STOCKS & BONDS

2. STOCKS & BONDS FOR INDIVIDUALS, GOVERNMENT & CORPORATIONS, CURRENT EXPENSES OFTEN EXCEED THEIR CURRENT INCOMES / REVENUES . . . PEOPLE TAKE OUT LOANS TO ATTEND COLLEGE, BUY HOMES, OR START SMALL BUSINESSES . . . GOVERNMENTS & BIG BUSINESSES NEED MORE CAPITAL FOR LONGER PERIODS THAN ANY BANK CAN PROVIDE • SELL OWNERSHIP: EQUITY IS THE RIGHT TO COLLECT PROFITS. ISSUING STOCK  MORE CAPITAL, BUT OWNERSHIP IS DILUTED • STOCK = EQUITY = OWNERSHIP • CITIZENSHIP = EQUITY / OWNERSHIP IN GOVERNMENT; KINGS SOLD “SHARES” (DEMOCRATIZED) TO RAISE FUNDS TO FIGHT WARS (16TH TO 18TH CENTURIES) • SELL DEBT: BONDS EXCHANGE FUTURE CAPITAL FOR CURRENT CAPITAL • IOU: BUY THIS FOR ME NOW, I WILL PAY YOU BACK LATER

3. STOCKS & BONDS STOCKS PRICES & BOND YIELDS TEND TO BE INVERSELY RELATED  WHEN STOCKS GO UP, BONDS GO DOWN STOCKS  10% CHANCE TO WIN $90 BONDS  90% CHANCE TO WIN $10 BONDS = “SAFE HAVEN” WHEN ECONOMIC CONDITIONS WORSEN & GROWTH PROSPECTS FOR FIRMS LOOKS DIM STOCKS = “GROWTH OPPORTUNITY” PREFERRED WHEN COMPANIES EXPAND THEIR MARKET OR PRODUCTS RATIONAL COMPANIES SHOULD ISSUE STOCKS WHEN THE ECONOMY RISES & BONDS WHEN IT FALLS . . . BUT TEND TO BE PRO-CYCLICAL, NOT COUNTER-CYCLICAL IN FINANCING

4. BONDS BOND: PROMISE TO PAY A CERTAIN AMOUNT AT A FIXED POINT IN THE FUTURE – A POST-DATED CHECK GOVERNMENTS / CORPORATIONS AUCTION BONDS TO THE HIGHEST BIDDER • LOAN: PRICE = PRINCIPLE + INTEREST RATE • BOND: PRICE = PAR VALUE – YIELD BONDS ARE SUPERIOR TO LOANS BECAUSE : 1) DEBT SOLD TO MANY DIFFERENT BUYERS (WAR BONDS) 2) THEY CAN BE BOUGHT & SOLD CONTINUOUSLY – PRICES RISE & YIELDS DECLINE AS BOND MATURES

5. PRICING A BOND ISSUER CREDIBILITY: CAN & WILL THE ISSUER OF THE BOND MAKE GOOD ON THEIR PROMISE? • AGENCIES GRADE BONDS FROM “AAA” – HIGHLY RELIABLE – TO “D” – DEFAULT OR “JUNK BONDS” / SIMILAR TO CREDIT SCORES • TIME HORIZON – UNLIKE INDIVIDUALS, GOVERNMENTS / CORPORATIONS CAN “ROLL OVER” DEBT IN PERPETUITY • SAFEST = US SHORT –TERM TREASURY BOND • LOWER CREDIBILITY  LOWER PRICE  HIGHER YIELD INTEREST RATE: HOW DO BONDS COMPARE TO OTHER “SAFE” INVESTMENTS? • BOND YIELD > INTEREST RATE  BETTER TO BUY BONDS • AS INTEREST RATES INCREASE, YIELDS SHOULD INCREASE, DECREASING BOND PRICES TIME TO MATURITY: • BOND YIELDS NORMALLY DECREASE AS THEY APPROACH MATURITY • COUPONS – SOME BONDS INCLUDE “COUPONS” THAT BEARERS CAN REDEEM FOR MONEY BEFORE MATURITY

