to the end of the time period, when you expect to retire.
These future value and present value concepts will be used in bond and stock valuations, in capital budgeting decisions, and in other applications throughout this course.
Two other concepts in this chapter are perpetuities and uneven cash flow streams. Perpetuities are annuities in that they have a series of payments, but they have no maturity date. They are made in perpetuity. For example, if you receive fixed dividends from stocks forever, then you receive these dividends in perpetuity.
Each valuation that we have done so far has been with equal cash flows-- in our example, $100 and $25. However, many investments provide uneven cash flow payments. Investment payments can vary from period to period. We will still use the present and future value equations, but we will discount or compound each cash flow individually.
Now assume that you are a financial analyst who must use these techniques to solve a series of problems for your bank. How can you determine the present value of a stream of payments? How long will it take you to accumulate a desired sum of money? What interest rate return will you earn on an investment? You will see throughout your study of finance, the time value of money is a central concept in understanding, planning, and making successful financial decisions.
Skillful financial management is an essential element of any successful enterprise. It is just as critical as other functions in a company. So even if finance isn't your primary field of study, the more you know about the theory and practice of financial management, the better.
Today we will be introducing concepts and methods for calculating the values of bonds, also known as capital debt, and of stocks, also known as capital equity. Corporate managers and corporate investors should be able to calculate the value of a corporation's debt and equity capital as part of any major financial decision. In this way, managers can determine if the price they're paying to raise money for the company is fair and affordable, while investors can determine if the return on their investments is in line with their expectations and requirements.
We will study the methods for evaluating two capital instruments: the bond and the stock. The methods we will use build on the time value of money, or discounted cash flow analysis skills. Stocks and bonds as capital instruments produce a specified cash flow stream within various degrees of certainty. We can calculate the present value of these cash flows to derive an estimated value of the stock or bond.
What is a bond? As we mentioned before, a bond is a debt capital instrument. There are several fundamental components that are necessary for calculating its value. They are term, the length of time between issuance and maturity. Par value, the face value of the bond. Coupon interest rate, the percentage of par value that is used to calculate periodic coupon interest payments. Required rate of return, minimum rate of return required by an investor.
What is a stock? There are two types of stock: common and preferred. Common stock is an equity capital instrument. That is, it represents ownership in a corporation. It has several basic components that are essential for calculating its value. They are dividends, a portion of corporate earnings that is paid to stockholders on a periodic basis. Sale price, the price an investor estimates the value of the stock will be when sold on the open market. Required rate of return, the minimum rate of return required by an investor.
Preferred stock is a hybrid of bonds and common stock. It has a fixed dividend stream like bond coupon payments, but the dividends can be omitted by management like common stock dividends. Like a bond, preferred stock has a par value, but like common stock, it doesn't have a maturity date. We'll discuss preferred stock in more detail later in the course.
Estimated cash flows are a key component of calculating bond and stock prices. These cash flows rely heavily on the earnings of the firm. What do you think would happen to the value of a bond or a stock if the firm's actual earnings were less than the earnings an investor expected? Keep this question in mind while we watch this news footage on Walt Disney's European amusement park, Euro Disney.
When the Walt Disney company opened its $4 billion Euro Disney theme park in France this spring, it was hailed as the biggest event since the liberation of Paris is the end of World War II. But all is not well in the Magic Kingdom, and Bill McLachlan has the report.
America's peaceful invasion of Europe is getting bogged down in the financial trenches. This week, Euro Disney said it will post a net loss for its first year. How big depends on how bad things get. A lot of those people dressed up as Goofy, Chip, and Dale are going to be let go.
This is Euro Disney on a midsummer's day. One of the reasons visitors are happy is that fewer people mean shorter lines for the crowd.
Tres beau. C'est magique.
Oh, I think it's quite fantastic.
Some people have been frightened away by prices. It costs a family of four about $150 just to get through the front gate. And there are complaints about the cost of merchandise. Want a balloon? It's $3. And Euro Disney has had to contend with angry truckers tying French roads into knots and local villagers complaining about the Euro Disney attracting crime and spreading pollution. So this week, Disney announced it will slash prices in hopes of keeping the European market at home.
Cutting costs may make it easier for travel agents to sell Euro Disney to Europeans, but Disney still has to face up to all the perils of doing business over here. Mickey's bosses still haven't come up with a workable plan to meet their greatest challenge.
It's called winter. This is northern France. The park sits astride an open plateau notorious for biting winds and freezing storms. It takes a lot more than fireworks to make northern France look and feel like Florida and California.
Put yourself in the place of a Disney bond or stock holder. Earnings from the Euro Disney park have been much lower than expected. The values of bonds and stocks generally decrease if the firm's actual earnings are less than the earnings an investor expects. We will understand this relationship better as we apply time value of money analysis first to the valuation of a bond, and then to the valuation of a stock.
To calculate the value of a bond, you must know or estimate the term, par value, coupon interest rate, and the required rate of return. As you may recall, the term is the length of time between issuance and maturity of the bond. The par value is the face value of the bond. This is the amount that should be redeemed on the maturity date. The coupon interest rate is the percentage of the par value that is used to calculate the coupon payment. The coupon payment is the amount paid by the borrower to the investor each year until maturity.
Once these cash flows are determined, it is just a matter of applying time value of money analysis. The required rate of return is simply the discount rate used in the time value of money equation. The sum of these cash flows in present value terms equals the current value of the bond.
