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ANDREW LO: The other item
that I auctioned off--

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00:00:22,940 --> 00:00:24,540
that's a good question.

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00:00:24,540 --> 00:00:27,460
Well, first of all,
before I tell you that,

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you'll note that I put
those two packages up here

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00:00:30,280 --> 00:00:33,280
in the front of the room
for this first section.

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One was bigger than the other.

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And you guys got the
smaller one, right?

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And you obviously
know what that was.

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00:00:39,070 --> 00:00:42,820
The bigger one turns
out to have been a book.

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00:00:42,820 --> 00:00:44,860
In fact, it's a
book that I recently

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00:00:44,860 --> 00:00:48,340
published on hedge funds.

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Now it turns out that the
bidding of that second item

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went for $60.

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The bidding of the item
that I sold to this auction

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00:00:59,310 --> 00:01:00,960
went for $45.

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00:01:00,960 --> 00:01:03,990
And the fact that it's a
smaller package I think

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00:01:03,990 --> 00:01:08,250
makes some sense of why it
went for a smaller amount.

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00:01:08,250 --> 00:01:10,830
That shows you the
power of information,

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00:01:10,830 --> 00:01:13,920
or lack of information, in
terms of determining values.

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00:01:13,920 --> 00:01:14,974
Yeah, question?

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00:01:14,974 --> 00:01:16,598
AUDIENCE: Yeah, I
was just going to ask

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00:01:16,598 --> 00:01:18,586
if there was some
insider information that

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00:01:18,586 --> 00:01:23,060
would up the value
of that second box?

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00:01:23,060 --> 00:01:24,670
ANDREW LO: Well,
I don't think so.

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00:01:24,670 --> 00:01:28,180
And one of the reasons that
I had two different packages

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00:01:28,180 --> 00:01:33,310
and I showed this entire section
the two different packages

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00:01:33,310 --> 00:01:36,820
is to try to eliminate a bit
of that private information.

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00:01:36,820 --> 00:01:38,410
I don't believe there was any.

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00:01:38,410 --> 00:01:40,990
If I used the same
two items, then I

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00:01:40,990 --> 00:01:43,660
think there would
have been a concern

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00:01:43,660 --> 00:01:46,520
that there might have been
some information spill over.

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00:01:46,520 --> 00:01:48,461
So I don't think that was it.

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00:01:48,461 --> 00:01:50,710
In fact, I think what it was
the size of the packages,

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00:01:50,710 --> 00:01:52,600
believe it or not.

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00:01:52,600 --> 00:01:56,350
So anybody that tells you that
size doesn't matter I think

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00:01:56,350 --> 00:01:58,259
is not being realistic.

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00:01:58,259 --> 00:01:59,800
Was there another
question back here?

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00:01:59,800 --> 00:02:00,720
AUDIENCE: I had
the same question.

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00:02:00,720 --> 00:02:01,553
ANDREW LO: OK, yeah?

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00:02:01,553 --> 00:02:05,230
AUDIENCE: How much did
the book retail at?

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00:02:05,230 --> 00:02:07,416
ANDREW LO: The book
retails for $45.

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00:02:10,509 --> 00:02:13,890
Now of course, I
autographed the book, so--

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00:02:13,890 --> 00:02:15,103
[LAUGHTER]

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00:02:15,457 --> 00:02:17,290
--so that probably
reduced the resale value.

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00:02:20,410 --> 00:02:23,050
We played-- I took the $60.

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No tears.

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Fair is fair.

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00:02:25,970 --> 00:02:29,650
So this class, the individual
who bid $45 for that iPod

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00:02:29,650 --> 00:02:31,480
did very, very well indeed.

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00:02:31,480 --> 00:02:35,020
And the student who
bid $60 for the book

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00:02:35,020 --> 00:02:36,490
didn't do quite as well.

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00:02:36,490 --> 00:02:38,890
But that's the point
of this example.

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It's that when you don't
know what you're bidding for,

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when there's literally
no information,

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00:02:44,410 --> 00:02:47,050
you're obviously not going
to get it exactly right.

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But you have to admit that in
the grand scheme of things,

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it's actually not that
far off, and not that far

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00:02:53,290 --> 00:02:54,830
off in a very particular way.

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I want to, in particular,
talk about the iPod.

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Because we are
looking at something

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like a 70% discount
off of the retail value

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00:03:02,860 --> 00:03:05,200
of that for this class.

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Now I want to comment on
that in the context of what's

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going on today.

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00:03:08,905 --> 00:03:11,500
I want to spend a few minutes,
before we start the lecture,

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talking about current events.

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Because finance of course
involves current events.

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And right now we are going
through an extraordinarily

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interesting set of times.

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I think that's a Chinese curse--

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may you live in
interesting times.

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Well, we're going through some
really extraordinary times.

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Because what happened
over the weekend

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is something that has
probably not happened

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since the Great Depression.

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What happened over the weekend
is that the federal government

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took over two of the largest
government-sponsored financial

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00:03:41,710 --> 00:03:44,830
entities in the world,
Fannie Mae and Freddie Mac.

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00:03:44,830 --> 00:03:47,087
These are two
government-sponsored entities.

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00:03:47,087 --> 00:03:48,670
They're private
organizations but they

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00:03:48,670 --> 00:03:51,790
have the backing
of the government

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00:03:51,790 --> 00:03:54,040
in some ambiguous sense.

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00:03:54,040 --> 00:03:58,300
And it was ambiguous, up until
this weekend, what that meant.

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00:03:58,300 --> 00:04:01,870
What happened was that these
large financial institutions

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00:04:01,870 --> 00:04:07,000
were responsible for
purchasing the mortgages

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00:04:07,000 --> 00:04:12,460
from various different regional
banks and lending institutions.

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00:04:12,460 --> 00:04:14,731
And why would they do that?

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00:04:14,731 --> 00:04:15,730
What was their function?

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00:04:15,730 --> 00:04:17,110
Anybody know?

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00:04:17,110 --> 00:04:17,780
Yeah?

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00:04:17,780 --> 00:04:21,239
AUDIENCE: To provide a
secondary market for mortgages

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00:04:21,239 --> 00:04:24,025
so that the banks that
are the initial lenders

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00:04:24,025 --> 00:04:28,629
can generate more mortgages
and make credit more available.

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00:04:28,629 --> 00:04:29,420
ANDREW LO: Exactly.

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00:04:29,420 --> 00:04:32,270
Their goal was to really
make credit more available

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00:04:32,270 --> 00:04:34,640
in the housing market, and
the student loan market,

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00:04:34,640 --> 00:04:38,240
and the auto loan market--
these consumer finance markets.

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00:04:38,240 --> 00:04:40,190
The purpose of these
two organizations

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00:04:40,190 --> 00:04:43,370
was to buy up the various
different obligations

107
00:04:43,370 --> 00:04:47,390
from banks and other
financial institutions

108
00:04:47,390 --> 00:04:49,250
so that the banks and
financial institutions

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00:04:49,250 --> 00:04:53,450
could then go out and lend more
money to more individuals that

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00:04:53,450 --> 00:04:55,492
wanted these kinds of loans.

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00:04:55,492 --> 00:04:57,200
So the purpose of
these two organizations

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00:04:57,200 --> 00:05:02,260
was really to support and
grow these various markets.

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00:05:02,260 --> 00:05:05,260
And it turns out that
over the last 20 years,

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00:05:05,260 --> 00:05:09,190
these markets have grown
to epic proportions,

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00:05:09,190 --> 00:05:11,020
tremendous proportions.

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00:05:11,020 --> 00:05:14,880
And now, as the housing
market has turned down,

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00:05:14,880 --> 00:05:20,430
the original lenders that
made these obligations

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00:05:20,430 --> 00:05:22,200
are facing some
severe pressures.

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00:05:22,200 --> 00:05:25,172
And that's carried
the ripple effects

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00:05:25,172 --> 00:05:26,880
all the way through
the financial system,

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00:05:26,880 --> 00:05:30,000
to the point where these
two organizations literally

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00:05:30,000 --> 00:05:32,500
could not stand on their own.

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00:05:32,500 --> 00:05:35,744
And if there had been a default
of these two organizations,

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00:05:35,744 --> 00:05:37,410
there would be some
major repercussions.

125
00:05:37,410 --> 00:05:40,340
We're going to talk about
that in about four lectures.

126
00:05:40,340 --> 00:05:42,840
The material that we're going
to develop over the next three

127
00:05:42,840 --> 00:05:46,902
lectures are going to allow
us to analyze the situation

128
00:05:46,902 --> 00:05:48,360
and really try to
understand what's

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00:05:48,360 --> 00:05:49,461
going on in these markets.

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00:05:49,461 --> 00:05:51,210
But I just wanted to
alert you to the fact

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00:05:51,210 --> 00:05:52,834
that something really
big has happened.

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00:05:52,834 --> 00:05:54,451
You won't understand
fully what it is.

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00:05:54,451 --> 00:05:55,950
You might read the
newspapers, and I

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00:05:55,950 --> 00:05:58,140
would encourage you to do
so, but you won't fully

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00:05:58,140 --> 00:06:01,121
appreciate the importance of
it for another three or four

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00:06:01,121 --> 00:06:01,620
lectures.

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00:06:01,620 --> 00:06:03,036
But you're going
to see this event

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00:06:03,036 --> 00:06:06,030
unfold before your very
eyes this semester.

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00:06:06,030 --> 00:06:07,680
And that will provide
the motivation

140
00:06:07,680 --> 00:06:11,110
for developing the tools to
understand what's going on.

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00:06:11,110 --> 00:06:12,212
Yeah?

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00:06:12,212 --> 00:06:15,747
AUDIENCE: Can I ask you
now, or can we ask you now,

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00:06:15,747 --> 00:06:19,170
do you think that
was the only option,

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00:06:19,170 --> 00:06:21,620
or do you think
that was the right--

145
00:06:21,620 --> 00:06:23,900
ANDREW LO: Well, that's
a very tough question.

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00:06:23,900 --> 00:06:27,110
In terms of the possibilities
for the Secretary

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00:06:27,110 --> 00:06:30,830
of the Treasury Paulson
and the government,

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00:06:30,830 --> 00:06:33,680
there aren't too many
left in the sense

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00:06:33,680 --> 00:06:39,290
that these two organizations
are in a real bind in that they

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00:06:39,290 --> 00:06:43,550
have issued lots of securities
based upon their activities.

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00:06:43,550 --> 00:06:47,090
And in order to maintain the
quality of those securities,

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00:06:47,090 --> 00:06:50,810
in order to make good on those
promises that it has made

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00:06:50,810 --> 00:06:52,640
to other counter-parties--

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00:06:52,640 --> 00:06:55,160
very important
counter-parties I might add,

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00:06:55,160 --> 00:06:58,070
including the governments
of India, China,

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00:06:58,070 --> 00:07:02,570
and a number of sovereign wealth
funds that we depend on to loan

157
00:07:02,570 --> 00:07:06,170
us the money that has kept us
in the style to which we have

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00:07:06,170 --> 00:07:08,720
become accustomed
in this country--

159
00:07:08,720 --> 00:07:11,720
in order for us to maintain
those kinds of relationships,

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00:07:11,720 --> 00:07:14,040
we have to make good
on our promises.

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00:07:14,040 --> 00:07:16,430
And it's getting harder
and harder for these two

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00:07:16,430 --> 00:07:17,600
organizations to do so.

163
00:07:17,600 --> 00:07:20,000
Because while they've
got all of these promises

164
00:07:20,000 --> 00:07:21,800
that they've made,
the money that's

165
00:07:21,800 --> 00:07:24,860
supposed to be coming in order
to allow them to make good

166
00:07:24,860 --> 00:07:28,070
on these promises is dwindling.

167
00:07:28,070 --> 00:07:31,292
And as they've tried to raise
more money in the open market,

168
00:07:31,292 --> 00:07:33,500
it's become harder and
harder, because people realize

169
00:07:33,500 --> 00:07:36,350
that they're in trouble, and
it's very difficult for them

170
00:07:36,350 --> 00:07:38,560
to raise that money.

171
00:07:38,560 --> 00:07:43,420
In fact, this is related exactly
to the point about the iPod

172
00:07:43,420 --> 00:07:46,180
auction that we
engaged in last time.

173
00:07:46,180 --> 00:07:52,060
Think about how little I
received for that $150 item.

174
00:07:52,060 --> 00:07:55,840
I received basically
$0.30 on the dollar.

175
00:07:55,840 --> 00:07:56,470
And why?

176
00:07:56,470 --> 00:07:59,690
It's because none of you knew
what was in that package.

177
00:07:59,690 --> 00:08:02,650
So now instead of an iPod
that's in a wrapped package,

178
00:08:02,650 --> 00:08:05,890
imagine if that wrapped
package contained paper issued

179
00:08:05,890 --> 00:08:07,870
by Fannie Mae or Freddie Mac.

180
00:08:07,870 --> 00:08:10,720
And now I'm going to ask you,
can you bid on this paper?

181
00:08:10,720 --> 00:08:13,262
Now I don't know whether Freddie
Mac or Fannie Mae will still

182
00:08:13,262 --> 00:08:15,803
be around in two years, but I'd
like you to bid on this paper

183
00:08:15,803 --> 00:08:16,330
anyway.

184
00:08:16,330 --> 00:08:18,730
And by the way, what you
get for this piece of paper,

185
00:08:18,730 --> 00:08:20,770
I don't really know,
so it's wrapped up.

186
00:08:20,770 --> 00:08:21,880
And you don't know either.

187
00:08:21,880 --> 00:08:22,630
You don't know.

188
00:08:22,630 --> 00:08:23,634
I don't know.

189
00:08:23,634 --> 00:08:24,550
You know I don't know.

190
00:08:24,550 --> 00:08:27,540
And I know you know
I know I don't know.

191
00:08:27,540 --> 00:08:29,890
So what's that piece of
paper going to go for?

192
00:08:29,890 --> 00:08:33,940
Well probably less than
$0.30 on the dollar, right?

193
00:08:33,940 --> 00:08:36,970
So what we saw happen in
this classroom last time

194
00:08:36,970 --> 00:08:39,400
is exactly what's happened
in spades to these two

195
00:08:39,400 --> 00:08:40,900
large organizations.

196
00:08:40,900 --> 00:08:43,690
At some point, there has
to be a day of reckoning.