6. BONDS, SECURITIES & SUB-PRIME BONDS = FIXED INCOME SECURITY  BOND OWNER ENTITLED TO INCOME “SECURED” BY THE ISSUER’S COLLATERAL • GOVERNMENT BONDS  TAX REVENUES • CORPORATE BONDS  CORPORATE ASSETS • MORTGAGE BACKED SECURITIES  MORTGAGE PAYMENTS FANNIE MAE & FREDDIE MAC CREATED TO “SECURITIZE” MORTGAGES INTO COLLATERALIZED DEBT OBLIGATIONS (CDOs) OR MORTGAGE BACKED SECURITIES (MBS) ISSUER CREDIBILITY RATING AGENCIES OVERRATED CDOs & MBS AS “AAA” SECURITIES INTEREST RATE RATES LOW AFTER 9/11, BUT INCREASED AFTERWARD  INCREASED YIELDS & REDUCED PRICES TIME TO MATURITY MBS “SLICED & DICED” INTO TRANCHES (COUPONS) BY MATURITY / RISK & SOLD TO DIFFERENT BUYERS ***SUB-PRIME / JUNK BONDS – SECURE SPECULATIVE***

7. NEWTONIAN & BROWNIAN MOTION NEWTONIAN BROWNIAN PROBABILISTIC RELATIVITY UNIQUENESS E = MC2 CLOUDS DNA SNOWFLAKES UNCERTAINTY ----- STOCKS DETERMINISTIC UNIVERSALITY GENERALITY F = M x A CLOCKS MACHINES RISK ------ BONDS

8. STOCKS & BEAUTY CONTESTS STOCK MARKET = BETS ON PUBLIC OPINION’S GUESS WHAT THE MAJORITY WILL CHOOSE TO WIN A BEAUTY CONTEST YOU WIN IF . . . 1) YOU BET 2) WHAT THE MAJORITY BELIEVED 3) WHAT THE MAJORITY WOULD PICK 4) AS THE WINNER OF A SUBJECTIVE CONTEST . . . BUT THE PRICE OF THE BET INCREASES AS MORE PEOPLE MAKE THE SAME BET AS YOU Ex. BOARD GAME: APPLES TO APPLES

9. STOCKS & RANDOM WALKS FOR EVERY STOCK BOUGHT, ONE MUST BE SOLD . . . STOCK PRICE = HALF THINK THE PRICE WILL INCREASE & HALF DECREASE  RANDOM COIN FLIP THEREFORE, STOCK PRICES MOVEMENTS IN A FAIR, COMPETITIVE ARE RANDOM OR UNSYSTEMATIC  “NOISE” EXPECTED VALUE OF A STOCK MARKET TRANSACTION = ZERO HALF WIN / HALF LOSE IMPLICATIONS: • ONLY BROKERS (TRANSACTION FEES) & INSIDERS (CHEATERS) CAN PROFIT OVER THE LONG RUN; STOCK MARKET = CASINO • A MONKEY THROWING DARTS WILL DO BETTER THAN ANY EXPERT INVESTMENT STRATEGY  (BEGINNER’S LUCK) • PAST  NO INDICATOR OF FUTURE SUCCESS; PICKING LOSERS > PICKING WINNERS

10. BEATING THE STOCK MARKET FAIR, COMPETITIVE MARKETS  NO PROFIT . . . . . . SO HOW DO PEOPLE MAKE MONEY ON WALL STREET? MONOPOLY / PSYCHOLOGY / INSIDE-INFORMATION / LEVERAGE / RENT-SEEKING / MATHEMATICS / DIVERSIFICATION • MONOPOLY – INSTITUTIONAL INVESTORS – HEDGE FUNDS, MUTUAL FUNDS & INVESTMENT BANKS – HAVE MARKET POWER PRICE MAKERS • LEVERAGE – MATHEMATICS IDENTIFIES MARKET FRICTIONS & PROVIDES PRECISE PROBABILITIES  EXPLOIT BY LEVERAGE • INTERPERSONAL / INTRAPERSONAL PSYCHOLOGY – READ “HERD” PSYCHOLOGY & CONTROL “ANIMAL SPIRITS” “VALUE INVESTING” • PROPRIETARY RESEARCH & STRATEGIES: MARKET RESEARCH & SECRET STRATEGIES • DIVERSIFICATION: BET ON MANY DIFFERENT COIN FLIPS SIMULTANEOUSLY

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