A very important relationship exists between the required rate of return and the present value. If the required rate of return increases, then the present value decreases. You can see this by studying the time value of money equation.
On an intuitive level, however, this relationship can be observed by asking this question. If the coupon interest payment remains fixed while the required rate of return increases, would you pay more or less for a bond you were considering for investment?
You would pay less. If the price remained fixed, then you would ultimately be receiving less than a fair market rate of return for your investment. Rather than buying this bond, you could get another bond on the market that would give you the required rate of return. This market pressure will push the bond's price down until its expected rate of return is in line with the market's required rate of return.
We'll return to these key ideas again and again. First, that price and required rates of return have an inverse relationship, and second, that price is influenced by the market until the expected rate of return equals the required rate of return.
We determine the value of a bond by applying time value of money analysis, and we'll use essentially the same techniques to determine the value of a stock. However, a major difference between a stock and a bond is that a stock has cash flows that are less certain. For example, rather than a term that is specified for a bond, a stock is simply held until the investor decides to sell. And unlike a bond that has a specified value at maturity, a stock's maturity value is the market value at the time the stock is sold. Rather than a specified coupon payment that is constant over the term of the bond, a stock has a periodic dividend payment. The dividend payment varies with the firm's earnings and the willingness of corporate managers to pay the dividend.
Given these differences, different methods must be used to determine the value of a stock. In essence, you must estimate the magnitude and timing of dividends and the sale price. The sum of these cash flows in present value terms equals the current value of the stock. The cash flows are discounted at the required rate of return, just like a bond's cash flow.
You will see in this chapter that there are three stock valuation scenarios. Zero growth, constant growth, and non-constant growth. Although each of these situations uses a specific method, they are all simply derivations of the basic time value of money equation.
So we've seen that the valuation of stocks and bonds is essentially a matter of estimating the timing and magnitude of cash flows, and then discounting them at the required rate of return. Fundamentally, this is just applying time value of money analysis to the particular characteristics of bonds and stocks. Generally, you'll evaluate a bond or stock to make an investment decision by comparing the expected rate of return with the required rate of return. Any time you find that the expected rate of return exceeds the required rate of return, a potentially profitable investment opportunity exists.
So imagine that as a financial manager, you are asked to measure the impact of a decline in earnings on the value of your company's stock. Where would you start the stock valuation problem? Would you re-estimate the dividend payments? If the required rate of return has recently increased, in what direction would you expect the price of your company's bonds to go? You will learn the skills to answer these questions as you go through the chapter.
3/ Money Never Sleeps: Global Financial Markets
Everyone is familiar with the real world of economy. You see it at work every day, in our smoking factories, transported goods, and glittering shop windows. It's tangible, concrete, and intelligible. We're at ease with it.
Financial markets, on the other hand, are quite a different matter. Although money circulates through them at the speed of light and on a worldwide scale, these markets remain, to the average person, incomprehensible, elusive, unreal almost. The most well-known amongst them are the equity markets-- the stock markets and the foreign exchange markets. But there are a great many more-- the energy commodity markets, the bond markets, the derivatives markets, the metal markets, the foodstuffs markets, the futures markets. The list is as long and as varied as the imagination of the financiers.
All these markets are, of course, interdependent. The Polish zloty drops, and the Warsaw Stock Market becomes erratic. The copper market catches cold in Chicago, and the one in London will be sneezing within the next few minutes. It's like a vast plumbing installation, with horizontal links within each country and vertical ones between the countries of the world.
Hence, the temptation to take a look at the inner workings of this intricate network. What sort of people navigate in these uncertain waters? How do they manage to hold their course and forecast future weather conditions? What strange compass guides their movements? Or more simply, how can they, or we, manage to make any sense out of it all?
The financial markets have their own glittering shop window, which twinkles with the lights of hundreds of monitor screens-- the trading room.
[SPEAKING FRENCH]
Here, we're on the second floor of the trading room. This is where the funds of the Credit Agricole Group are going to be managed.
The financial markets are perfect illustration of the proverb, "From little acorns, great oaks grow." Funds collected in 1,000 different ways accumulate here. The modest savings of private individuals to the vast capital reserves of American retirement funds and foreign currencies that circulate through international commerce. All these different amounts of money merge together, build up, to be finally lent out or borrowed through a simple phone call or click of a mouse. And all in the space of a few seconds by spoken word and by very young people.
2 billion, 100 million.
2 billion, 100 million what?
2 billion, 100 million euros. That's our cash balance. It has to be cleared within the next hour and a half or so.
In other words, the Credit Agricole traders we see here have a vast reserve of money to lend. The voices on the telephone are colleagues from other banks throughout the world who want to borrow.
[SPEAKING FRENCH]
The discussions concern the interest rate percentage, the duration, but also the size of the loan.
And what size, please?
The bigger, the better.
Could you do more?
I don't think so.
Could you do 100?
No.
[SPEAKING FRENCH]
We have to invest the 2 billion, 100 million either with some of our clients, who are themselves borrowers, or with banks, who are in the opposite situation to ourselves. That is, they are short. They need liquidity. So we're going to lend this liquidity in such a way as to make a return on the money that's lying idle in our accounts.
[SPEAKING FRENCH]
And all that in an hour and a half.
It has to be completed before 5 o'clock.
[SPEAKING FRENCH]
The strange language spoken here is a mixture of English, French, and in-trade abbreviations.