197
00:08:43,690 --> 00:08:45,292
And the Treasury
decided rather than

198
00:08:45,292 --> 00:08:46,750
waiting for that
day of reckoning--

199
00:08:46,750 --> 00:08:49,720
because if that day of
reckoning came before they were

200
00:08:49,720 --> 00:08:52,630
able to do something, it's very
hard to put the pieces back

201
00:08:52,630 --> 00:08:53,960
together.

202
00:08:53,960 --> 00:08:57,580
So in my opinion, I think
they had very little choice

203
00:08:57,580 --> 00:09:01,512
but to do something right now,
before it got out of hand.

204
00:09:01,512 --> 00:09:03,220
And we're going to
talk about this again.

205
00:09:03,220 --> 00:09:06,460
In fact, we're going to run a
trading game where all of you

206
00:09:06,460 --> 00:09:09,820
are going to get a chance to
engage in this kind of trading.

207
00:09:09,820 --> 00:09:13,450
It's not exactly the kind
that involves credit.

208
00:09:13,450 --> 00:09:15,970
But it'll be a
trading game, where

209
00:09:15,970 --> 00:09:18,610
you'll get to see what it's
like to be under pressure

210
00:09:18,610 --> 00:09:20,350
and to have to make
decisions and value

211
00:09:20,350 --> 00:09:22,450
securities in real time.

212
00:09:22,450 --> 00:09:24,580
And you'll have a much
deeper appreciation

213
00:09:24,580 --> 00:09:27,367
for the kind of issues
that we're up against.

214
00:09:27,367 --> 00:09:28,321
Yeah?

215
00:09:28,321 --> 00:09:30,706
AUDIENCE: Sorry, what did
the government exactly do

216
00:09:30,706 --> 00:09:34,275
to agree to pay for all their--

217
00:09:34,275 --> 00:09:35,650
ANDREW LO: Yes,
so the government

218
00:09:35,650 --> 00:09:38,860
said, OK, you guys, Fannie
Mae and Freddie Mac,

219
00:09:38,860 --> 00:09:41,470
you can't make good
on your obligations

220
00:09:41,470 --> 00:09:42,850
because you've
got some problems.

221
00:09:42,850 --> 00:09:48,910
So we, the Treasury, will
stand by all of your claims.

222
00:09:48,910 --> 00:09:50,954
AUDIENCE: And the
government paid that?

223
00:09:50,954 --> 00:09:51,870
ANDREW LO: Absolutely.

224
00:09:51,870 --> 00:09:52,990
You know how?

225
00:09:52,990 --> 00:09:55,670
How can the government pay that?

226
00:09:55,670 --> 00:09:56,170
What?

227
00:09:56,170 --> 00:09:58,022
AUDIENCE: How, issuing money?

228
00:09:58,022 --> 00:09:59,299
AUDIENCE: [INAUDIBLE]

229
00:09:59,299 --> 00:10:00,090
ANDREW LO: Exactly.

230
00:10:00,090 --> 00:10:03,210
The government-- they
own the printing presses.

231
00:10:03,210 --> 00:10:05,400
So they just-- you want
to get paid dollars?

232
00:10:05,400 --> 00:10:06,360
I'll pay you dollars.

233
00:10:06,360 --> 00:10:07,710
Here, how many dollars
would you like?

234
00:10:07,710 --> 00:10:08,550
I'm going to run it.

235
00:10:08,550 --> 00:10:09,689
Here you go!

236
00:10:09,689 --> 00:10:11,980
AUDIENCE: So we're probably
getting hit with inflation?

237
00:10:11,980 --> 00:10:13,470
ANDREW LO: That's the concern.

238
00:10:13,470 --> 00:10:16,870
So the concern is that
if you do this too much

239
00:10:16,870 --> 00:10:21,760
and you do it without anything
backing up the pieces of paper

240
00:10:21,760 --> 00:10:26,155
you now print and
give to your debtors,

241
00:10:26,155 --> 00:10:27,280
then there'll be a problem.

242
00:10:27,280 --> 00:10:28,780
Because pretty
soon they're going

243
00:10:28,780 --> 00:10:30,490
to realize that
the piece of paper

244
00:10:30,490 --> 00:10:32,830
isn't really worth as much
as they thought it was.

245
00:10:32,830 --> 00:10:34,700
So inflation could be a problem.

246
00:10:34,700 --> 00:10:35,950
It could be a problem.

247
00:10:35,950 --> 00:10:36,970
We'll have to see.

248
00:10:36,970 --> 00:10:41,080
But right now the paper, the
dollars that are being printed,

249
00:10:41,080 --> 00:10:44,560
are backed by the full faith
and credit of the US Government.

250
00:10:44,560 --> 00:10:47,196
And for the time being,
that still means something.

251
00:10:47,196 --> 00:10:49,661
Yeah?

252
00:10:49,661 --> 00:10:52,126
AUDIENCE: Are all
the levels of debt

253
00:10:52,126 --> 00:10:56,070
being guaranteed with interest?

254
00:10:56,070 --> 00:11:00,510
How much of the Fannie
and Freddie is debt?

255
00:11:00,510 --> 00:11:02,117
ANDREW LO: So the
question is, is

256
00:11:02,117 --> 00:11:04,200
all of the debt being
guaranteed or is it just how

257
00:11:04,200 --> 00:11:06,060
much Freddie and Fannie issued?

258
00:11:06,060 --> 00:11:07,860
Well certainly it's
what they've issued.

259
00:11:07,860 --> 00:11:09,810
So all of the paper
that they've issued

260
00:11:09,810 --> 00:11:11,460
will be backed by
the government.

261
00:11:11,460 --> 00:11:14,430
In addition, there
is some new paper

262
00:11:14,430 --> 00:11:16,650
that they have to issue
in order to finance

263
00:11:16,650 --> 00:11:17,820
additional mortgages.

264
00:11:17,820 --> 00:11:20,540
And the government
will back that too.

265
00:11:20,540 --> 00:11:22,470
Now this is not for free.

266
00:11:22,470 --> 00:11:23,940
It's not just printing presses.

267
00:11:23,940 --> 00:11:25,200
That sounds a little too easy.

268
00:11:25,200 --> 00:11:26,500
Somebody has to pay for it.

269
00:11:26,500 --> 00:11:28,260
The money's got to
come from somewhere.

270
00:11:28,260 --> 00:11:29,550
Or I'll put it another way.

271
00:11:29,550 --> 00:11:33,450
That money that is spent now
backing these instruments

272
00:11:33,450 --> 00:11:35,680
cannot be used for other things.

273
00:11:35,680 --> 00:11:38,250
So if you believe in
balancing your budget as

274
00:11:38,250 --> 00:11:41,640
opposed to spending on credit,
which frankly is what got us

275
00:11:41,640 --> 00:11:44,070
into the problems to
begin with, then there

276
00:11:44,070 --> 00:11:45,810
will be additional reckoning.

277
00:11:45,810 --> 00:11:49,350
People have said that
the American taxpayer

278
00:11:49,350 --> 00:11:50,310
will pay for this.

279
00:11:50,310 --> 00:11:51,360
Well, that's true.

280
00:11:51,360 --> 00:11:54,540
But the question is
which set of taxpayers?

281
00:11:54,540 --> 00:11:55,860
Is it us?

282
00:11:55,860 --> 00:11:57,270
Is that your children?

283
00:11:57,270 --> 00:11:58,800
Is it your children's children?

284
00:11:58,800 --> 00:12:01,350
There are a lot of
intergenerational questions

285
00:12:01,350 --> 00:12:02,770
about where the burden lies.

286
00:12:02,770 --> 00:12:05,430
But the fact of the matter
is yes, we are on the hook,

287
00:12:05,430 --> 00:12:08,520
that the American taxpayers
are on the hook for tens

288
00:12:08,520 --> 00:12:09,630
of billions of dollars.

289
00:12:09,630 --> 00:12:12,900
Now in the grand scheme of
things, tens of billions

290
00:12:12,900 --> 00:12:15,210
of dollars is nothing.

291
00:12:15,210 --> 00:12:17,910
The federal budget is much,
much larger than that,

292
00:12:17,910 --> 00:12:19,930
so this is not a big deal.

293
00:12:19,930 --> 00:12:22,860
The concern is if this
spreads and ends up

294
00:12:22,860 --> 00:12:24,977
costing us more because
of ripple effects

295
00:12:24,977 --> 00:12:27,060
and knock on effects that
we don't yet know about,

296
00:12:27,060 --> 00:12:28,197
that could be a problem.

297
00:12:28,197 --> 00:12:30,030
And that, frankly, is
one of the reasons why

298
00:12:30,030 --> 00:12:33,390
the Fed and the Treasury have
decided to step in now to try

299
00:12:33,390 --> 00:12:34,990
to contain this problem.

300
00:12:34,990 --> 00:12:37,770
How good they will be at
doing that we don't know.

301
00:12:37,770 --> 00:12:40,882
Read the newspapers over the
next few weeks and let's see.

302
00:12:40,882 --> 00:12:41,382
Yep?

303
00:12:41,382 --> 00:12:43,555
AUDIENCE: Do you think
the common stock basically

304
00:12:43,555 --> 00:12:45,180
has to be worth zero
at this point now?

305
00:12:45,180 --> 00:12:46,890
ANDREW LO: Well, it's
not worth exactly zero,

306
00:12:46,890 --> 00:12:48,014
but it's pretty darn close.

307
00:12:48,014 --> 00:12:49,740
And in fact, it's
come down quite a lot,

308
00:12:49,740 --> 00:12:51,630
I think, over the
last couple of years.

309
00:12:51,630 --> 00:12:53,010
I don't know what the
peak of the price was.

310
00:12:53,010 --> 00:12:53,968
I haven't looked at it.

311
00:12:53,968 --> 00:12:56,160
But I think that
the decline has been

312
00:12:56,160 --> 00:13:00,150
on the order of 90%
to 95% decline of what

313
00:13:00,150 --> 00:13:02,609
the peak was over the last
couple of years, which is--

314
00:13:02,609 --> 00:13:04,150
AUDIENCE: This
morning it's down 83%.

315
00:13:04,150 --> 00:13:05,550
ANDREW LO: Yeah, 83% since when?

316
00:13:05,550 --> 00:13:06,150
AUDIENCE: Since yesterday.

317
00:13:06,150 --> 00:13:07,858
ANDREW LO: Yeah, that
was just a day ago.

318
00:13:07,858 --> 00:13:09,720
But I'm talking
about since the peak.

319
00:13:09,720 --> 00:13:11,680
I think it's come
down dramatically.

320
00:13:11,680 --> 00:13:15,480
So effectively, the value
of the shareholders' equity

321
00:13:15,480 --> 00:13:16,590
is pretty close to zero.

322
00:13:16,590 --> 00:13:18,386
But that's what happens
in a bankruptcy.

323
00:13:18,386 --> 00:13:20,760
And by the way, we're going
to talk about bankruptcy too.

324
00:13:20,760 --> 00:13:23,370
That's going to be a very
important part of what

325
00:13:23,370 --> 00:13:25,636
we do when we analyze
fixed income instruments.

326
00:13:25,636 --> 00:13:27,219
So we're going to
get to that shortly.

327
00:13:27,219 --> 00:13:27,966
Yeah?

328
00:13:27,966 --> 00:13:29,460
AUDIENCE: Has
there been anything

329
00:13:29,460 --> 00:13:33,444
about potentially going
private again down the road?

330
00:13:33,444 --> 00:13:34,087
Is that--

331
00:13:34,087 --> 00:13:35,670
ANDREW LO: There
have been discussions

332
00:13:35,670 --> 00:13:39,870
about them going private, but
private in a much smaller way.

333
00:13:39,870 --> 00:13:41,610
So the discussions
that have occurred

334
00:13:41,610 --> 00:13:43,200
at the Treasury--
and we don't know

335
00:13:43,200 --> 00:13:44,730
which way things
are going to end up

336
00:13:44,730 --> 00:13:47,760
because it's a political process
as well as an economic one.

337
00:13:47,760 --> 00:13:51,310
But there's a feeling that these
two institutions got too big,

338
00:13:51,310 --> 00:13:53,100
too quickly and
that there wasn't

339
00:13:53,100 --> 00:13:57,420
enough oversight to allow
them to be able to fail.

340
00:13:57,420 --> 00:13:58,920
In other words,
they grew so big,

341
00:13:58,920 --> 00:14:01,050
so quickly that
after a point they

342
00:14:01,050 --> 00:14:03,620
were in fact too big to fail.

343
00:14:03,620 --> 00:14:05,370
And when you're too
big to fail, all sorts

344
00:14:05,370 --> 00:14:09,120
of abuses and improper
risk management practices

345
00:14:09,120 --> 00:14:11,730
can go on, which we will
talk about in probably eight

346
00:14:11,730 --> 00:14:14,220
or nine lectures.

347
00:14:14,220 --> 00:14:16,440
So there's a
variety of proposals

348
00:14:16,440 --> 00:14:17,730
that have been put forward.

349
00:14:17,730 --> 00:14:20,880
And we'll talk about those
also over the next six or seven

350
00:14:20,880 --> 00:14:21,688
weeks.

351
00:14:21,688 --> 00:14:23,600
AUDIENCE: Who did the
government actually

352
00:14:23,600 --> 00:14:25,034
bought the shares from?

353
00:14:25,034 --> 00:14:26,946
Are they federal agencies?

354
00:14:26,946 --> 00:14:28,858
Are these private companies?

355
00:14:28,858 --> 00:14:30,284
Who--

356
00:14:30,284 --> 00:14:31,950
ANDREW LO: So Fannie
Mae and Freddie Mac

357
00:14:31,950 --> 00:14:35,970
are called GSEs,
Government-Sponsored Entities,

358
00:14:35,970 --> 00:14:38,650
which means that they're
not a federal agency.

359
00:14:38,650 --> 00:14:42,300
But they are backed by
the federal government

360
00:14:42,300 --> 00:14:46,680
in some manner that has been,
up until now, relatively vague.

361
00:14:46,680 --> 00:14:48,690
So they're meant to
be private companies.

362
00:14:48,690 --> 00:14:50,220
They had a CEO.

363
00:14:50,220 --> 00:14:53,670
Both of them had CEOs, who
were fired over the weekend.

364
00:14:53,670 --> 00:14:55,800
They had separate
boards of directors.

365
00:14:55,800 --> 00:15:00,630
And they pay pretty attractive
salaries, private sector

366
00:15:00,630 --> 00:15:01,800
salaries.

