01/13/2014
Class 1 (Monday January 13, 2014)
Marking breakdown of report
1.strategy
2. Research
3. Trading
4. Results per week
Analysis:
Discussion of strategies and results (success/failure)
Overall evaluation of stock market experience
Attach transaction history of at least 3 dates per week.
Growth and Business Cycle
Fluctuations in the pace of expansion of real production is called the business cycle
The business cycle is a periodic irregular up and down movement of total production and other measure of
economic activity.
Phases of the Business cycle
trough
peak
expansion recession
Market Bubbles
A cycle characterized by rapid expansion followed by rapid contraction.
Stock market bubble: a surge in equity prices, often more than warranted by the fundamentals, followed by
a drastic drop in prices as a massive selloff occurs.
A bubble involves a nonsustainable pattern of price changes.
Example:
1630s in Dutch Republic: tulip market bubble
Late 1980s in Japan: real estate bubble
Late 1990s in the US: stock market bubble
Phases of a bubble
Mania (increase)
Boom (top)
Panic (decrease)
Bust (flat)
Class 2 (Friday January 17, 2014)
Manias
Bubble involves the purchase of an asset (real or financial asset) not because of the rate of return on the
investment but in anticipation that the asset or security can be sold to someone else at an even high price
(greater fool) Return = Income flows + capital gain/loss
Manias describe the frenzied patter of purchases, often an increase in both prices and trading volumes.
Bubble: increase in (asset) prices in the mania phase of the cycle
Virtually every mania is associated with a robust economic expansion
Economic expansion:
Investors become increasingly optimistic and more eager to pursue profit opportunities
Lenders become less riskaverse
Personal
Vendors
Institutions
Money Supply= Currency + Deposits
Rational exuberance morphs into irrational exuberance
Speculation Intensifies:
Increasingly large share of the purchases of these assets is undertaken in anticipation of short term capital
gains
Exceptionally large share of these purchases is financed with credit
Rapid increase in the indebtedness of one or several groups of borrowers.
AssetPrice Bubbles: Credit Driven
Credit booms drives up asset prices
Rise in asset values in turn encourages further lending
Higher asset prices increase the value of collateral, making it easier to borrow
Higher asset prices raise the value of capital at financial institutions, which gives them more capacity to
lend Particularly Dangerous
When bubbles bursts, asset prices collapse, loans go sour, lenders cut back on credit supply
Insolvency is when liabilities are higher than assets
Demand for assets decline further, and prices drop even more
Panics
Events which can trigger a panic:
Change in government policy
Unexplained failure of a big firm previously thought to have been successful
Investors distress sales
The rush to sell before prices decline further becomes selffulfilling.
Financial Crisis
Baking Crisis
When some or all of the banks are threatened with insolvency and the banking system’s becoming unable
to perform its normal lending functions.
Currency or exchange crisis
Sudden and unexpected collapse in the value of a nation’s currency
Under a flexible exchange rate system, crisis means an uncontrolled, rapid depreciation of the currency
Sovereign debt crisis (government debt)
When a national government cannot pay debt owed
Ex. Latin American debt crisis in the 1980s
Economic Crisis
Asset deflation led to massive bankruptcies
Recession and rising unemployment
Ex. Mexico (1994), Asian (1997), Russia (1998), Brazil (1999) 01/13/2014
Cont. Monday January 20 2014 01/13/2014
Contagion
Domestic contagion: a boom in one market spills over to other markets
International contagion: a financial and or economic crisis can affect more than one economy
Transmission Mechanisms
Trade flows: import/export
Capital flows: foreign investment, portfolio investment
Financial Liberalization:
Lower restrictions on international financial transactions
Increases exposure of financial institutions and asset markets to foreign investors/speculators.
Swindles
Crashes and panics are often precipitated by the revelation of some scandals that occurred during the
mania
Swindles are a response to the greedy appetite for wealth stimulated by the boom/bubble
Ponzi Scheme
Fraudulent investments in which money from new investors is used to pay off earlier investors
Generally promises to pay a high interest of 3050% interest
Ponzi:1920s
Operated a small loans company in the 1920s
Promised interest of 30%/month
Scheme collapsed in 4 months and went to prison 01/13/2014
Policy Implications
Government can intervene when there’s a sharp decline in asset prices because investors will be less
cautious, causing frequent market break downs.
In a financial crisis, the surge in demand for liquidity may drive many financial institutions into bankruptcy
Central bank=role of the “lender of last resort”
In post war era, International Monetary Fund (IMF) acts as the international lender of last resort.
Schools of Thoughts
Classical/Neoclassical:
Free Markets can selfregulate
Keynesian:
Government plays an important role
Monetarist
Money supply and interest rates are significant factors
Rational Expectations:
Expectations are rational and will affect market response to government policies
Minsky Model
Minsky argued that the financial system is unstable, fragile, and prone to crisis
Procyclical
Increases in the supply of credit in good times and the decline in bad times led to fragility in financial
arrangements and increased the likelihood on financial crisis
Attached great importance to the behaviors of heavily indebted borrowers, particularly those who purchase
assets for short term capital gains.