[SPEAKING FRENCH]
For example, when the traders negotiate an interest rate, only the third and fourth decimals of the percentage are mentioned. The other figures are assumed to be known by everyone.
OK. Yours at 17 and a 1/2. Yours.
Hang on.
[SPEAKING FRENCH]
Yours.
[SPEAKING FRENCH]
When we say "yours," it means we're lending. It's either "mine," I'm borrowing, or "yours," I'm lending. We use the English terms.
The unit used for counting is the million-- millions of dollars or euros.
[SPEAKING FRENCH]
What behind?
I'm waiting to see where the market's going to position itself, because it looks like it wants to climb very high. So I'm not going to sell off. I think it might climb a bit higher.
How much do you have left now after half an hour?
We have something like one billion two left.
To lend?
Yeah.
So that means you've already lent out about a billion in half an hour.
That's right. We started out at 3 and 1/2, but half an hour ago, it was even lower, 335. So you see in half an hour, from 335 we're now at 3/4, 375. That's 40-something.
A percentage point gained in one night on an amount of 2 billion, 100 million euros means an extra 400,000 francs in the bank's safe the next morning.
[SPEAKING FRENCH]
Yeah, we heard there was a bank paying 4%, so we're calling to tell them we have the money and can help them out.
[SPEAKING FRENCH]
We know that anyone who is in need of liquidity has to go and look for it. So by definition, they're ready to pay, even if it's 10 or 15 centimes higher. It doesn't matter, because they really need the cash.
It seems exactly like the sort of bargaining that goes on between normal commercial traders.
It is. However sophisticated or complex the tools, we inevitably have to apply the usual market strategy. That's why it's called the trading room. Of course, I'm going to try to get them to think that I'm going in one direction, while in fact, I may have a very big transaction lined up in the opposite direction. It's like bluffing in poker.
[SPEAKING FRENCH]
Before closing a deal, the traders first have to check through their information system that the potential borrower hasn't reached the borrowing ceiling granted him.
[SPEAKING FRENCH]
It's not accepted?
No.
[SPEAKING FRENCH]
The lines of credit are granted according to the ratings of the various banks. And as we're making loans here to other counterparts, we have to make sure that we have authorization from the risk committee to lend this money.
[SPEAKING FRENCH]
In traders' language, it's called checking the quality of a signature. It's exactly as in everyday life. The richer and healthier you are, the more easily you'll obtain loans.
[SPEAKING FRENCH]
You're giving yourself another quarter of an hour?
Another quarter of an hour, even though our balance today has gone down considerably. At the worst, we can always lend this money to the European Central Bank, which has a marginal deposit rate of 2%. Which means that if we haven't managed to lend our money by this evening, then we'll lend at 2% instead of the present 3.5%.
[SPEAKING FRENCH]
Finding one's way in this complicated universe is something that can be learned. Here, for example, at the Sloan Business School, a department of the highly-renowned Massachusetts Institute of Technology. The classroom here is, in fact, a simulated trading room, where the traders of tomorrow learn the basics of their future profession. As for the teacher, he has 40 years of Wall Street behind him.
Every generation in history has a group of people who are traders. Jesus threw the moneychangers from the temple, and it's the second-oldest profession in the world.
It's like in Monopoly. Each students starts out with 200 stocks in two fictitious companies plus $10,000 cash-- also fictitious, of course.
Quite often traders, when they start in the real world, they make terrible mistakes, and they get fired. They lose money, and then they could become depressed. In this case, we put a lot of pressure on them, so they are in as close to a real world situation as possible without the risk of losing real money.
Here, the students work with the same electronic transaction systems that are used in the big financial markets all over the world. In order to sell their shares, the student traders indicate to the central computer in this window the price they want to obtain. It's the ask, that is, the selling price. Inversely, when they want to buy they indicate the price they're willing to pay. It's the bid, the buying offer.
This is how it looks on a real-life scale. The Hong Kong Stock Exchange. More than 1,000 traders, each in front of his monitor. That's the basic principle. But what provides the challenge and difficulty to the professional trader is the way in which he reacts to the information he receives.
In this game, there's a lot of people with really big positions. So the spreads on the winnings are gonna be much wider than before.
So just as a pilot instructor programs an engine failure in a flight simulator, the teacher here introduces an element of complication. The cash brings in interest.
The choice is between being in stocks or being in cash. And if I set the interest rates above the possible dividends, then they might as well sell all their stocks and be in cash. And so the risk now that interest rates will rise means that the stocks won't be quite so popular.
And in order to make things more realistic, as in a real training room, the teacher employs the assertive tone of the professional analyst and comments the situation to one and all.
The Chairman of the Federal Reserve has made a couple of speeches suggesting that he is concerned about the pickup in wages and prices. So there now is a risk that we will have higher interest rates in the second period than the first period. As a cautious economist, I will say 9%, but that may not be exactly the rate that comes out.
Hoo. Gonna get hurt.
Me too.
Yeah, me too.
Very bad. Very bad news. Bad, bad news.
So you play Greenspan basically.
Yes. It's more than Greenspan. You're playing God in this one. Because you talk about invisible hand. We are the visible hand in this case, because by setting the interest rate, then we change the terms under which they can trade stocks.
Finally, an interest rate of 12%, and not 9%, is announced.
12% interest rate.
12%.
Oh, no. That's bad. 12? I was expecting higher.
Ugh!
Who's bidding 29? God damn.