367
00:15:01,800 --> 00:15:04,200
But they were related to the
government in the sense that

368
00:15:04,200 --> 00:15:08,250
their objectives were to try to
support and expand the housing

369
00:15:08,250 --> 00:15:12,990
market financing, which was
a government-dictated mandate

370
00:15:12,990 --> 00:15:13,853
to this--

371
00:15:13,853 --> 00:15:17,164
AUDIENCE: Their main goal
is not to earn money?

372
00:15:17,164 --> 00:15:20,480
It's to bring a secondary
market for mortgages?

373
00:15:20,480 --> 00:15:25,010
ANDREW LO: Their main goal was
to create additional financing

374
00:15:25,010 --> 00:15:28,160
to allow the mortgage market to
grow and to allow people to buy

375
00:15:28,160 --> 00:15:30,790
homes at reasonable rates.

376
00:15:30,790 --> 00:15:35,430
Their secondary goal was to
make a profit on top of that.

377
00:15:35,430 --> 00:15:38,090
So that's why they're not
just a government entity,

378
00:15:38,090 --> 00:15:44,150
but they have a kind of a quasi
private sector type of mandate.

379
00:15:44,150 --> 00:15:46,105
And by the way, they
did a great job.

380
00:15:46,105 --> 00:15:47,480
They did a great
job in the sense

381
00:15:47,480 --> 00:15:49,860
that the housing market
has grown tremendously.

382
00:15:49,860 --> 00:15:51,872
Now you could argue that
that was irresponsible

383
00:15:51,872 --> 00:15:53,330
and that created
all these problems

384
00:15:53,330 --> 00:15:55,530
that we're facing today.

385
00:15:55,530 --> 00:15:59,460
But you talk to somebody who
has a subprime mortgage that

386
00:15:59,460 --> 00:16:02,160
otherwise couldn't have afforded
a house that now has made

387
00:16:02,160 --> 00:16:04,950
every single payment, and really
enjoys living in their home,

388
00:16:04,950 --> 00:16:07,500
and has a lifestyle that they
couldn't have otherwise had.

389
00:16:07,500 --> 00:16:10,750
You talk to them and you tell
them that it was a mistake.

390
00:16:10,750 --> 00:16:15,570
So it's not at all clear that
this is a total disaster.

391
00:16:15,570 --> 00:16:16,560
It's unfortunate.

392
00:16:16,560 --> 00:16:18,240
And it's a catastrophe
from the point

393
00:16:18,240 --> 00:16:21,810
of view of the current holders
of various pieces of paper

394
00:16:21,810 --> 00:16:24,196
that are related to
these subprime mortgages.

395
00:16:24,196 --> 00:16:26,070
But there's a whole
group of people out there

396
00:16:26,070 --> 00:16:28,290
that have benefited from
these subprime mortgages.

397
00:16:28,290 --> 00:16:32,190
And so you've got to balance
the costs and the benefits.

398
00:16:32,190 --> 00:16:33,750
And we're not doing
that right now.

399
00:16:33,750 --> 00:16:35,583
Right now we're just
panicking because we're

400
00:16:35,583 --> 00:16:37,920
all scared like hell
that something really

401
00:16:37,920 --> 00:16:39,030
is going to break.

402
00:16:39,030 --> 00:16:41,760
But there's a positive side
as well as a negative side

403
00:16:41,760 --> 00:16:42,385
to every story.

404
00:16:42,385 --> 00:16:44,926
And so we're going to have to
talk about that in a little bit

405
00:16:44,926 --> 00:16:45,480
more detail.

406
00:16:45,480 --> 00:16:47,521
But we can't do that unless
we have the framework

407
00:16:47,521 --> 00:16:48,912
to think about it.

408
00:16:48,912 --> 00:16:50,870
So that is going to lead
me to today's lecture.

409
00:16:50,870 --> 00:16:51,832
Yeah?

410
00:16:51,832 --> 00:16:54,237
AUDIENCE: Just to follow
up on another question,

411
00:16:54,237 --> 00:16:58,085
who were the shareholders in
Freddie and Fannie Mae system,

412
00:16:58,085 --> 00:17:01,889
and did the investment
go to zero overnight?

413
00:17:01,889 --> 00:17:03,930
ANDREW LO: So there are
two groups of individuals

414
00:17:03,930 --> 00:17:04,680
that are involved.

415
00:17:04,680 --> 00:17:07,710
One are the shareholders of
the companies themselves.

416
00:17:07,710 --> 00:17:08,950
And these are investors.

417
00:17:08,950 --> 00:17:11,450
A number of them are pension
funds, institutional investors.

418
00:17:11,450 --> 00:17:14,400
So therefore, you and
I, in our 401(k) plans--

419
00:17:14,400 --> 00:17:16,050
we might actually
have an investment

420
00:17:16,050 --> 00:17:18,599
in one of these organizations
through the plan sponsor

421
00:17:18,599 --> 00:17:21,040
that invests in various
different entities.

422
00:17:21,040 --> 00:17:24,420
So they're a stock that was
traded on the exchanges,

423
00:17:24,420 --> 00:17:26,900
just like any other stock.

424
00:17:26,900 --> 00:17:27,740
That's one group.

425
00:17:27,740 --> 00:17:31,076
And those are going to
lose most of their capital.

426
00:17:31,076 --> 00:17:32,700
They're going to lose
their investment,

427
00:17:32,700 --> 00:17:34,580
just like when a
stock goes belly up,

428
00:17:34,580 --> 00:17:36,165
the investors of Enron, too bad.

429
00:17:36,165 --> 00:17:37,040
They lose everything.

430
00:17:37,040 --> 00:17:37,820
They're gone.

431
00:17:37,820 --> 00:17:38,420
They knew it.

432
00:17:38,420 --> 00:17:41,210
They took the risks and the
risks don't always work out,

433
00:17:41,210 --> 00:17:43,100
so that's that.

434
00:17:43,100 --> 00:17:45,680
The other parties
that are involved

435
00:17:45,680 --> 00:17:50,180
are the folks that do
business with these agencies,

436
00:17:50,180 --> 00:17:53,690
the counter-parties that bought
the paper that they issued,

437
00:17:53,690 --> 00:17:57,290
these IOUs and other complex
instruments that Freddie Mae

438
00:17:57,290 --> 00:17:59,890
and Freddie Mac issued.

439
00:17:59,890 --> 00:18:03,550
Those individuals,
we're hoping, will

440
00:18:03,550 --> 00:18:08,590
be relatively happy about
the outcome of the government

441
00:18:08,590 --> 00:18:09,460
backing the paper.

442
00:18:09,460 --> 00:18:12,670
Because now the paper that
they once held and thought

443
00:18:12,670 --> 00:18:16,270
was in trouble will have the
full faith and credit of the US

444
00:18:16,270 --> 00:18:17,870
government behind them.

445
00:18:17,870 --> 00:18:20,140
And that is a major concern.

446
00:18:20,140 --> 00:18:23,530
Because these counter-parties
are very, very substantial

447
00:18:23,530 --> 00:18:24,160
investors.

448
00:18:24,160 --> 00:18:27,580
If they decide that
this paper is no good

449
00:18:27,580 --> 00:18:30,040
and they start getting
rid of it wholesale,

450
00:18:30,040 --> 00:18:33,130
that will create some really
significant market dislocation

451
00:18:33,130 --> 00:18:34,540
and mass panic.

452
00:18:34,540 --> 00:18:36,190
And that's what the
Treasury stepped in

453
00:18:36,190 --> 00:18:39,380
to stave off this weekend.

454
00:18:39,380 --> 00:18:42,020
And hopefully they
will have succeeded.

455
00:18:42,020 --> 00:18:44,820
In fact, if you
look at the data,

456
00:18:44,820 --> 00:18:46,340
it looks like they did succeed.

457
00:18:46,340 --> 00:18:49,010
But I'm not going to talk about
that for another three or four

458
00:18:49,010 --> 00:18:51,800
lectures, because I want to
show you exactly how to think

459
00:18:51,800 --> 00:18:52,984
about these instruments.

460
00:18:52,984 --> 00:18:54,650
And then we're going
to look at the data

461
00:18:54,650 --> 00:18:56,556
and see whether or
not they've actually

462
00:18:56,556 --> 00:18:57,680
done something significant.

463
00:18:57,680 --> 00:18:58,850
And you'll be able to tell.

464
00:18:58,850 --> 00:19:00,740
By looking at market
prices, by looking

465
00:19:00,740 --> 00:19:04,112
at the outcome of auctions
like we did last time,

466
00:19:04,112 --> 00:19:06,320
we're going to be able to
tell exactly what happened.

467
00:19:10,320 --> 00:19:13,110
All right, well, that took a
little longer than I thought,

468
00:19:13,110 --> 00:19:15,510
but I think it is useful
for motivation for what

469
00:19:15,510 --> 00:19:19,060
we're going to do in the class.

470
00:19:19,060 --> 00:19:20,970
What I want to do
today is to start

471
00:19:20,970 --> 00:19:24,810
on lectures two and three,
present value relations.

472
00:19:24,810 --> 00:19:26,490
And I have to tell
you, this is one

473
00:19:26,490 --> 00:19:29,940
of the most interesting
lectures of the entire course,

474
00:19:29,940 --> 00:19:33,790
not because of the
underlying material,

475
00:19:33,790 --> 00:19:36,930
but rather because of the
novelty of the perspective

476
00:19:36,930 --> 00:19:42,010
that I want to give you
about these kinds of issues.

477
00:19:42,010 --> 00:19:45,300
This is the very first step
in changing the way you

478
00:19:45,300 --> 00:19:47,850
look at financial transactions.

479
00:19:47,850 --> 00:19:49,860
We're going to
start by discussing

480
00:19:49,860 --> 00:19:51,970
cashflows and assets.

481
00:19:51,970 --> 00:19:53,630
I'm going to define some terms.

482
00:19:53,630 --> 00:19:56,520
And I want to change the
way you think of an asset.

483
00:19:56,520 --> 00:19:58,770
And then we're going to
talk about the present value

484
00:19:58,770 --> 00:20:01,070
operator.

485
00:20:01,070 --> 00:20:03,320
And then we're
going to apply that

486
00:20:03,320 --> 00:20:06,830
to the time value of money.

487
00:20:06,830 --> 00:20:08,900
I want to make that
concrete so that all of you

488
00:20:08,900 --> 00:20:11,510
will start thinking
differently now about money

489
00:20:11,510 --> 00:20:13,910
today versus money next year.

490
00:20:13,910 --> 00:20:17,210
And then-- probably not
today, but next time-- we're

491
00:20:17,210 --> 00:20:22,190
going to cover two very
special kinds of cashflows,

492
00:20:22,190 --> 00:20:24,080
the annuity and the perpetuity.

493
00:20:24,080 --> 00:20:26,330
These are two
mathematical abstractions

494
00:20:26,330 --> 00:20:28,820
that provide some really
interesting insights

495
00:20:28,820 --> 00:20:31,252
into this whole notion
of present value.

496
00:20:31,252 --> 00:20:32,960
And then I'm going to
talk about a couple

497
00:20:32,960 --> 00:20:35,510
of technical issues,
compounding and inflation.

498
00:20:35,510 --> 00:20:39,230
And that will lead us right
to thinking about fixed income

499
00:20:39,230 --> 00:20:41,240
securities, and
how to value them,

500
00:20:41,240 --> 00:20:43,670
and how the market values
them, and whether or not

501
00:20:43,670 --> 00:20:46,910
the two are the
same or different.

502
00:20:46,910 --> 00:20:49,700
For the readings, I'd like you
to start on Brealey and Myers,

503
00:20:49,700 --> 00:20:51,260
Allen, chapters two and three.

504
00:20:51,260 --> 00:20:53,870
You should have already read
chapter two from last time.

505
00:20:53,870 --> 00:20:56,377
I'd like you to reread that
and also focus on chapter 3

506
00:20:56,377 --> 00:20:57,710
for the next couple of lectures.

507
00:21:01,340 --> 00:21:07,250
So first order of business,
let's define some terms.

508
00:21:07,250 --> 00:21:09,620
I think you all know what
a cashflow is, right?

509
00:21:09,620 --> 00:21:11,900
It's just money
that's coming to you

510
00:21:11,900 --> 00:21:16,310
or going away from
you, a flow of cash.

511
00:21:16,310 --> 00:21:20,020
And you all know what
cash is, I presume.

512
00:21:20,020 --> 00:21:23,920
The next question I want to
take on is, what is an asset?

513
00:21:23,920 --> 00:21:25,720
We talk about valuing assets.

514
00:21:25,720 --> 00:21:28,420
But we have to start
first by agreeing

515
00:21:28,420 --> 00:21:30,580
on a definition for
what an asset is.

516
00:21:30,580 --> 00:21:34,090
And I've just put some examples
up here of what assets are.

517
00:21:34,090 --> 00:21:35,990
Business entity is an asset.

518
00:21:35,990 --> 00:21:37,890
If you guys decide
to do a startup,

519
00:21:37,890 --> 00:21:40,210
that startup has value.

520
00:21:40,210 --> 00:21:42,400
It's an asset.

521
00:21:42,400 --> 00:21:49,530
Property, plant and equipment,
patents, R&D, stocks, bonds,

522
00:21:49,530 --> 00:21:54,870
options, and even something as
difficult to value as knowledge

523
00:21:54,870 --> 00:21:59,750
and reputation are assets.

524
00:21:59,750 --> 00:22:06,860
Does anybody know of an example
of a really valuable asset that

525
00:22:06,860 --> 00:22:09,020
is not physical at all?

526
00:22:09,020 --> 00:22:10,390
You can't touch it or feel it.

527
00:22:10,390 --> 00:22:11,001
Yeah?

528
00:22:11,001 --> 00:22:13,432
AUDIENCE: The algorithms
that Google is using?

529
00:22:13,432 --> 00:22:15,390
ANDREW LO: The algorithms
that Google is using.

530
00:22:15,390 --> 00:22:15,931
That's right.

531
00:22:15,931 --> 00:22:17,980
Now how do you know
that those are assets?

532
00:22:17,980 --> 00:22:20,304
AUDIENCE: Because
they generate revenue.

533
00:22:20,304 --> 00:22:21,970
ANDREW LO: They
generate revenue, right.

534
00:22:21,970 --> 00:22:26,170
And has anybody turned them
into anything concrete,

535
00:22:26,170 --> 00:22:31,610
like any type of legal
structure to make them assets?

536
00:22:31,610 --> 00:22:32,360
AUDIENCE: Patents.

537
00:22:32,360 --> 00:22:33,840
ANDREW LO: A patent, exactly.