There are 5 stages:
Displacement 01/13/2014
Boom
Euphoria
Profit
Taking
Panic
The boom is fueled by an expansion of credit
Overtrading: speculation about increases in prices of assets or commodities; or excessive leverage
Speculation involves buying for resale rather than for investment
Different Types of Firm Financing
Hedge Financing
The firm’s anticipated operating income is more than sufficient to pay both the interest and scheduled
reduction in its debt
Speculative Financing
The firm can pay the interest but it must use cash from new loans to repay part or all of the amounts due on
maturing loans
Ponzi Financing
The firm cannot pay all of the interest and must either increase its indebtedness or sell some assets 01/13/2014
Monday
Tulip Mania
Historical Background
Early 17 century: Dutch Republic was the most advanced and thriving economy in Europe
Amsterdam: Great entrepot (trading hub) and the financial “capital” of Europe
Most ships in European merchant fleets were built by the Dutch, so they dominated transport in grains,
salts, metal, and other goods
Finance evolved and developed with the commodity markets
Tulip
1630s outburst of speculative euphoria
Easy to cultivate, required little land
Large number of buyers and sellers
Introduced into Europe from Turkey
Initially confined to gardens of nobility and specialist botanists
Associated with wealth and power
Tulip Market
Each bulb was given a number, recording its variety and weight at planting (1 ace= .05 gram)
Each bulb’s trading history recorded on a separate sheet
Standardization into papers that were similar to shares of a company
Tulip Trade
Traditionally, buying and selling occurred during summers after flowers bloomed in may/June. 01/13/2014
Flowers would have been viewed and inspected and exchanged before being replanted in September.
Sellers promised to deliver when harvested and buyer would pay on delivery
Payments were made in kind: cows, houses, furniture etc
1634: Tulips became accessible to a popular market
were purchased by a larger number of small buyers
Buying in the winter for delivery in the summer became acceptable
Futures market had developed
Wind Trade (Windhandel)
September: bulbs planted to bloom in spring
Sellers promised to deliver a bulb in spring
Buyers took the right to delivery
Bidding in the winter months conducted with no specimen in evidence
Most transactions were for tulip bulbs that could never be delivered because they didn’t exist and were paid
with credit notes that could never be honored.
Tulip Mania
1634; arrival of outsiders: new amateurs (peasants, bakers, weavers) attracted by stories of rising prices of
tulip bulbs in France.
Tulip Prices
Average annual wage in Holland: 200 to 400 florins
Price of a Semper Augustus bulb in 1624: 1200 florins
Tulip Mania: NovDec 1636
Many local mayors started to invest
Fall 1636: The European tulip market suddenly wilted because of a crisis in Germany. 01/13/2014
German demand for tulips declined.
Dutch burgomasters (mayors) wanted to change the market rules: they threatened to abandon the contracts
Under the new deal, investors agreed to pay a small fraction of the contract price to get out of the contract.
Peak prices: 20 times higher than 3 months before
1637 Feb 3: Tulip Market Crashed!
Tulip Mania: Aftermath
May 1638: A government commission declared tulip contracts could be annulled on payment of 3.5% of
agreed price.
Did not cause major economic crisis because speculation only involved a small segment of population
Is tulip speculation rational?
Peter Garber: Yes
Efficient market school: market prices always reflect their intrinsic value
As it becomes more common, prices decline rapidly as other products were introduced
Edward Chancellor: No
Investors expectations were ittational
Tulips did not produce dividend
No guarantee of quality
Mississippi and South Sea Bubbles
Late 17 Century: Financial Revolution
Emergence of stock market in London
Parliamentary guarantee for government loans (1693) 01/13/2014
Establishment of Bank of England (1694)
Intro of Exchequer bills (1696) and Promissory Notes Act (1704) which made all government debts
negotiable, thus transferable
Bank of England
1694: was granted a royal charter and banking monopoly on condition that it lent £1.2 million to the
government
Was allowed to provide the loan in form of own banknotes (of no intrinsic value) aka they weren’t backed by
gold.
Paper currency had received the first mark of government approval.
th
Financial Developments (Late 17 Century)
Goldsmiths acted like bankers by making loans and creating a market for merchants bills of exchange
(credit notes)
Jointstock company: business organization whose capital was divided into shares
Until 1690s, no regular market for trading and foreigners were forbidden to hold shares
Ownership of companies were limited to a few wealthy people
Gambling in Early Capital Markets
Many new companies with patents floated in the market by late 17 century
Many of these patents were not genuine attempts to apply scientific advances for commercial purposes
Rather they were used by promoters to draw attention to launch companies
Tools of speculation were imported from Amsterdam, i.e. standardization of sale contracts, stock options
and futures
1694: The first British government lottery “The Million Adventure”
First price: £1000 a year for 16 years
Tickets were £10 and 100,000 were sold
East India Company
Chartered Company 01/13/2014
1693: Failed to pay a special tax on the value of its stock
The company’s charters were technically forfeited
A rival syndicate was attempting to snatch the Eastern trade monopoly by competing for the new charter
Both groups engaged in extensive bribery both and court and parliament
The contest ended in victory for the establishment after expenditure of over £200,000 of secret service
money
France in Early 18 Century
1715: Louis XIV, the Sun King was succeeded by his 5 year old great grandson Louis XV
Due to
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