God damn.
A minute ago, you told them that it was going to be 9%. And so then, it's 12%.
Economists, quite often, are wrong. They are not good forecasters. They have two hands. One hand says better. One hand says worse. So one of the things I'm training them, as an economist, I'm training them not always to listen to economists, even MIT economists.
Well, no one's paying me anything good for my stock. So I'm just going to have to sit on it, and take it like a man.
I'm sitting on cash. With 12%, it's good. Good feeling.
So that day, it seemed more profitable just to sit on one's cash without trying to invest it.
You won?
Oh, I was above average, 6.9. The others were 6.3.
Who's the winner? The winner is Tuchman, 1.6.
Who's Tuchman? Where is he?
Tuchman.
Who's Tuchman?
It's an opportunity to work in an environment where success is not subjective. Either you're smart, and you do well, and you're lucky. Or you think you're smart, and you don't do quite as well.
That's the reason so few private individuals play the stock markets directly themselves. It's simply too complicated. Most people just go to their agency and subscribe for shares in SICAV, as it is called in France, or mutual funds, as they are called in the United States. But whatever its name, the principle is the same everywhere-- Have your capital managed by a professional.
What's more, everything here is in line with the image of the trading rooms, from the fund manager's white shirt and tie to the photos of the guru star managers and the green, moving, display band of the stock exchange quotations. All the client has to do is sign his modest check, which will then take its place in the intricate circuit of the financial markets.
If the client is willing to take a few risks, his money may well wind up here at Firebird, a hedge fund or risk investment fund. Fireside manages a little over $400 million, all of it invested in Eastern European countries, including Russia. Sasha the strategy consultant, Constance the economic analyst, and Bob the manager have a difficult decision to make.
I mean, I think the last time you expressed a concern, it was at a higher level. And if we had acted immediately, we would have gotten out before it had moved down to this level. So it's going to now take another move down. Let's just get out immediately.
Yeah.
Knowing that Poland is undergoing an economic crisis, should they keep the $3 million of shares they own in a Polish telecommunication society or not?
Can't it just be weak?
The zloty has been weaker against the euro, and that's the concern. I mean, obviously, for our purposes it is a concern it gets weaker against the dollar, because we're dollar-based investors.
It seems like it's going to be the focus of Poland's stock market effort.
OK. Well, let me get on looking into it, and I'll get back to you this afternoon.
The decision is going to be made in less than an hour right here in this New York office, 8,000 kilometers away from Warsaw.
What I'm trying to sort of ascertain right now is, what is this pressure on the currency. What is it going to develop into? Are we better off, will we make more money, if we sell now and take that cash and the profits we've made on our position and wait and see what happens?
This is the stock. Now, we can get information about the company.
Constance has logged on to the Bloomberg online financial data service, which displays in real time the balance sheets and quotations of all the companies listed on any stock exchange in the world.
The current price is 5.83.
And may I ask you if you bought it lower or higher?
We bought it lower.
She then consults a chart showing the rate of the Polish zloty.
So it's moving along, getting a little weaker. And look at that. That is not a good sign. Hey, David, check this out.
Yes?
Zloty-euro today.
Today?
That doesn't look too healthy, does it?
Well, it could be bad data, no?
There's just so much information and so many channels for transmitting that information. The more channels there are, the less possible it is to have perfect information. And the more advanced that computers become in generating, processing, and distributing information, then the less possible it is to have perfect markets and to have efficient markets.
Hi.
Then, a phone call to an analyst colleague based in Warsaw.
What have you seen as far as pressure against the zloty? And I'm more concerned about the zloty against the euro, quite frankly, than I am against the dollar.
We have Polish growth of 2.6%. Consumption credit expanding already, but we do expect still-widening account deficit in this year.
If you're having pressure on your currency, then you could be expecting all the FDI in the world in June because you're doing a big privatization. But that's not going to help you now.
Well, unless people have realized that and--
No, I totally disagree with that. FDI is not a sure thing. The deal is not done until the money has been transferred.
Well--
Deals get cancelled all the time. Nobody in their right mind running money in Poland is going to consider that a sure thing.
Excellent, excellent. Good.
OK.
OK thank you both for your time.
All right, guys. Talk to you later.
Bye bye.
Bye.
Well, they had very poor auction results today, so interest rates look like they're going a little bit higher. Now, that will impact this credit growth that he's talking about. Economics is very dynamic. And unless you can sort of factor that into your thinking, you could be an interesting economist, but you're not going to make a very good fund manager. So I sort of have to mull this over.
Constance's extreme prudence with regard to the Polish money is easily explained. Firebird has lost a lot of money due to the Russian default and nosedive of the ruble.
Nobody could predict that Russia would default. I mean, I thought that they were going to devalue and that we would lose money.
It happened over the weekend.
The Thursday before, the finance minister were on a conference call saying, no, we will not devalue. You could almost hear the irony in their voice.
And meanwhile, we're selling our bonds. As that conference call's happening, we have orders in to sell our bonds.
Friday, by that time, it was a bit obvious that something was going to break.
To put it bluntly, you've lost some money.
Over $100 million.
What did you say?
Over $100 million.
Over $100 million, which is shocking.
Ooh, what's this in dollar terms though?
All the European telecoms are off these days.
Yeah. I would say we wait until that trend comes around.