538
00:22:33,840 --> 00:22:36,450
A patent-- and Google
has many patents--

539
00:22:36,450 --> 00:22:37,470
those have value.

540
00:22:37,470 --> 00:22:39,300
Not only are they
considered assets,

541
00:22:39,300 --> 00:22:41,010
but you can actually trade them.

542
00:22:41,010 --> 00:22:45,290
You can buy a patent, sell
a patent, license a patent.

543
00:22:45,290 --> 00:22:46,017
Yeah?

544
00:22:46,017 --> 00:22:48,225
AUDIENCE: Are they patents
or are they trade secrets?

545
00:22:48,225 --> 00:22:49,500
ANDREW LO: Well, they're both.

546
00:22:49,500 --> 00:22:50,877
So Google has patents.

547
00:22:50,877 --> 00:22:52,710
But there are also a
number of trade secrets

548
00:22:52,710 --> 00:22:55,470
that it uses to protect
its intellectual property.

549
00:22:55,470 --> 00:22:57,270
What's the distinction?

550
00:22:57,270 --> 00:22:59,250
AUDIENCE: I think
a trade secret is

551
00:22:59,250 --> 00:23:01,725
if you have a patent, but
not an implicit patent.

552
00:23:01,725 --> 00:23:03,720
AUDIENCE: No, it doesn't
have any patents.

553
00:23:03,720 --> 00:23:04,944
ANDREW LO: No, no.

554
00:23:04,944 --> 00:23:06,720
AUDIENCE: What does that mean?

555
00:23:06,720 --> 00:23:08,125
What What is a trade secret?

556
00:23:08,125 --> 00:23:09,460
AUDIENCE: It's a secret.

557
00:23:09,460 --> 00:23:11,040
ANDREW LO: It's a secret.

558
00:23:11,040 --> 00:23:11,670
Thank you.

559
00:23:11,670 --> 00:23:13,378
AUDIENCE: A patent
without legal backing.

560
00:23:13,378 --> 00:23:15,240
ANDREW LO: Well,
I'm not sure it's

561
00:23:15,240 --> 00:23:17,340
a patent without any
kind of legal standing.

562
00:23:17,340 --> 00:23:19,964
In fact, it's sort of an
anti-patent, isn't it?

563
00:23:19,964 --> 00:23:21,130
AUDIENCE: It's not a patent.

564
00:23:21,130 --> 00:23:22,615
It's a secret, specifically.

565
00:23:22,615 --> 00:23:24,490
Like Coke, for example--
the formula for Coke

566
00:23:24,490 --> 00:23:26,830
is a trade secret
that is not patented.

567
00:23:26,830 --> 00:23:30,140
When you apply for a patent
you have to disclose fully

568
00:23:30,140 --> 00:23:31,220
what your patent covers.

569
00:23:31,220 --> 00:23:37,210
And that means that at the at
the end of the life coverage,

570
00:23:37,210 --> 00:23:37,710
you're out.

571
00:23:37,710 --> 00:23:40,200
And so I could go and--

572
00:23:40,200 --> 00:23:44,200
if Coke would have applied for
a patent however many years ago,

573
00:23:44,200 --> 00:23:45,650
it would have expired.

574
00:23:45,650 --> 00:23:47,226
I could be making
Coke right now.

575
00:23:47,226 --> 00:23:49,100
But a trade secret is
secret forever, as long

576
00:23:49,100 --> 00:23:53,060
as you take steps
to keep it secret.

577
00:23:53,060 --> 00:23:53,854
ANDREW LO: Right.

578
00:23:53,854 --> 00:23:55,470
AUDIENCE: So they are taking
the risk of the secret.

579
00:23:55,470 --> 00:23:56,261
ANDREW LO: Exactly.

580
00:23:56,261 --> 00:23:59,550
Coke is taking a big
risk in that it has not

581
00:23:59,550 --> 00:24:00,930
filed for a patent.

582
00:24:00,930 --> 00:24:03,900
And frankly, if it did, it
would have expired long ago.

583
00:24:03,900 --> 00:24:05,962
Now what exactly is a patent?

584
00:24:05,962 --> 00:24:07,420
What's the motivation
for a patent?

585
00:24:07,420 --> 00:24:10,470
A patent is a legal
agreement that

586
00:24:10,470 --> 00:24:13,200
says that if you
tell me everything

587
00:24:13,200 --> 00:24:16,500
there is to know about
how to construct the item

588
00:24:16,500 --> 00:24:18,570
or algorithm that you
want to patent, if you're

589
00:24:18,570 --> 00:24:22,730
willing to disclose that
to me and the whole world,

590
00:24:22,730 --> 00:24:27,050
and I acknowledge that
it is new and useful,

591
00:24:27,050 --> 00:24:29,900
then I will grant
you the ability

592
00:24:29,900 --> 00:24:35,090
to be the sole user of
that algorithm, product,

593
00:24:35,090 --> 00:24:39,230
or business process for
a finite period of time--

594
00:24:39,230 --> 00:24:41,400
say, 17 years.

595
00:24:41,400 --> 00:24:45,470
So for 17 years, if anybody
wants to use that algorithm,

596
00:24:45,470 --> 00:24:48,920
they have to pay you
for that privilege.

597
00:24:48,920 --> 00:24:50,420
So it's a monopoly.

598
00:24:50,420 --> 00:24:53,540
It's a monopoly that the
government grants you

599
00:24:53,540 --> 00:24:56,570
for a fixed period of
time in exchange for what?

600
00:24:56,570 --> 00:24:59,420
In exchange for you to be
willing to disclose everything

601
00:24:59,420 --> 00:25:01,130
there is to know about it.

602
00:25:01,130 --> 00:25:02,180
And why is it?

603
00:25:02,180 --> 00:25:04,130
So that everybody else
can learn from it.

604
00:25:04,130 --> 00:25:05,900
And after 17 years,
and after you've

605
00:25:05,900 --> 00:25:08,240
made a god awful
amount of money,

606
00:25:08,240 --> 00:25:10,730
somebody else can take that
idea and incorporate it

607
00:25:10,730 --> 00:25:14,960
into what they're doing
and make money off of that.

608
00:25:14,960 --> 00:25:19,700
The patent process creates
assets out of ideas.

609
00:25:19,700 --> 00:25:21,980
And it allows you to
derive economic value

610
00:25:21,980 --> 00:25:26,120
from that in exchange for
freely sharing those ideas.

611
00:25:26,120 --> 00:25:27,320
That's one path to go.

612
00:25:27,320 --> 00:25:28,760
And the other path
is I don't want

613
00:25:28,760 --> 00:25:32,150
to share because I think
that I can do better

614
00:25:32,150 --> 00:25:33,270
by keeping it a secret.

615
00:25:33,270 --> 00:25:34,760
And that's what
Coca-Cola has done.

616
00:25:34,760 --> 00:25:37,700
That's the example
that I was thinking of,

617
00:25:37,700 --> 00:25:41,750
of an idea that has
no legal standing

618
00:25:41,750 --> 00:25:44,570
but that's one of the most
incredibly valuable ideas

619
00:25:44,570 --> 00:25:45,950
in the world today.

620
00:25:45,950 --> 00:25:47,810
The amount of money
that Coca-Cola produces

621
00:25:47,810 --> 00:25:51,620
is unbelievable given
this simple recipe

622
00:25:51,620 --> 00:25:54,140
that apparently people haven't
been able to figure out

623
00:25:54,140 --> 00:25:55,520
how to reproduce.

624
00:25:55,520 --> 00:25:56,990
How hard could it be?

625
00:25:56,990 --> 00:25:59,240
You just mix a few things
and add some coloring

626
00:25:59,240 --> 00:26:00,690
and then you get Pepsi.

627
00:26:00,690 --> 00:26:02,120
I don't know.

628
00:26:02,120 --> 00:26:02,787
Yeah?

629
00:26:02,787 --> 00:26:05,120
AUDIENCE: But a lot of their
value is also in the brand.

630
00:26:05,120 --> 00:26:05,570
ANDREW LO: That's right.

631
00:26:05,570 --> 00:26:07,861
AUDIENCE: There's the trillions
of people who associate

632
00:26:07,861 --> 00:26:09,752
a red dot with feeling happy.

633
00:26:09,752 --> 00:26:10,710
ANDREW LO: That's true.

634
00:26:10,710 --> 00:26:12,530
Now that's the case.

635
00:26:12,530 --> 00:26:15,710
They've spent years building
the Coca-Cola brand.

636
00:26:15,710 --> 00:26:17,480
That's one of the most
recognizable brands

637
00:26:17,480 --> 00:26:18,680
in the world.

638
00:26:18,680 --> 00:26:20,180
And that has value, too.

639
00:26:20,180 --> 00:26:23,270
And by the way, that value
is different from the trade

640
00:26:23,270 --> 00:26:24,590
secret.

641
00:26:24,590 --> 00:26:28,310
So now we see that there's
lots of different assets.

642
00:26:28,310 --> 00:26:29,480
And that's an asset, right?

643
00:26:29,480 --> 00:26:29,980
Yeah?

644
00:26:29,980 --> 00:26:31,471
AUDIENCE: I'm just curious.

645
00:26:31,471 --> 00:26:34,950
Is there a financial
reason-- or maybe not--

646
00:26:34,950 --> 00:26:39,420
for why you would patent
something versus have a trade

647
00:26:39,420 --> 00:26:39,920
secret?

648
00:26:39,920 --> 00:26:43,160
And what I was thinking of
is pharmaceutical companies.

649
00:26:43,160 --> 00:26:46,160
Why would you go
and patent Lipitor?

650
00:26:46,160 --> 00:26:49,160
Wouldn't it be better to
keep that a trade secret

651
00:26:49,160 --> 00:26:51,430
and be the only company in
the world ever to make it?

652
00:26:51,430 --> 00:26:52,638
ANDREW LO: Well that depends.

653
00:26:52,638 --> 00:26:56,290
It depends on whether or not you
think you can keep it a secret.

654
00:26:56,290 --> 00:26:59,800
Coca-Cola apparently has
been kept secret pretty well.

655
00:26:59,800 --> 00:27:02,020
But there are a lot of
other people working

656
00:27:02,020 --> 00:27:05,320
on the various different kinds
of cholesterol reducing drugs,

657
00:27:05,320 --> 00:27:08,410
not just the folks
that develop Lipitor.

658
00:27:08,410 --> 00:27:12,110
So if you can keep it a secret,
great, keep it for yourself.

659
00:27:12,110 --> 00:27:14,980
But very often you won't
be, because other people are

660
00:27:14,980 --> 00:27:16,480
working on the same research.

661
00:27:16,480 --> 00:27:19,030
Also there's a certain
cachet to having a patent.

662
00:27:19,030 --> 00:27:20,710
And it provides you
with a certain kind

663
00:27:20,710 --> 00:27:23,200
of business viability.

664
00:27:23,200 --> 00:27:26,470
You can go to an investor and
say, here, I've got this idea.

665
00:27:26,470 --> 00:27:29,320
The idea has been certified
by the US Patent Office.

666
00:27:29,320 --> 00:27:31,780
It is patent number
XYZ, and that's

667
00:27:31,780 --> 00:27:34,240
why you should give me money,
versus you go to an investor

668
00:27:34,240 --> 00:27:35,710
and say, hey, I got a secret.

669
00:27:35,710 --> 00:27:37,500
I can't tell you what it is.

670
00:27:37,500 --> 00:27:38,260
You know what?

671
00:27:38,260 --> 00:27:40,780
You're back to the iPod.

672
00:27:40,780 --> 00:27:41,470
Andy, question?

673
00:27:41,470 --> 00:27:42,374
AUDIENCE: Oh, no.

674
00:27:42,374 --> 00:27:43,940
I was going to say
the same thing.

675
00:27:43,940 --> 00:27:45,160
ANDREW LO: Yep, OK.

676
00:27:45,160 --> 00:27:48,160
So now we know that there
are all sorts of assets.

677
00:27:48,160 --> 00:27:51,040
Even intangibles, even
things that you can't hold

678
00:27:51,040 --> 00:27:55,370
in your hand can be an asset.

679
00:27:55,370 --> 00:27:57,560
I want you to forget
about all of that.

680
00:27:57,560 --> 00:27:59,120
I want you to think
about an asset

681
00:27:59,120 --> 00:28:02,440
in a completely different way.

682
00:28:02,440 --> 00:28:08,500
I want to reduce an asset to
its fundamental core properties.

683
00:28:08,500 --> 00:28:13,120
And to do that, here's my
definition of an asset.

684
00:28:13,120 --> 00:28:17,550
An asset, at a given
point in time t,

685
00:28:17,550 --> 00:28:27,110
is simply equal to a sequence
of future cashflows--

686
00:28:27,110 --> 00:28:33,910
CFt, CFt plus 1, CFt
plus 2, dot, dot, dot.

687
00:28:33,910 --> 00:28:37,120
That is the
definition of an asset

688
00:28:37,120 --> 00:28:39,640
that I would like to adopt
for the next 12 weeks.

689
00:28:42,680 --> 00:28:47,480
Now this might seem trivial to
you, but trust me, it's not.

690
00:28:47,480 --> 00:28:49,370
It's a very subtle idea.

691
00:28:49,370 --> 00:28:52,130
And it's going to have all sorts
of interesting implications

692
00:28:52,130 --> 00:28:55,110
that we're going to discuss
over the next few lectures.

693
00:28:55,110 --> 00:28:56,943
But I want to make sure
that everybody fully

694
00:28:56,943 --> 00:28:59,030
appreciates what
I mean when I say

695
00:28:59,030 --> 00:29:04,345
an asset is a sequence of
current and future cashflows.

696
00:29:04,345 --> 00:29:06,470
Let me just describe a
couple of interesting things

697
00:29:06,470 --> 00:29:07,386
about this definition.

698
00:29:07,386 --> 00:29:11,100
First of all, it doesn't
involve past cashflows.

699
00:29:11,100 --> 00:29:14,510
So when I define an
asset I have to define

700
00:29:14,510 --> 00:29:16,910
it relative to a point in time.

701
00:29:16,910 --> 00:29:19,700
That, in and of itself,
I think is something new.

702
00:29:19,700 --> 00:29:24,780
So it's not enough to say
an asset is Coca-Cola.

703
00:29:24,780 --> 00:29:26,960
You have to say
that the asset is

704
00:29:26,960 --> 00:29:32,880
Coca-Cola today, versus
Coca-Cola 10 years ago, versus

705
00:29:32,880 --> 00:29:35,710
Coca-Cola 100 years from now.