Well, I'm just trying to figure out what's wrong. I mean, we were talking yesterday-- I guess you weren't here yesterday. We were talking about whether the euro looks like it's not working. Like from its first day, it hasn't worked.
I think if one's misunderstood, that would be a multi-year sort of process. It's not going to happen this quarter.
So we know we're going to sell half the position. And we're waiting to figure out if we get more information about whether or not to keep the other half.
Oh, and FDI is such a big thing to them, and this has been their most high-profile offering. And they want to do more. And I would just think that if they're going to support any stock, any company, this is a company that they would support.
What do you mean support, though? They're not going to go into the market and buy the shares.
No, but--
I'm not saying we sell it and walk away from it. What I'm proposing is that we sell it, see where it goes. If it seems to get some support at a lower level, we buy it back. Because I agree with you that it's fundamentally a really good company. It just happens to be in a bad market right now.
[INAUDIBLE] pragmatism and cross-border efficiency is very impressive, but also arouses a lot of criticism. These buildings belong to the Center of Economic Studies at Yale University. This is where the project to tax international financial transactions was conceived-- the famous Tobin tax, named after its inventor, Professor James Tobin, Nobel Prize winner for economics in 1981. His work is structured around a central interrogation-- do the ultra-rapid movements of capital have a positive social function or not?
Most of the fluctuations in the stock markets, in short term, are not of tracking fundamental values at all. They're just speculations, and they're often speculations on what other speculators think or will think about. That's certainly true right now.
It's not a guaranteed stable situation, even though your friends who are doing the job in their little cubicles with their monitor and all that and their computer, they don't see the whole picture of it. They just see what they're doing. And it makes sense to them, but it doesn't mean that it makes sense for the world.
Is it efficient?
It's efficient in a very minor, technical sense of the word efficiency. It's efficient in providing people who have paper assets liquidity in the sense that on short notice, whenever they want, they can turn the promise of the Korean government to pay them back next week into cash today. And so it's efficient in that sense.
It's efficient in making assets which are intrinsically not liquid liquid from the point of view of the individual holder of them. So the individual holder of them, he thinks that's great. But the economy, the world, is not liquid. The wealth which is really represented by these paper clients is buildings, stones, factories. You can't liquidate them all of a sudden.
John Maynard Keynes said it might be a good idea to make an attachment, a union, between an investor and the stock he buys in the stock market or the bond he buys in the bond market. Make that as permanent as a marriage of a man and a wife-- well, those are not so permanent as they were in 1936, but anyway-- so that the dissolution of the bond between them would be a big thing. And not just something you do at 2 o'clock and think about going the other way back at 4 o'clock.
What is true for stock markets is even more so for currency markets. London's financial center, the City, is the uncontested world capital of foreign exchange markets. This trading room centralizes the transactions of a major European bank. Here, decisions aren't made within the day, or even within the hour, but within the second. Its manager is a former highly-reputed foreign exchange broker, Nathalie Rachou.
[SPEAKING FRENCH]
Here, you have the dollar/yen desk. Swiss francs here, Swiss francs with two people. Yen here. Over there, sterling. And there, the euro, three people.
Financial markets do not necessarily mean high-tech organization. The foreign exchange market, for example, despite its size, still uses an old-fashioned listing technique. The brokers shout out their bids all day in the same way as an auctioneer.
68 and 1/3. 68 and 1/3.
58.
58. 5.8
58.
When the trader hears a price that interests him, he gives his agreement. It's a method that owes everything to tradition and nothing at all to modern technology.
34, 38.
34, 38.
57 and 80.
575.
575.
How many brokers do you listen to at the same time?
I listen to three. You get used to it, trying to hear which voices are whose. Because they've all got different voices, and you can really listen.
[SPEAKING FRENCH]
The emerging countries desk handles 150 currencies, which are quoted spot and forward.
Just then, to everyone's surprise, the Czech central bank announces that it isn't lowering its interest rates.
[SIDE CONVERSATIONS]
The Czech central bank had in fact been expected to raise its interest rates in order to support the falling koruna, due to the country's weak economic situation. It's panic aboard.
No, wait. Cut them all off. Cut them all off and wait.
45?
Wait. Do nothing. Cut everybody off. Cut them off. Don't quote.
OK. I've got my 36 though, right?
Wait a sec. The market was long, possibly in anticipation of a rate cut. So the euro/Czech got sold off.
This group of five traders is organized in accordance with the traditional method. The four traders, considered to be too closely wrapped up in their screens, are seconded by an economist who is there to guide them and enlighten them.
I think that the ECB is going to cut rates very soon. And that means that the pressure on the Czech and the satellites to keep going, pushing the rate cut button is going to-- And that's exactly when euro/Czech bounced.
The traders listen politely, but immediately turn back to their keyboards to ask for the opinions of their colleagues in other banks through the use of an electronic mail system, Reuters, which instantaneously links up traders all over the world.
[SIDE CONVERSATIONS]
We broke the 400 levels again. It's gotta go a lot, lot lower. We've got all--
I feel like we might have to wait half an hour, an hour now.
Or we're both going down the pub.
We're in a sort of period of calm before the storm. The never-ending storms.
Now, we're betting that it will trade lower by the end of the day. So if we break through this 400 level, where we've found these good supports, and you can see the euro/Czech accelerate on the lower side. From 38.400 you can see that change to 38.200, 38,250. Even so, that's another 150 points lower.
While they wait, the traders listen to the voice broker reciting the progressive decent of the Czech currency.