706
00:29:35,710 --> 00:29:38,220
Those are different assets.

707
00:29:38,220 --> 00:29:41,580
The point in time actually
matters, in other words.

708
00:29:41,580 --> 00:29:43,387
This is like the zen paradox.

709
00:29:43,387 --> 00:29:44,970
You can never step
into the same river

710
00:29:44,970 --> 00:29:47,980
twice because water is moving.

711
00:29:47,980 --> 00:29:49,530
It's always a different river.

712
00:29:49,530 --> 00:29:53,400
In that sense, an asset,
as at every point in time,

713
00:29:53,400 --> 00:29:55,500
is a different asset.

714
00:29:55,500 --> 00:29:57,120
And that's not that surprising.

715
00:29:57,120 --> 00:30:00,420
Because if you believe,
from my definition,

716
00:30:00,420 --> 00:30:04,530
that an asset is equivalent
to its current and future

717
00:30:04,530 --> 00:30:08,820
cashflows, then those
cashflows are very different

718
00:30:08,820 --> 00:30:10,960
depending on where you stand.

719
00:30:10,960 --> 00:30:14,880
So for example, the stock of
Fannie Mae and Freddie Mac

720
00:30:14,880 --> 00:30:18,840
as an asset was very
different five years ago

721
00:30:18,840 --> 00:30:20,880
than it is today.

722
00:30:20,880 --> 00:30:21,900
They're both assets.

723
00:30:21,900 --> 00:30:24,060
They're both cashflows.

724
00:30:24,060 --> 00:30:26,460
But the cashflows
are very different

725
00:30:26,460 --> 00:30:30,940
depending on what point in
time you're talking about.

726
00:30:30,940 --> 00:30:33,480
So when I think
about a cashflow,

727
00:30:33,480 --> 00:30:36,960
I'm thinking about a
particular sequence that

728
00:30:36,960 --> 00:30:40,160
occurs given market conditions.

729
00:30:40,160 --> 00:30:43,590
An asset is comprised
of those cashflows.

730
00:30:43,590 --> 00:30:45,420
They are one and the same.

731
00:30:45,420 --> 00:30:48,700
When you tell me that
you have an asset,

732
00:30:48,700 --> 00:30:50,650
I immediately
think of OK, what's

733
00:30:50,650 --> 00:30:51,800
the sequence of cashflows?

734
00:30:51,800 --> 00:30:53,350
That's all I care about.

735
00:30:53,350 --> 00:30:55,150
From the purposes of
financial analysis,

736
00:30:55,150 --> 00:30:57,340
that's all that matters.

737
00:30:57,340 --> 00:30:59,530
So over the next
few weeks, we're

738
00:30:59,530 --> 00:31:02,860
going to be building up a
theory of financial analysis.

739
00:31:02,860 --> 00:31:07,710
The basic building blocks
of that theory are assets.

740
00:31:07,710 --> 00:31:11,040
So you could think of
assets as the molecules

741
00:31:11,040 --> 00:31:15,150
or atoms of a unified
field theory of finance.

742
00:31:15,150 --> 00:31:17,460
And the protons and electrons--

743
00:31:17,460 --> 00:31:19,280
those are the cashflows.

744
00:31:19,280 --> 00:31:19,780
Yeah?

745
00:31:19,780 --> 00:31:22,067
AUDIENCE: Do the cashflows
have to be positive?

746
00:31:22,067 --> 00:31:22,650
ANDREW LO: No.

747
00:31:22,650 --> 00:31:24,090
They don't have to be
positive or negative.

748
00:31:24,090 --> 00:31:25,900
But they do have
to be real numbers,

749
00:31:25,900 --> 00:31:29,250
so no complex numbers here, OK?

750
00:31:29,250 --> 00:31:31,800
Positive or negative--
that's what an asset is.

751
00:31:31,800 --> 00:31:34,710
Now you might think, well,
gee, if all the cashflows

752
00:31:34,710 --> 00:31:37,470
are negative then I don't
really want that asset.

753
00:31:37,470 --> 00:31:39,030
Well that's the
nature of an asset.

754
00:31:39,030 --> 00:31:41,737
Maybe then instead of
an asset you call it a--

755
00:31:41,737 --> 00:31:42,570
AUDIENCE: Liability.

756
00:31:42,570 --> 00:31:44,160
ANDREW LO: --liability, exactly.

757
00:31:44,160 --> 00:31:47,760
But from my perspective,
developing this atomic theory

758
00:31:47,760 --> 00:31:50,681
of finance, I'm going to focus
on this as the basic building

759
00:31:50,681 --> 00:31:51,180
blocks.

760
00:31:51,180 --> 00:31:53,388
And I don't care whether
they're positive or negative

761
00:31:53,388 --> 00:31:54,080
for the moment.

762
00:31:54,080 --> 00:31:56,330
We're going to talk about
their characteristics later.

763
00:31:56,330 --> 00:31:59,370
But I just want to agree on a
definition of what an asset is.

764
00:31:59,370 --> 00:32:00,740
Question, yeah?

765
00:32:00,740 --> 00:32:03,470
AUDIENCE: So it's a
sequence of cashflows,

766
00:32:03,470 --> 00:32:04,570
it's not a summation?

767
00:32:04,570 --> 00:32:06,790
ANDREW LO: Right,
it's not a summation.

768
00:32:06,790 --> 00:32:10,080
It's a sequence,
meaning it's basically

769
00:32:10,080 --> 00:32:16,900
just a list of cash flows at
different points in the future,

770
00:32:16,900 --> 00:32:20,730
including the present,
but not the past.

771
00:32:20,730 --> 00:32:24,690
So according to my definition,
the past doesn't matter.

772
00:32:24,690 --> 00:32:28,260
When you talk to me about
an asset, all I'm looking at

773
00:32:28,260 --> 00:32:31,454
is current and
future cash flows.

774
00:32:31,454 --> 00:32:32,870
And it's a sequence
of cash flows.

775
00:32:32,870 --> 00:32:35,410
So that means they're
ordered in time.

776
00:32:35,410 --> 00:32:37,780
And I'm not even telling
you whether or not

777
00:32:37,780 --> 00:32:39,620
what the cash flows are.

778
00:32:39,620 --> 00:32:41,950
So it could be that
the future cash flows--

779
00:32:41,950 --> 00:32:45,310
I'm writing them as
letters, but who knows

780
00:32:45,310 --> 00:32:46,840
what the letters stand for.

781
00:32:46,840 --> 00:32:49,330
You might not know what
the future cash flows are.

782
00:32:49,330 --> 00:32:52,390
But you can still, nevertheless,
acknowledge that they

783
00:32:52,390 --> 00:32:55,550
exist as an abstraction.

784
00:32:59,150 --> 00:33:00,620
That's what an asset is.

785
00:33:00,620 --> 00:33:03,620
I don't care what
you use to value

786
00:33:03,620 --> 00:33:06,020
your various
different cash flows.

787
00:33:06,020 --> 00:33:09,170
But the definition
of an asset is simply

788
00:33:09,170 --> 00:33:11,324
a sequence of current
and future cash flows.

789
00:33:11,324 --> 00:33:12,740
All right, that's
what we're going

790
00:33:12,740 --> 00:33:13,823
to talk about as an asset.

791
00:33:13,823 --> 00:33:15,590
So all the things that
I listed up there--

792
00:33:15,590 --> 00:33:18,800
knowledge, reputation.

793
00:33:18,800 --> 00:33:22,330
Can reputation be considered a
sequence of future cash flows?

794
00:33:22,330 --> 00:33:23,860
Does that make sense?

795
00:33:23,860 --> 00:33:25,560
How?

796
00:33:25,560 --> 00:33:26,060
What?

797
00:33:26,060 --> 00:33:27,000
AUDIENCE: Goodwill.

798
00:33:27,000 --> 00:33:28,410
ANDREW LO: Goodwill.

799
00:33:28,410 --> 00:33:30,556
How would you use that goodwill?

800
00:33:30,556 --> 00:33:32,796
Yeah?

801
00:33:32,796 --> 00:33:34,380
AUDIENCE: Your
reputation is such

802
00:33:34,380 --> 00:33:39,275
that people choose you
instead of a competitor.

803
00:33:39,275 --> 00:33:42,189
And so that cash flow,
from that choice,

804
00:33:42,189 --> 00:33:43,480
is coming from your reputation.

805
00:33:43,480 --> 00:33:44,521
ANDREW LO: Exactly right.

806
00:33:44,521 --> 00:33:49,030
The additional cashflow that you
get based on that reputation--

807
00:33:49,030 --> 00:33:52,840
that's the value of the
asset, or that is the asset

808
00:33:52,840 --> 00:33:53,691
right there.

809
00:33:53,691 --> 00:33:54,190
Yeah?

810
00:33:54,190 --> 00:33:56,320
AUDIENCE: Can assets
have common elements?

811
00:33:56,320 --> 00:33:57,850
ANDREW LO: Absolutely.

812
00:33:57,850 --> 00:33:59,890
No reason why you
can't have common cash

813
00:33:59,890 --> 00:34:02,690
flows across different assets.

814
00:34:02,690 --> 00:34:05,360
But nevertheless,
a single asset is

815
00:34:05,360 --> 00:34:08,794
a collection of present
and future cash flows.

816
00:34:08,794 --> 00:34:09,768
Yeah?

817
00:34:09,768 --> 00:34:12,699
AUDIENCE: I'm not sure if
I can explain correctly,

818
00:34:12,699 --> 00:34:17,510
but as you said, if I have
one asset, a building,

819
00:34:17,510 --> 00:34:19,086
and if she has a
building, and if I

820
00:34:19,086 --> 00:34:21,489
am a lender, that means
I have a different cash

821
00:34:21,489 --> 00:34:22,390
flow on that asset.

822
00:34:22,390 --> 00:34:23,015
ANDREW LO: Yes.

823
00:34:23,015 --> 00:34:27,375
AUDIENCE: But however, there
is a market of the building.

824
00:34:27,375 --> 00:34:32,007
But if the sequence of the
cash flow, how can you like--

825
00:34:32,007 --> 00:34:33,590
ANDREW LO: We're
going to get to that.

826
00:34:33,590 --> 00:34:35,510
That's actually a
very deep question

827
00:34:35,510 --> 00:34:38,300
that will require three more
lectures before we get to.

828
00:34:38,300 --> 00:34:40,969
But I will answer that exact
question in three lectures,

829
00:34:40,969 --> 00:34:43,429
if not before.

830
00:34:43,429 --> 00:34:46,618
Before we talk about how
to value these assets

831
00:34:46,618 --> 00:34:49,159
I want to make sure we agree on
what a definition of an asset

832
00:34:49,159 --> 00:34:50,090
is.

833
00:34:50,090 --> 00:34:51,400
So I think we agree, right?

834
00:34:51,400 --> 00:34:52,639
Any questions about that?

835
00:34:52,639 --> 00:34:53,611
Yeah?

836
00:34:53,611 --> 00:34:55,069
AUDIENCE: So if, say, you
have a bunch of patents,

837
00:34:55,069 --> 00:34:57,110
but they can't generate
any incremental cashflows

838
00:34:57,110 --> 00:34:57,985
they don't exist.

839
00:34:57,985 --> 00:35:00,901
Like, you have them,
but incremental cash

840
00:35:00,901 --> 00:35:02,690
flow from [INAUDIBLE] matter?

841
00:35:02,690 --> 00:35:06,050
ANDREW LO: Well, not
to be anal about this,

842
00:35:06,050 --> 00:35:09,710
but mathematically, a
sequence of 0, 0, 0, 0

843
00:35:09,710 --> 00:35:12,110
is a bona fide cash flow.

844
00:35:12,110 --> 00:35:14,450
So the zero asset
is possible too.

845
00:35:17,360 --> 00:35:19,540
So this is absolutely general.

846
00:35:19,540 --> 00:35:22,070
And you might argue, at
this level of generality

847
00:35:22,070 --> 00:35:22,760
it's useless.

848
00:35:22,760 --> 00:35:25,040
Well not quite, not quite.

849
00:35:25,040 --> 00:35:28,460
Because I think it helps us
to formulate a perspective.

850
00:35:28,460 --> 00:35:31,220
And the perspective is when you
start thinking about various

851
00:35:31,220 --> 00:35:34,460
different kinds of assets-- and
I'm talking really complicated

852
00:35:34,460 --> 00:35:38,960
assets, assets with all
sorts of options and triggers

853
00:35:38,960 --> 00:35:41,480
and various contingencies--

854
00:35:41,480 --> 00:35:44,180
the more complicated it
gets, the more important

855
00:35:44,180 --> 00:35:45,050
this framework is.

856
00:35:45,050 --> 00:35:48,380
Because no matter how
intimidating the problem

857
00:35:48,380 --> 00:35:50,840
you are faced with,
the bottom line

858
00:35:50,840 --> 00:35:54,870
is an asset is a
sequence of cash flows.

859
00:35:54,870 --> 00:35:57,140
It's simple, conceptually.

860
00:35:57,140 --> 00:36:01,430
The hard part is figuring out
what those cash flows are.

861
00:36:01,430 --> 00:36:04,100
But the conceptual framework is
what I want you to start with.

862
00:36:04,100 --> 00:36:06,500
Because that will clear your
mind of a lot of cobwebs

863
00:36:06,500 --> 00:36:09,420
that really don't belong in
any kind of financial analysis.

864
00:36:09,420 --> 00:36:11,930
So we start with cash flows.

865
00:36:11,930 --> 00:36:15,710
Sequence of cash
flows is an asset.

866
00:36:15,710 --> 00:36:18,020
Now that I've told you that,
there's lots of examples

867
00:36:18,020 --> 00:36:19,200
that you can come up with.

868
00:36:19,200 --> 00:36:20,699
So I've given you
some in the notes.

869
00:36:20,699 --> 00:36:21,890
Please take a look at them.

870
00:36:21,890 --> 00:36:24,680
Each one of these is an asset.

871
00:36:24,680 --> 00:36:28,370
And each one of these
represents a certain sequence

872
00:36:28,370 --> 00:36:29,630
of cash flows.

873
00:36:29,630 --> 00:36:31,310
Some may be more
subtle than others.

874
00:36:31,310 --> 00:36:33,974
But they are,
nevertheless, cash flows.

875
00:36:33,974 --> 00:36:35,390
So I want you to
think about that,

876
00:36:35,390 --> 00:36:37,306
read through these
examples, and make sure you

877
00:36:37,306 --> 00:36:40,520
understand why they are assets.

878
00:36:40,520 --> 00:36:45,100
Now valuing an asset--

879
00:36:45,100 --> 00:36:48,340
that's the question that
[INAUDIBLE] was asking about.

880
00:36:48,340 --> 00:36:51,550
How do you value a
sequence of cash flows?

881
00:36:51,550 --> 00:36:53,260
Because you and
I-- we might have

882
00:36:53,260 --> 00:36:57,280
a very different perspective on
what that cash flow is worth.

883
00:36:57,280 --> 00:37:01,780
So for the moment, I'm not
going to answer that question,

884
00:37:01,780 --> 00:37:05,890
or rather I'm going to answer
it with a typical device

885
00:37:05,890 --> 00:37:09,070
that economists use
all the time, which

886
00:37:09,070 --> 00:37:11,380
is I'm going to just
create some notation

887
00:37:11,380 --> 00:37:13,270
to answer the question.

888
00:37:13,270 --> 00:37:17,290
And the notation I'm
going to give you is V,

889
00:37:17,290 --> 00:37:19,660
in particular V sub t.

890
00:37:19,660 --> 00:37:25,130
That's a function that
takes as its input

891
00:37:25,130 --> 00:37:28,430
a sequence of cash
flows and spits

892
00:37:28,430 --> 00:37:32,600
out a number, which I'm going
to call the value of the asset

893
00:37:32,600 --> 00:37:34,310
at time t.

894
00:37:34,310 --> 00:37:36,410
So how do you value a cash flow?

895
00:37:36,410 --> 00:37:40,310
Well, you use the
value operator V sub t.

896
00:37:40,310 --> 00:37:45,239
You stick in a cash flow
and out pops a number.

897
00:37:45,239 --> 00:37:47,780
We're going to have to spend
the next three lectures figuring

898
00:37:47,780 --> 00:37:50,030
out what V is.

899
00:37:50,030 --> 00:37:52,320
But I can tell you
one answer right away.

900
00:37:52,320 --> 00:37:56,940
In fact, all of you know what
V is, or one definition of V.

901
00:37:56,940 --> 00:37:57,440
What is it?

902
00:37:57,440 --> 00:38:00,140
Can anybody tell me what V is?

903
00:38:00,140 --> 00:38:03,658
Where do you get V from?

904
00:38:03,658 --> 00:38:04,158
Yeah?

905
00:38:04,158 --> 00:38:06,050
AUDIENCE: What you pay for it?

906
00:38:06,050 --> 00:38:09,380
ANDREW LO: That's
right, but you're close.

907
00:38:09,380 --> 00:38:11,300
Where did that come from,
what you pay for it?

908
00:38:11,300 --> 00:38:12,341
What do you mean by that?

909
00:38:15,530 --> 00:38:17,030
Market price.

910
00:38:17,030 --> 00:38:17,660
What market?

911
00:38:20,964 --> 00:38:21,908
What market?

912
00:38:25,700 --> 00:38:26,317
Yeah?

913
00:38:26,317 --> 00:38:28,650
AUDIENCE: Any market where
someone's willing to sell it.

914
00:38:28,650 --> 00:38:28,830
ANDREW LO: Exactly.

915
00:38:28,830 --> 00:38:29,190
Any market.

916
00:38:29,190 --> 00:38:29,940
This is what you
were getting at.

917
00:38:29,940 --> 00:38:31,800
What you pay for
it-- any market.

918
00:38:31,800 --> 00:38:35,670
If there's a market,
you've got your V.

919
00:38:35,670 --> 00:38:42,000
So V-- one0 example of a
Vt is a market at time t.

920
00:38:42,000 --> 00:38:43,830
That's what we did last time.

921
00:38:43,830 --> 00:38:45,520
We had a value operator.

922
00:38:45,520 --> 00:38:51,340
Stick in a gift wrapped
box and you get out $45.

923
00:38:51,340 --> 00:38:54,400
That's an example of a V.
What we're going to try to do,

924
00:38:54,400 --> 00:38:56,680
though, is to take
apart that box

925
00:38:56,680 --> 00:39:01,010
and see how it works and
whether or not it does work.

926
00:39:01,010 --> 00:39:04,440
AUDIENCE: Would it be any
market or the markets that

927
00:39:04,440 --> 00:39:06,024
generate the best cashflows?

928
00:39:06,024 --> 00:39:07,940
ANDREW LO: Well we don't
know what best means.

929
00:39:07,940 --> 00:39:11,959
So for our discussion right
now any market will do.

930
00:39:11,959 --> 00:39:14,000
But then you can have a
separate discussion as to

931
00:39:14,000 --> 00:39:16,370
whether or not there are better
markets or worse markets.

932
00:39:16,370 --> 00:39:17,730
And we have to define
what that means.

933
00:39:17,730 --> 00:39:19,490
So we're going to get to
that when we start talking

934
00:39:19,490 --> 00:39:20,961
about how the V operators work.

935
00:39:20,961 --> 00:39:21,461
Yeah?

936
00:39:21,461 --> 00:39:24,347
AUDIENCE: Does this work
for a perfect market?

937
00:39:24,347 --> 00:39:26,909
Or perfect market just
means that the value

938
00:39:26,909 --> 00:39:28,200
would be the summation of the--

939
00:39:28,200 --> 00:39:29,460
ANDREW LO: So we
don't know we don't

940
00:39:29,460 --> 00:39:31,590
know what a perfect or an
imperfect market is yet.

941
00:39:31,590 --> 00:39:33,840
And I'm going to hold off
on that for quite a few more

942
00:39:33,840 --> 00:39:34,560
weeks.

943
00:39:34,560 --> 00:39:37,230
All we know is it's a market.

944
00:39:37,230 --> 00:39:38,735
So let me put it
to you this way--

945
00:39:38,735 --> 00:39:40,830
in the last lecture,
when I auctioned off

946
00:39:40,830 --> 00:39:43,650
that iPod and I only
got 1/3 of the price,

947
00:39:43,650 --> 00:39:45,840
would you consider
that a perfect market?

948
00:39:45,840 --> 00:39:48,240
It didn't feel that way to me.

949
00:39:48,240 --> 00:39:50,940
But on the other
hand, it worked.

950
00:39:50,940 --> 00:39:53,340
I had something that
I wanted to unload

951
00:39:53,340 --> 00:39:57,150
and I unloaded it at a price
that two mutually consenting

952
00:39:57,150 --> 00:39:58,800
adults agreed to.

953
00:39:58,800 --> 00:40:00,800
So that worked.

954
00:40:00,800 --> 00:40:03,450
It was pretty good.

955
00:40:03,450 --> 00:40:05,750
But in order for us to
understand whether or not

956
00:40:05,750 --> 00:40:09,110
it really works, we've actually
got to take apart the box.

957
00:40:09,110 --> 00:40:10,874
We've got to open up Vt.

958
00:40:10,874 --> 00:40:12,290
I'm not going to
do that just yet.

959
00:40:12,290 --> 00:40:15,800
I want to first acknowledge
that there exist Vts out there.

960
00:40:15,800 --> 00:40:17,330
And more often
than not, when you

961
00:40:17,330 --> 00:40:20,570
let the market dictate
what that Vt is,

962
00:40:20,570 --> 00:40:23,120
you actually get some
pretty interesting results,

963
00:40:23,120 --> 00:40:26,090
results that will require
a little bit more structure

964
00:40:26,090 --> 00:40:27,530
to interpret.

965
00:40:27,530 --> 00:40:29,600
One way to interpret
the structure

966
00:40:29,600 --> 00:40:33,500
is to acknowledge that there
is a time element to the cash

967
00:40:33,500 --> 00:40:34,530
flows.

968
00:40:34,530 --> 00:40:39,890
So when I ask you to
analyze a Vt or an asset,

969
00:40:39,890 --> 00:40:42,500
the first thing you're
going to want to do

970
00:40:42,500 --> 00:40:44,570
is to draw this
picture right here.

971
00:40:44,570 --> 00:40:46,130
And I'm serious about this.

972
00:40:46,130 --> 00:40:48,920
In order for you to understand
the value of an asset,

973
00:40:48,920 --> 00:40:52,280
you have to know the
timing of the cash flows.

974
00:40:52,280 --> 00:40:56,240
Time means everything
in finance.

975
00:40:56,240 --> 00:41:00,185
A cash flow today is not the
same as a cash flow next year.

976
00:41:00,185 --> 00:41:00,684
Yeah?

977
00:41:00,684 --> 00:41:05,028
AUDIENCE: So are we going
to divorce the accounting

978
00:41:05,028 --> 00:41:10,836
definition of an asset
from the finance?

979
00:41:10,836 --> 00:41:13,740
For instance, land
has to be recorded

980
00:41:13,740 --> 00:41:15,880
at book value [INAUDIBLE]
in accounting.

981
00:41:15,880 --> 00:41:17,140
ANDREW LO: Yes, right.

982
00:41:17,140 --> 00:41:21,010
So what I'm asking you to
do is to think abstractly

983
00:41:21,010 --> 00:41:23,410
in terms of the
cashflows themselves.

984
00:41:23,410 --> 00:41:26,110
I haven't talked about
accounting practices at all.

985
00:41:26,110 --> 00:41:28,700
I'm going to come back to how
we actually implement this.

986
00:41:28,700 --> 00:41:30,910
And at that point, it'll
be important to bring

987
00:41:30,910 --> 00:41:32,470
in the accounting elements.

988
00:41:32,470 --> 00:41:35,230
But for now, let's
set them aside.

989
00:41:35,230 --> 00:41:38,864
So these are actual cashflows
that you will receive

990
00:41:38,864 --> 00:41:40,030
at different points in time.

991
00:41:40,030 --> 00:41:42,880
And by the way, I want you to
use this exact same framework

992
00:41:42,880 --> 00:41:45,850
for analyzing
accounting practices.

993
00:41:45,850 --> 00:41:48,370
Because financial
analysis can actually

994
00:41:48,370 --> 00:41:51,670
be used to ask the question,
are accounting conventions

995
00:41:51,670 --> 00:41:53,260
good or bad?

996
00:41:53,260 --> 00:41:55,600
Some accounting
conventions are favorable.

997
00:41:55,600 --> 00:41:56,920
Some are unfavorable.

998
00:41:56,920 --> 00:41:58,660
But the only way
to analyze them is

999
00:41:58,660 --> 00:42:02,140
by using this kind
of a framework first.

1000
00:42:02,140 --> 00:42:05,830
So I would argue that this will
be certainly useful for looking

1001
00:42:05,830 --> 00:42:07,270
at accounting practices.

1002
00:42:07,270 --> 00:42:09,040
But it won't
necessarily be the same.

1003
00:42:09,040 --> 00:42:13,360
So you'll need to have
to make that distinction.

1004
00:42:13,360 --> 00:42:16,450
So, so far, nothing I've said
is all that controversial,

1005
00:42:16,450 --> 00:42:17,380
I don't think.

1006
00:42:17,380 --> 00:42:21,070
I've simply defined that
there is a value operator.

1007
00:42:21,070 --> 00:42:22,390
Operator means function.

1008
00:42:22,390 --> 00:42:24,070
You stick in a
sequence of cashflows.

1009
00:42:24,070 --> 00:42:25,660
Out pops a number.

1010
00:42:25,660 --> 00:42:29,620
And when you analyze
the value of an asset,

1011
00:42:29,620 --> 00:42:32,920
I want you to always
draw a timeline

1012
00:42:32,920 --> 00:42:38,680
and make sure you understand
the sequence of cashflows.

1013
00:42:38,680 --> 00:42:41,650
Without the timeline I
don't know that you really

1014
00:42:41,650 --> 00:42:43,070
understand what's going on.

1015
00:42:43,070 --> 00:42:45,790
So first of all, as a
tip for your midterm

1016
00:42:45,790 --> 00:42:49,240
and final exams, any time
you have a calculation, which

1017
00:42:49,240 --> 00:42:53,070
you have to do a present
value or a valuation exercise,

1018
00:42:53,070 --> 00:42:54,130
I want to see this.

1019
00:42:54,130 --> 00:42:57,270
I want to see that you know
when things are going to happen.

1020
00:42:57,270 --> 00:42:58,920
Because nine out
of 10 times, when

1021
00:42:58,920 --> 00:43:01,110
you make a mistake
in valuation, it's

1022
00:43:01,110 --> 00:43:03,357
because you lined
this up incorrectly.

1023
00:43:05,980 --> 00:43:06,840
Now what is V?

1024
00:43:06,840 --> 00:43:09,990
Well we said that one
example of a V is the market.

1025
00:43:09,990 --> 00:43:12,360
But is that objective?

1026
00:43:12,360 --> 00:43:13,320
Is it subjective?

1027
00:43:13,320 --> 00:43:15,210
Does it work well?

1028
00:43:15,210 --> 00:43:17,100
How is value determined?

1029
00:43:17,100 --> 00:43:21,180
And what we're going to do in
this lecture and the next one

1030
00:43:21,180 --> 00:43:29,860
is to take apart this function
V in the case of no uncertainty.

1031
00:43:29,860 --> 00:43:32,700
So remember I told you
the two important factors

1032
00:43:32,700 --> 00:43:34,770
in financial analysis
that makes finance

1033
00:43:34,770 --> 00:43:39,900
interesting and exciting
is time and uncertainty.

1034
00:43:39,900 --> 00:43:43,350
And we've seen both of those
things happen this weekend.

1035
00:43:43,350 --> 00:43:47,700
A lot of time has passed in
resolving the uncertainty

1036
00:43:47,700 --> 00:43:51,140
with regard to Fannie
Mae and Freddie Mac.

1037
00:43:51,140 --> 00:43:54,800
What I'd like to do is to
abstract from the uncertainty

1038
00:43:54,800 --> 00:43:55,880
part.

1039
00:43:55,880 --> 00:44:00,410
For the next couple of lectures
there's no uncertainty.

1040
00:44:00,410 --> 00:44:02,090
I'm going to get rid
of the randomness.

1041
00:44:02,090 --> 00:44:05,120
And I'm only going to
focus on figuring out

1042
00:44:05,120 --> 00:44:09,440
the value operator, this V
sub t function, for cases

1043
00:44:09,440 --> 00:44:12,540
where we have cashflows at
different points in time

1044
00:44:12,540 --> 00:44:15,132
but where the cashflows
are known for sure.

1045
00:44:15,132 --> 00:44:17,090
So there's no uncertainty
about whether they're

1046
00:44:17,090 --> 00:44:20,390
going to happen or not happen.