30.52 by 3. 30.52 by 3.
Is that a given?
30.52 by 3.
[SPEAKING FRENCH]
Who makes the market? The market is made, in fact, by a multitude of dealers, all with different objectives. For example, the market is supplied by exporters and importers who need to sell the currencies in which their exports are denominated. And then again, you have importers who have to pay for their commodities purchases in a given currency. The most typical examples of this are the petrol companies who pay the petrol-supplying country in dollars.
Oh, dear. But Richard, it's not as bad as it was earlier. Oh, dear. Lordy.
[SPEAKING FRENCH]
Yes, but there are also the pure speculators-- the Chicago dentists, as they're called-- who just like to speculate.
Yes, of course. There are a lot of speculators, although there have been a lot less since last year. Because the crisis in the emerging markets reduced the speculation capacities of all the main players, whether they be companies or banks. So while we still have the Chicago dentists-- although not so many of these now-- they aren't responsible for the size of the foreign exchange markets.
New York are coming in now. So you've got another set of market players which are going to analyze the information that's come out. If they were looking for rate cuts, and they haven't found it, that might create some selling pressure.
ECB says a strong euro to help Eastern European entrants. A strong and stable euro will help the European Union's Central and Eastern European applicant countries as they prepare for EU.
The support seems to be disappearing at the moment, all right?
Oh, it's dropped 100 points from the last 15 minutes when you were here. So now, we'll wait and see what happens. And hopefully, we'll get active again. It was at 440, and now it's at 400. So its 40 points lower.
In less than an hour?
Oh, yeah. That just did that in the last two minutes. This is a short-term move for part of the big picture. There's nothing more rewarding than having a view, taking a position, and maximizing return out of it. There's nothing more satisfying than that.
This sort of ultra-rapid movement of money is the nightmare of finance ministers. But what about for traders?
[SPEAKING FRENCH]
My teams love volatility, and so do I. Because in general, it provides good opportunities to make profits.
It's coming lower. We're smiling a little bit.
The Czech koruna is taking a nose dive. It's the right time to buy.
You want to sell 15 euros? OK, one sec. 15 euros.
95.
One sec.
[SPEAKING FRENCH]
You learn to rely on your instinct. It's as simple as that. A trader is either born lucky or not. It's like in cards.
The most important thing, I'd say, for me is learning when to stop listening to all the noise. It's learning to find out what the right decision is. There's so much information here. You could find 15 reasons to buy it, 15 reasons to sell it. But only one thing is going to be right. It's either going to up, or it's going to go down.
A trader who is unlucky doesn't remain one for very long. This may seem fantastical, but I assure you that it's very important. A trader will learn to just follow his nose.
15 at 385, sir. See you, buddy. I gotta put this in. 15.
There's a further sudden drop, but the quantities negotiated are too large to be true.
It's Gary, isn't it?
It's Geary.
Oh, is it?
Curiouser and curiouser.
Do you want another 290?
Yeah.
Yeah, I'll have him hit you.
At 4 and 1/2, I got, all right?
You think this is an elaborate spoof?
Well, he's a spoofing bastard to be honest, but yeah. I don't like him, but--
There are some very big offers being made. Yes, and far too loudly, replies a colleague.
Yeah, a couple of London banks just bought this aggressively and loudly, all right? But there are some offers up here, all right?
Thank you.
What do you mean when you say an elaborate spoof?
They'll sell with one guy to buy it somewhere else. You do the opposite with a guy who you think is going to run out of the position. And you give him, and he'll go [PANTING]. And at the same time, he's sitting there going, yeah, I'll take all those. I'll take all those. Sometimes it works. Sometimes it doesn't.
So you mean that someone is manipulating?
Trying to manipulate the market, yeah. Trying to trick us into doing the opposite thing.
And how do you detect that?
You have to just keep your eye on the screens a lot. And there's nothing better than getting the right side of the market and squeezing some of these bastards. And there's nothing worse than getting it wrong. So that has big highs and big lows.
Peter? This is looking pretty heavy. I've just been given by an investment house 400. It looks like they've got them all and it looks like it's going to come off.
Thanks.
All right.
Who were you talking to?
One of the corporate dealers. He sits right over there on the far side of the room, and it stops us shouting.
There's two things, really, that sort of drive the market. One's fear. The other's greed. When the market's scared, or people who are in the market are scared, then it becomes pretty volatile and pretty dangerous to run positions. Because it starts moving around all over the place. You don't actually know what's going on.
It's like a sinking ship. First guy jumps, I'm selling because it's not moved. And then the next person, and then it's just the whole. It's just like one person jumps too, and then everyone's jumping. And that's when it becomes irrational. That's when it becomes total madness, because everyone's jumping.
And then everyone just will hit any price. They don't care. They just want to be out, because they're scared of losing so much money.
Looks like you're a profession of sheep.
Yeah. At the end of the day, I wouldn't say we're a profession of sheeps. But when the market's scared, everyone becomes a sheep. And it takes a very strong man to go against the sheep.
Andre Orlean, a professor at the Ecole Polytechnique, has made these phenomena the subject of his research.
[SPEAKING FRENCH]
Very often, the traditional image of market traders is that of isolated, calculating, individuals who study the basic economic data of the companies in which they're investing, and then, on the strength of their calculations, behave in certain ways. Now, what one actually observes in the markets is a behavior which, although rational, is very different from the behavior of an isolated, calculating individual.