1047
00:44:20,390 --> 00:44:23,720
After we do that, after
we do the no uncertainty

1048
00:44:23,720 --> 00:44:26,620
case, for which we have
a complete solution,

1049
00:44:26,620 --> 00:44:29,680
I will then come back
and introduce uncertainty

1050
00:44:29,680 --> 00:44:32,020
in a somewhat more natural way.

1051
00:44:32,020 --> 00:44:35,571
And then we're going to focus
on valuation with uncertainty

1052
00:44:35,571 --> 00:44:36,070
as well.

1053
00:44:39,270 --> 00:44:42,630
So let me start with
the perfect certainty

1054
00:44:42,630 --> 00:44:46,860
case about how to figure
out what this V sub t is.

1055
00:44:46,860 --> 00:44:50,100
And I'm going to start with
a very simple example that

1056
00:44:50,100 --> 00:44:53,670
has to do with
manipulating cashflows.

1057
00:44:53,670 --> 00:44:55,230
And I'm going to
talk in particular

1058
00:44:55,230 --> 00:44:57,640
about foreign currencies.

1059
00:44:57,640 --> 00:45:02,040
So I wanted to ask
you, what happens when

1060
00:45:02,040 --> 00:45:07,970
you add 150 yen to 300 pounds?

1061
00:45:07,970 --> 00:45:11,000
What do you get when
you add those two?

1062
00:45:11,000 --> 00:45:16,660
150 yen plus 300 pounds
is equal to 450 what?

1063
00:45:20,160 --> 00:45:22,240
$450?

1064
00:45:22,240 --> 00:45:27,340
If you believe that, please
see me after class and we'll

1065
00:45:27,340 --> 00:45:29,000
need to do some transactions.

1066
00:45:33,680 --> 00:45:37,880
Well look, obviously 450
makes no sense, right?

1067
00:45:37,880 --> 00:45:40,400
It's like adding your
weight to your age.

1068
00:45:40,400 --> 00:45:42,020
That number might
be interesting,

1069
00:45:42,020 --> 00:45:44,630
but there's no
interpretation for it.

1070
00:45:44,630 --> 00:45:47,870
So 150 and 300--

1071
00:45:47,870 --> 00:45:52,260
you would never add those
two and talk about 450 what.

1072
00:45:52,260 --> 00:45:56,910
You don't even have a unit
to be able to ascribe to it.

1073
00:45:56,910 --> 00:46:01,170
Well that natural
reaction that you have,

1074
00:46:01,170 --> 00:46:07,250
that natural aversion you have
to adding up dollars or yen

1075
00:46:07,250 --> 00:46:10,140
in different currencies--

1076
00:46:10,140 --> 00:46:15,390
I want you to develop that exact
same attitude towards cashflows

1077
00:46:15,390 --> 00:46:18,000
at different points in time.

1078
00:46:18,000 --> 00:46:19,790
So let me continue on with this.

1079
00:46:19,790 --> 00:46:21,357
Obviously if you
want to add the two,

1080
00:46:21,357 --> 00:46:22,940
you know that you
have to convert them

1081
00:46:22,940 --> 00:46:24,800
to the same currency.

1082
00:46:24,800 --> 00:46:29,030
So 300 pounds converts to
a certain number of yen.

1083
00:46:29,030 --> 00:46:33,590
And so when you add that
up, you get 46,050 yen.

1084
00:46:33,590 --> 00:46:35,750
Or if you want to
convert it to pounds,

1085
00:46:35,750 --> 00:46:41,870
it converts to 300.98
pounds sterling.

1086
00:46:41,870 --> 00:46:44,225
Those numbers make sense.

1087
00:46:44,225 --> 00:46:46,100
The reason they make
sense is because they're

1088
00:46:46,100 --> 00:46:47,270
in the same units.

1089
00:46:47,270 --> 00:46:52,940
So apples to apples is the
familiar adage that we use.

1090
00:46:52,940 --> 00:46:55,580
You can't add apples to oranges.

1091
00:46:55,580 --> 00:46:57,846
Actually, in theory you could.

1092
00:46:57,846 --> 00:46:58,970
You could make fruit salad.

1093
00:46:58,970 --> 00:47:00,740
And you need apples, and
oranges, and pears, and all

1094
00:47:00,740 --> 00:47:01,240
that.

1095
00:47:01,240 --> 00:47:06,020
But for argument's sake,
when it comes to money

1096
00:47:06,020 --> 00:47:11,360
it really doesn't tell you
much that you've got 450 blah.

1097
00:47:11,360 --> 00:47:13,700
You need to have a set of units.

1098
00:47:13,700 --> 00:47:20,420
Well it turns out that this
actual analysis requires

1099
00:47:20,420 --> 00:47:23,150
that we pick a base currency.

1100
00:47:23,150 --> 00:47:26,410
We pick what's
called a numeraire.

1101
00:47:26,410 --> 00:47:29,090
A numeraire is a
unit of account,

1102
00:47:29,090 --> 00:47:34,100
or a standard, by which
we measure everything.

1103
00:47:34,100 --> 00:47:37,350
So either yen or pounds
will work just fine.

1104
00:47:37,350 --> 00:47:38,570
It doesn't matter which.

1105
00:47:38,570 --> 00:47:41,120
If you're a British investor,
you might care about pounds.

1106
00:47:41,120 --> 00:47:44,060
If you're a Japanese investor,
you might care more about yen.

1107
00:47:44,060 --> 00:47:46,160
It just depends upon
your perspective,

1108
00:47:46,160 --> 00:47:48,740
but either one will
do for the purposes

1109
00:47:48,740 --> 00:47:54,080
of analyzing how much money
you have at a point in time.

1110
00:47:54,080 --> 00:47:56,950
Well that exact
same exercise has

1111
00:47:56,950 --> 00:48:02,070
to be applied to money
today versus money tomorrow.

1112
00:48:02,070 --> 00:48:04,020
Because those two
things are not the same.

1113
00:48:04,020 --> 00:48:06,340
It's like yen and pounds.

1114
00:48:06,340 --> 00:48:07,270
They're not the same.

1115
00:48:07,270 --> 00:48:08,970
They can't buy the same things.

1116
00:48:08,970 --> 00:48:10,890
They aren't used
in the same way.

1117
00:48:10,890 --> 00:48:12,390
They have different markets.

1118
00:48:12,390 --> 00:48:16,050
The markets are related,
but they're different.

1119
00:48:16,050 --> 00:48:18,870
So once you know
the exchange rate,

1120
00:48:18,870 --> 00:48:21,000
and once you pick
a base currency,

1121
00:48:21,000 --> 00:48:22,860
you can combine the thing.

1122
00:48:22,860 --> 00:48:25,620
The same idea holds
true for cashflows

1123
00:48:25,620 --> 00:48:27,690
at different points in time.

1124
00:48:27,690 --> 00:48:29,940
Cashflows at different
points in time

1125
00:48:29,940 --> 00:48:31,980
are like different currencies.

1126
00:48:31,980 --> 00:48:33,840
In order to add them
together, you've

1127
00:48:33,840 --> 00:48:37,140
got to use the appropriate
exchange rates.

1128
00:48:37,140 --> 00:48:39,620
Once you do, then
all of the valuation

1129
00:48:39,620 --> 00:48:42,120
that we're going to conduct
over the next couple of lectures

1130
00:48:42,120 --> 00:48:44,740
becomes absolutely trivial.

1131
00:48:44,740 --> 00:48:47,170
So let give you an
example of that.

1132
00:48:47,170 --> 00:48:49,410
Here's my timeline.

1133
00:48:49,410 --> 00:48:56,390
And my timeline has payoffs
at various different dates.

1134
00:48:56,390 --> 00:48:58,850
Now I'm arguing that the
past and the future cannot be

1135
00:48:58,850 --> 00:49:01,100
combined without
converting them.

1136
00:49:01,100 --> 00:49:05,530
So we have to have a
set of exchange rates

1137
00:49:05,530 --> 00:49:09,190
that convert all the
various different currencies

1138
00:49:09,190 --> 00:49:14,150
into a numeraire or
single base currency.

1139
00:49:14,150 --> 00:49:15,860
And for the sake
of argument, I'm

1140
00:49:15,860 --> 00:49:20,960
going to just pick,
times 0, dollars today

1141
00:49:20,960 --> 00:49:23,560
as my base currency.

1142
00:49:23,560 --> 00:49:27,900
So in other words, I want
to convert every cashflow

1143
00:49:27,900 --> 00:49:31,780
into the single currency
that is today's dollars.

1144
00:49:35,270 --> 00:49:39,290
So in particular, over
the course of t days,

1145
00:49:39,290 --> 00:49:43,270
days 1 through t, how many
different currencies do I

1146
00:49:43,270 --> 00:49:49,290
have apart from my base
currency of time 0 money.

1147
00:49:49,290 --> 00:49:53,060
Yeah, I've got t different
currencies, t dates.

1148
00:49:53,060 --> 00:49:55,485
Every single date, it's
a different currency.

1149
00:49:58,060 --> 00:50:00,230
And I need to convert them
in order to add them up.

1150
00:50:03,800 --> 00:50:12,040
So I'm going to argue that
sequence of cashflow, CF1, CF2,

1151
00:50:12,040 --> 00:50:14,260
dot, dot, dot-- if
I want to figure out

1152
00:50:14,260 --> 00:50:20,320
what it's worth in a single
currency, date 0 currency,

1153
00:50:20,320 --> 00:50:23,830
I got to multiply the cashflows
by the appropriate exchange

1154
00:50:23,830 --> 00:50:24,659
rate.

1155
00:50:24,659 --> 00:50:25,700
What's the exchange rate?

1156
00:50:25,700 --> 00:50:28,420
The exchange rate is
how many dollars at date

1157
00:50:28,420 --> 00:50:30,850
1 per dollar at date 0?

1158
00:50:30,850 --> 00:50:34,630
How many dollars at date
2 per date 0 dollar?

1159
00:50:34,630 --> 00:50:38,050
How many dollars at date
3 per date $0 and so on.

1160
00:50:38,050 --> 00:50:43,660
I'll have t exchange rates
for the t different kinds

1161
00:50:43,660 --> 00:50:46,540
of currencies that I have.

1162
00:50:46,540 --> 00:50:50,620
Each currency is
dollars denominated

1163
00:50:50,620 --> 00:50:54,970
as of a particular date.

1164
00:50:54,970 --> 00:50:57,470
Any questions about that?

1165
00:50:57,470 --> 00:50:58,470
Pretty straightforward.

1166
00:50:58,470 --> 00:51:00,910
You think it's
straightforward, but you're

1167
00:51:00,910 --> 00:51:02,993
going to have to think
about it for a little while

1168
00:51:02,993 --> 00:51:05,570
and do some problems to really
make sure you appreciate

1169
00:51:05,570 --> 00:51:08,930
this perspective.

1170
00:51:08,930 --> 00:51:14,450
Now we're ready to talk about
what this value operator is.

1171
00:51:14,450 --> 00:51:18,800
I'm going to argue that
once you've got the exchange

1172
00:51:18,800 --> 00:51:23,430
rates across the various
different currencies,

1173
00:51:23,430 --> 00:51:28,040
then the value of the
collection of cashflows

1174
00:51:28,040 --> 00:51:31,370
is just the sum of
all of the values

1175
00:51:31,370 --> 00:51:35,150
of the cashflows denominated
in the same currency.

1176
00:51:35,150 --> 00:51:40,010
But instead of currency, meaning
pounds or dollars or yen,

1177
00:51:40,010 --> 00:51:43,715
the currency is going
to be date 0 dollars.

1178
00:51:48,420 --> 00:51:49,530
Questions about this?

1179
00:51:49,530 --> 00:51:52,200
This is important now.

1180
00:51:52,200 --> 00:52:00,180
So I'm going to define something
called the net present value

1181
00:52:00,180 --> 00:52:10,950
operator, NPV, as the date
0 value of the cashflows.

1182
00:52:10,950 --> 00:52:13,430
Now why is this called
net present value?

1183
00:52:13,430 --> 00:52:17,540
Because typically, when you
are valuing an investment,

1184
00:52:17,540 --> 00:52:20,030
you have to pay
some money up front

1185
00:52:20,030 --> 00:52:22,670
and then you get
cashflows later on.

1186
00:52:22,670 --> 00:52:25,220
And so your net
investment is going

1187
00:52:25,220 --> 00:52:29,510
to be given by some
summation of those pieces.

1188
00:52:29,510 --> 00:52:30,979
But it's not a simple sum.

1189
00:52:30,979 --> 00:52:32,270
You can't just add the numbers.

1190
00:52:32,270 --> 00:52:37,490
That would be like adding 300
yen to 150 pounds or whatever.

1191
00:52:37,490 --> 00:52:40,970
You have to figure
out how to convert

1192
00:52:40,970 --> 00:52:48,060
all the currencies to the same
unit of account, dollars today.

1193
00:52:48,060 --> 00:52:51,770
And so that's why it's
called present value.

1194
00:52:51,770 --> 00:52:54,660
That's the value at
the present, today.

1195
00:52:54,660 --> 00:52:56,510
And the reason
it's net is you're

1196
00:52:56,510 --> 00:53:00,890
netting out any initial
investment, which

1197
00:53:00,890 --> 00:53:05,600
is the cashflow at time 0.

1198
00:53:05,600 --> 00:53:09,626
So V sub 0 is equal to CF0.

1199
00:53:09,626 --> 00:53:11,000
Notice, there's
no exchange rate,

1200
00:53:11,000 --> 00:53:13,950
because we're doing
it in today's dollars,

1201
00:53:13,950 --> 00:53:16,220
so that's the base currency--

1202
00:53:16,220 --> 00:53:18,350
plus the cashflow tomorrow.

1203
00:53:18,350 --> 00:53:20,840
Multiply by the exchange
rate between dollars tomorrow

1204
00:53:20,840 --> 00:53:23,810
and dollars today and so on.

1205
00:53:23,810 --> 00:53:25,190
If there's an
initial investment,

1206
00:53:25,190 --> 00:53:27,069
then the initial cash
flow is negative.

1207
00:53:27,069 --> 00:53:28,610
That just means you
have to put money

1208
00:53:28,610 --> 00:53:32,480
in to the project
or the investment.

1209
00:53:32,480 --> 00:53:35,870
And then, over the course
of the next t periods,

1210
00:53:35,870 --> 00:53:40,730
you get cashflows, which could
also be positive or negative.

1211
00:53:40,730 --> 00:53:44,350
And you have to convert
them into today's dollars.