What interests an investor more than the basic economic figures is the way in which the market is behaving. And therefore, he finds himself focalizing on the market's fluctuations.
So that means the market becomes almost a being in itself.
Yes, exactly. Something like that. There's a sort of hypostasis of the market which enables it to be considered as a kind of global entity, whose movements can be predicted and forecast in advance. This is exactly how it works. And even more so in the sense that it will sometimes be credited with characteristics that are different from individual characteristics.
For example, an individual may consider that a certain drop in an exchange rate is excessive in relation to what he believes, in relation to the data he's observing, and in relation to what the other financial analysts are saying. But he can think at the same time that the market itself may consider that a 40% percent drop, for example, as has been known for exchange rates, was entirely plausible. And therefore, he's going to credit the market with having beliefs and behaviors which may be different from his own personal ones.
And what is paradoxical and wonderful about this is that if everyone reacted in this way, then the behaviors that appear on the market will, in fact, end up by conforming to these forecasts. This is what we call in economic theory a self-fulfilling prophecy.
It was looking very break. Now it's just looking foggy.
Financial speculation also has its great names. On the right side of the law, George Soros, Warren Buffett. But on the shadier side, we have Michael Milken with his junk bonds and Nick Leeson and the Barings catastrophe. It's now time to take a look at the more obscure rank-and-file speculator. People like you and me.
Ramon doesn't work for a bank. This former car park attendant speculates for his own account with his own money.
It's a beautiful day in Florida. It's another wonderful day here.
He's what's known as a day trader.
Hello? Yup. Yeah, so if you see the stock change, then go back to-- I guess, what is it? 108 and 1/2 or 109? Yeah, just give me a shout. All right, thanks.
Well, last year I turned $30,000 into $1.4 million last year. And this year, I'll expect to at least do three times that much, maybe four times.
That's $3 or $4 million?
Yeah.
When the market opens for the day, Ramon possesses nothing. And in the evening, he'll sell everything before it closes. He spends the day swinging backwards and forwards, buying and selling. Hence the name of this perfectly legal but 100% speculative activity, day trading.
Ramon rents his technical space here, like three other day traders who are also speculating for their own account.
Hello. The large players in the market-- your institutions, your banks, mutual funds, retirement funds, right-- they're the ones that are really in charge of moving the market in directions. And so we're basically looking to catch a ride on where they want to move a stock. In a sense, we're almost like leeches, where we just basically look for the right opportunity that they're pushing the stock. And we'll just kind of attach ourselves to that trade and ride it with them until we think we've got a good enough profit.
How much stock do you hold at the moment?
At the moment? Let's see. I'm probably long 15,000 shares and I'm short 6,000 shares. I'll narrow that down.
In US dollars, it's about?
US dollars? Let's see. That would be $2 million.
You're holding at the moment?
Yeah. Probably just a little over $2 million. Look at this thing. It went from down four to up six in probably 15 minutes.
Wow.
Something's going on here. We're going to take our profits out of this thing at $12. I bought this just a few minutes ago. And it continues to show a lot of strength and stuff. So there it is. I'm knocked out of it. I mean, that's how fast. Just flipping over this other screen to find a trade, I just made $4,000 back. So sometimes it happens that fast. Not all the time, but sometimes.
Obviously, with things happening at such lightning speed, the problem is finding the time to go and have lunch.
Yeah. I'd rather be safe than sorry.
Sometimes lunch is a good thing. You can relax and not look at all the numbers moving around. Early on when I was trading, I had taken a position in a stock. And we went to lunch, and we went to a Mexican restaurant. And when I got back, the stock had moved like two points against me. And so for a quick lunch., my tacos ended up costing me about $3,000. So we kind of refer to it as the taco effect.
Ramon learned this trade, which isn't really one, by following a five-day training course here in New York at Harbor Securities, a company that rents day trading technical space by the hour to private individuals.
I do know that day trading is something that anyone can try. Because all you need is money and a computer, and you can try it. Whereas you can't try to be a doctor or try to be a lawyer without going to years and years of school and very advanced certification.
It costs $4,000 to learn everything you need to know to become a day trader.
This afternoon, we're going to entertain thoughts about the most challenging aspect of trading, the emotional discipline factor. This is what separates the winners from the losers. The mechanics and the techniques, we can teach you. Anyone can learn those and do them. But not everyone has the personal discipline to exercise emotional discipline.
How about yourself?
Good morning, My name is Nehad. I recently graduated from Queens College.
I turn 23 today. And--
Happy birthday.
Thank you. Just been doing personal investing the last few years.
I look not to lose too much money in the stock market.
What I hope to get out of this is to live wherever I want to live and do whatever I want to do, whenever I want to do it.
Put this picture on the wall here. It's Mr. Spock from the original Star Trek series. Why is he up there? What's he doing?
Mr. Spock would've been the greatest traitor ever, because Mr. Spock operates completely devoid of emotion. Pure logic, rational thinking, truth is what governs his decision making. That would make him an excellent trader. Successful traders consider trading a serious intellectual pursuit. They practice defensive money management, and they guard their capital like a professional scuba diver watches his air supply.
Mr Spock would've been the greatest trader, because he's devoid of emotions. Remember not to blame the market. The market does not care one way or another what you do. It's simply there for you to take advantage of. That's all. Once you find a place to defer responsibility, you're setting yourself up for any number of negative results from trading.
Hoping a trade will go your way. Remember, hope is four letter word. Hope is a dirty word. If there's any time at all that you're hoping, get out of the position.
Profits make traders feel powerful. It gives them a high, and then they go and try to get high again. They put on reckless trades, and they give back their profits or they suffer losses. Getting reckless is exactly what people have a tendency to do when they don't feel any fear. So to be successful, you can't trade for, need, or even think about the money.
Any good trades?
Corey, was it a good idea to sell at $58?
I'd definitely sell it there. Right, that's your objective. When you put on the trade, that's where they're selling.
So I figured it got so close. I mean, I could always buy it back later if it breaks above. So I did do it right.
Very good.
When you do day trading, and you only own shares for a few minutes, your main focus is obviously not on a company's long-term economic results. Day traders often know nothing at all about the companies they're buying into.
No, day trading is based entirely on a mathematical method of market analysis, which is called "chartism," from the word "chart."
The leading light in this discipline is John Murphy, author of the bible of chartist analysis, The Visual Investor.
It's a very visual approach. We chart the price of the stock, and then we try to determine which direction it's going. OK.
This is called a 50-day average. What the computer simply does is it goes back and it takes an average of the last 50 days' closing prices. It's a smoothing device that tends to trail behind the price action. The 50-day happens to be a very popular indicator.
And the way we trade this is that when prices move above the indicator, which they did to the left there, you'll notice that at particular point, that is treated as a buy signal by technical traders. Over here, when prices moved below the 50-day moving average, that is taken as a sell signal. So traders would be buying the stock down here and selling the stock here.
You can take all these technical indicators, and you can program them. And your computer will literally give you buy and sell signals. In fact, the computer can even be programmed to send those signals directly to a discount broker who will activate those signals for you.
Which is exactly what Mike, the king of the mathematical method of speculation, actually does.
As you see, I have three screens that I monitor. These are stocks I'm looking at buying. These are stocks I'm looking at selling. This is sort of a combination of the two. And when lights show up, it usually means there's trading opportunity.
A few years ago, I didn't have these tools. And not only that, I'm really good at it. I'm really an expert at this.
I'm watching this line right here at the moment. And whenever that number turns green, that tells me that the one stock is cheap. You should be able to realize a profit, like my customer's doing right now.
Institutions trade millions and hundreds of thousands of shares. And if they can save themselves a few pennies going in, going out, they're going to improve their rate of return. If we can do it every time for them or most times for them, then we're really doing them a huge service.
Oh boy. Look what's happening here. We got a yellow. Can you buy 1,000 units to save 54 and 5 [INAUDIBLE]? Oh, I missed it. Ah. Don't do it. Don't do it. Don't do it. I was too slow.
Cancel the Unisys.
Cancel Unisys.
Right.
Why did you say that?
Cancel what?
You said, cancel the Unisys. Why?
I saw the color changed. The spread no longer makes mathematical sense. So when these colors change, or essentially when the numbers line up the way I like them, I'm able to take action very quickly.
Whereas my competitors are still like, oh yeah, OK. My order's already down on the floor. I'm already buying stuff. They're still figuring out whether it's mathematically worthwhile or not.
When you first sat down I was doing something. Now, 20 minutes later, if we were to unwind it, it would've made over $2,000. Which is nice. You can't beat that, right?
Well, you can beat it. You can make $4,000. Hopefully, in 20 minutes that'll happen. But that's what we're trying to do here. We're trying to spot those opportunities. When we see 'em, grab 'em,
Here is perhaps the ultimate stage in financial market organization. We're in New York, not far from Wall Street, in the office of an investment fund which manages several hundred million. Not too long ago in the past, dozens of traders worked here. But today, the rooms are strangely silent.
No interphones buzz. No telephones ring. The television, which was always tuned to CNN, is now turned off. The only people working here now are a handful of programming experts whose job is to pattern market behavior. Investment decisions are now made by the computers in the basement.
There's that characteristic short sale or volatility that always bothers me.
Mm hmm.
The actual trading that we do is 100% model driven, yeah. And I'm happy that way.
You have to forget your personality.
No. Personality, in words of George Bush, (GEORGE H.W. BUSH IMPRESSION) bad. Numbers, good. (NORMAL VOICE) We really like to create, effectively, a generic equivalent strategy of all the managers that we make allocations to. And sadly enough, it turns out to be reasonably easy to do in most cases.
It's almost artificial intelligence.
That's the only kind of intelligence we have around here. It does make use of some of the techniques involved in AI. I have had the opportunity in my time in this business to take a look at literally hundreds of different trading strategies, which are what makes one guy better than the other. Interestingly enough, 80% of the variation in performance between managers can be explained by asset allocation.
In other words, if the grain markets do very well in a particular year, and he happens to be a grain trader, he's going to make a lot of money and look like a genius. If the stock market goes up eight years in a row, guys that have long-side equity exposure are going to look like geniuses. Are they?
I've seen technical trend following, neural nets, fractal analysis, throwing chicken entrails against the wall. Actually, strangely enough, they had a guy at Bankers Trust who was using astrology, which I thought was fascinating. And he actually made money over time. I have no idea how he did it.
So the reality is that while the strategies for defining trend and mean reversion may vary, the sources of value remain constant. And as a result, the returns tend to be highly correlated, and the performance tends to be quite close between managers.
So why don't you just flip a coin? I mean, it would be cheaper.
We've almost come to that conclusion.
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