1212
00:53:44,350 --> 00:53:47,630
And once you do, you
look at that number

1213
00:53:47,630 --> 00:53:50,810
and you see whether
or not you like it.

1214
00:53:50,810 --> 00:53:55,830
That's the value, the
net present value,

1215
00:53:55,830 --> 00:53:58,490
of the cashflows.

1216
00:53:58,490 --> 00:54:01,159
Now I have one unanswered
question for you.

1217
00:54:01,159 --> 00:54:03,450
What's the unanswered question
in all of this analysis?

1218
00:54:03,450 --> 00:54:04,241
Sounds good, right?

1219
00:54:04,241 --> 00:54:06,380
This is pretty simple stuff.

1220
00:54:06,380 --> 00:54:08,709
But I pulled something
out of the air.

1221
00:54:08,709 --> 00:54:10,000
What did I pull out of the air?

1222
00:54:10,000 --> 00:54:10,970
AUDIENCE: The exchange rate.

1223
00:54:10,970 --> 00:54:11,810
ANDREW LO: Exactly, exactly.

1224
00:54:11,810 --> 00:54:13,226
Where do I get the
exchange rates?

1225
00:54:13,226 --> 00:54:16,634
You should be asking me, where
do you get the exchange rates?

1226
00:54:16,634 --> 00:54:18,300
And you know what I'm
going to tell you?

1227
00:54:18,300 --> 00:54:19,966
What's the answer I'm
going to give you?

1228
00:54:19,966 --> 00:54:21,787
Where do I get the
exchange rates?

1229
00:54:21,787 --> 00:54:22,870
AUDIENCE: From the market.

1230
00:54:22,870 --> 00:54:24,400
ANDREW LO: From the
market, exactly.

1231
00:54:24,400 --> 00:54:25,720
From the market.

1232
00:54:25,720 --> 00:54:26,850
I get it from the market.

1233
00:54:26,850 --> 00:54:27,580
How do I get it from the market?

1234
00:54:27,580 --> 00:54:29,140
Well, we did it last time.

1235
00:54:29,140 --> 00:54:30,400
You know how.

1236
00:54:30,400 --> 00:54:31,760
We're going to auction it off.

1237
00:54:31,760 --> 00:54:33,340
You want to see how?

1238
00:54:33,340 --> 00:54:37,636
I've got a security that
pays $1 a year from today.

1239
00:54:37,636 --> 00:54:41,060
It pays $1 a year from today.

1240
00:54:41,060 --> 00:54:45,940
Who will offer me a penny
for that piece of paper?

1241
00:54:45,940 --> 00:54:49,340
Who will offer me $0.50
for that piece of paper?

1242
00:54:49,340 --> 00:54:51,210
$0.75?

1243
00:54:51,210 --> 00:54:52,860
$0.80?

1244
00:54:52,860 --> 00:54:54,540
$0.90?

1245
00:54:54,540 --> 00:54:56,750
$0.95?

1246
00:54:56,750 --> 00:54:59,120
$0.97?

1247
00:54:59,120 --> 00:55:01,950
$0.98?

1248
00:55:01,950 --> 00:55:03,070
Well, all right.

1249
00:55:03,070 --> 00:55:04,459
$0.97 to the dollar.

1250
00:55:04,459 --> 00:55:05,000
There you go.

1251
00:55:05,000 --> 00:55:06,541
That's the exchange
rate right there.

1252
00:55:06,541 --> 00:55:08,660
We're done.

1253
00:55:08,660 --> 00:55:10,140
And by the way, I
appreciate that.

1254
00:55:10,140 --> 00:55:12,740
That's a lot of confidence
in my credit worthiness.

1255
00:55:12,740 --> 00:55:16,100
It's only a 3% discount.

1256
00:55:16,100 --> 00:55:18,080
All right, well that's
the exchange rate

1257
00:55:18,080 --> 00:55:20,430
between today and next year.

1258
00:55:20,430 --> 00:55:22,670
What about today and
five years from now?

1259
00:55:22,670 --> 00:55:25,400
Where do we get that from?

1260
00:55:25,400 --> 00:55:26,359
AUDIENCE: The market.

1261
00:55:26,359 --> 00:55:27,650
ANDREW LO: Exactly, the market.

1262
00:55:27,650 --> 00:55:28,620
OK, I've got a piece of paper.

1263
00:55:28,620 --> 00:55:29,810
It pays $1 five years from now.

1264
00:55:29,810 --> 00:55:31,684
How many people will
pay me a penny for that?

1265
00:55:31,684 --> 00:55:33,140
We'll go through
the whole motion

1266
00:55:33,140 --> 00:55:37,340
and come up with the
same kind of process.

1267
00:55:37,340 --> 00:55:38,720
And we'll get a number.

1268
00:55:38,720 --> 00:55:41,604
So the market--
now in a few weeks,

1269
00:55:41,604 --> 00:55:43,520
we're going to have to
question whether or not

1270
00:55:43,520 --> 00:55:46,830
that is a good way of
getting the exchange rates.

1271
00:55:46,830 --> 00:55:48,980
I'm not going to talk
about that just yet.

1272
00:55:48,980 --> 00:55:51,560
But that's where we get it from.

1273
00:55:51,560 --> 00:55:53,900
So I've begged the
question a little bit,

1274
00:55:53,900 --> 00:55:56,810
but I think I've actually
made some progress

1275
00:55:56,810 --> 00:56:00,110
in providing a framework
to think about valuation.

1276
00:56:00,110 --> 00:56:01,970
Once we establish
the exchange rates,

1277
00:56:01,970 --> 00:56:07,430
you will agree with me that
I can value any, any cashflow

1278
00:56:07,430 --> 00:56:10,640
whatsoever where the
cashflow payments are known

1279
00:56:10,640 --> 00:56:14,260
with certainty in advance.

1280
00:56:14,260 --> 00:56:16,210
So that's a pretty
impressive achievement

1281
00:56:16,210 --> 00:56:18,640
in the space of 45 minutes.

1282
00:56:18,640 --> 00:56:21,310
We've actually figured out
how to value any cashflow

1283
00:56:21,310 --> 00:56:25,390
whatsoever under
perfect certainty, given

1284
00:56:25,390 --> 00:56:26,182
the exchange rates.

1285
00:56:26,182 --> 00:56:28,431
And I've told you where to
get the exchange rate from.

1286
00:56:28,431 --> 00:56:30,010
You get it from the marketplace.

1287
00:56:30,010 --> 00:56:32,070
That's why financial
markets are so important.

1288
00:56:32,070 --> 00:56:36,550
It's because we require those
inputs into our valuation

1289
00:56:36,550 --> 00:56:37,870
process for doing the analysis.

1290
00:56:37,870 --> 00:56:40,310
We rely on financial markets.

1291
00:56:40,310 --> 00:56:44,147
Financial markets didn't
exist, we can't do this.

1292
00:56:44,147 --> 00:56:45,980
I'd have to wave my
hands and say, well, you

1293
00:56:45,980 --> 00:56:48,240
can get it from some kind
of theoretical source.

1294
00:56:48,240 --> 00:56:49,330
You just make it up.

1295
00:56:49,330 --> 00:56:51,320
Just come up with some numbers.

1296
00:56:51,320 --> 00:56:53,150
That doesn't sound
very compelling.

1297
00:56:53,150 --> 00:56:54,350
And in fact, it's not.

1298
00:56:54,350 --> 00:56:57,650
The power of financial markets
is the wisdom of the crowds.

1299
00:56:57,650 --> 00:57:00,760
And like it or not, you're the
wisdom that we're tapping on.

1300
00:57:00,760 --> 00:57:03,440
We're tapping your
wisdom to come up

1301
00:57:03,440 --> 00:57:04,610
with these exchange rates.

1302
00:57:07,350 --> 00:57:11,160
So we know now that the value
of a sequence of cashflows

1303
00:57:11,160 --> 00:57:17,160
is simply equal
to today's dollars

1304
00:57:17,160 --> 00:57:20,490
when you use these exchange
rates to convert them

1305
00:57:20,490 --> 00:57:24,300
to present dollars,
dollars today.

1306
00:57:24,300 --> 00:57:27,610
And that's often
called present value.

1307
00:57:27,610 --> 00:57:31,590
Notice that these exchange
rates are sometimes

1308
00:57:31,590 --> 00:57:34,970
called discount factors.

1309
00:57:34,970 --> 00:57:36,720
The reason they're
called discount factors

1310
00:57:36,720 --> 00:57:40,260
is because typically they are
numbers that are less than 1,

1311
00:57:40,260 --> 00:57:41,550
like what we saw today.

1312
00:57:41,550 --> 00:57:46,200
$1 next year I was able to
auction off for $0.97 today.

1313
00:57:46,200 --> 00:57:50,760
That number is smaller than $1
because people are impatient.

1314
00:57:50,760 --> 00:57:53,890
$1 today is worth more
than $1 next year.

1315
00:57:53,890 --> 00:57:56,490
So if I promise
you $1 next year,

1316
00:57:56,490 --> 00:57:59,850
you're only willing to
pay me a little bit less

1317
00:57:59,850 --> 00:58:03,990
than that for that privilege.

1318
00:58:03,990 --> 00:58:09,990
So it's a discount over
what it would be on the day

1319
00:58:09,990 --> 00:58:12,152
that it gets paid.

1320
00:58:12,152 --> 00:58:13,110
AUDIENCE: One question.

1321
00:58:13,110 --> 00:58:13,735
ANDREW LO: Yes?

1322
00:58:13,735 --> 00:58:16,068
AUDIENCE: What exactly
are you discounting

1323
00:58:16,068 --> 00:58:19,026
if there's perfect, perfect?

1324
00:58:19,026 --> 00:58:21,662
My impatience?

1325
00:58:21,662 --> 00:58:23,120
ANDREW LO: That's
a great question.

1326
00:58:23,120 --> 00:58:25,570
Let me repeat it for
everybody to hear.

1327
00:58:25,570 --> 00:58:27,640
The question is, what
are you discounting

1328
00:58:27,640 --> 00:58:28,780
if there's no uncertainty?

1329
00:58:28,780 --> 00:58:33,780
Why should $1 next year be
worth less than $1 today?

1330
00:58:33,780 --> 00:58:35,190
Because there's no uncertainty.

1331
00:58:35,190 --> 00:58:37,290
I've ruled out
uncertainty, right?

1332
00:58:37,290 --> 00:58:39,000
So there's no default risk.

1333
00:58:39,000 --> 00:58:40,620
It's impatience.

1334
00:58:40,620 --> 00:58:43,920
People want to consume
now versus later.

1335
00:58:43,920 --> 00:58:46,500
And therefore, if you're
going to force somebody

1336
00:58:46,500 --> 00:58:49,890
to consume later, you've
got to somehow offer them

1337
00:58:49,890 --> 00:58:52,420
some incentive to do that.

1338
00:58:52,420 --> 00:58:56,760
So in order for me to
have you give me $1,

1339
00:58:56,760 --> 00:58:58,890
so that I can take
the dollar now,

1340
00:58:58,890 --> 00:59:00,520
and I'll pay you
back a year from now,

1341
00:59:00,520 --> 00:59:02,392
so that you can't consume
that dollar today,

1342
00:59:02,392 --> 00:59:04,350
you have to wait a year
to consume that dollar.

1343
00:59:04,350 --> 00:59:06,281
In order for me to
do that, I actually

1344
00:59:06,281 --> 00:59:07,780
have to make it
interesting for you,

1345
00:59:07,780 --> 00:59:12,281
which means you give me $0.97
now and I give you back $1

1346
00:59:12,281 --> 00:59:12,780
next year.

1347
00:59:12,780 --> 00:59:16,079
I pay you extra for that
time that you have to wait.

1348
00:59:16,079 --> 00:59:16,579
Yeah?

1349
00:59:16,579 --> 00:59:18,974
AUDIENCE: Could you
also make an argument

1350
00:59:18,974 --> 00:59:21,049
that I could take my
dollar now and give it

1351
00:59:21,049 --> 00:59:23,285
to somebody who needs to
use it now and charge them

1352
00:59:23,285 --> 00:59:26,160
for the privilege of
using my dollar now?

1353
00:59:26,160 --> 00:59:28,620
ANDREW LO: Absolutely,
absolutely.

1354
00:59:28,620 --> 00:59:30,450
We haven't talked
about the mechanism

1355
00:59:30,450 --> 00:59:33,030
for determining what
that exchange rate is.

1356
00:59:33,030 --> 00:59:34,420
And I'm going to come to that.

1357
00:59:34,420 --> 00:59:35,910
But before we even
talk about that,

1358
00:59:35,910 --> 00:59:40,350
I want to acknowledge that
it exists, and it's real,

1359
00:59:40,350 --> 00:59:41,940
and we can figure
out what it is just

1360
00:59:41,940 --> 00:59:46,920
from a simple auction of
market, and we can use it.

1361
00:59:46,920 --> 00:59:49,110
But I'm going to get to
exactly what it means

1362
00:59:49,110 --> 00:59:51,630
and how we arrive at
those exchange rates.

1363
00:59:51,630 --> 00:59:54,130
That's going to be a very
important part of this.

1364
00:59:54,130 --> 00:59:57,070
AUDIENCE: For inflation, we
know that because of inflation

1365
00:59:57,070 --> 01:00:00,780
$1 today is also much
less than $1 next year.

1366
01:00:00,780 --> 01:00:01,780
ANDREW LO: That's right.

1367
01:00:01,780 --> 01:00:02,970
I'm going to get to that
at the end of this lecture.

1368
01:00:02,970 --> 01:00:04,870
That's another reason
why there might

1369
01:00:04,870 --> 01:00:06,229
be some kind of discounting.

1370
01:00:06,229 --> 01:00:07,645
It's not just the
time preference.

1371
01:00:07,645 --> 01:00:09,160
AUDIENCE: That's
part of the answer.

1372
01:00:09,160 --> 01:00:10,657
ANDREW LO: That's
right, exactly.

1373
01:00:10,657 --> 01:00:12,490
So we're going to come
back to that as well.

1374
01:00:12,490 --> 01:00:15,790
AUDIENCE: Is there such thing
as a deflationary environment?

1375
01:00:15,790 --> 01:00:17,980
ANDREW LO: Deflation can occur.

1376
01:00:17,980 --> 01:00:20,380
Negative real interest
rates can occur

1377
01:00:20,380 --> 01:00:23,960
during certain unusual periods
of economic development.

1378
01:00:23,960 --> 01:00:26,000
So that's a possibility.

1379
01:00:26,000 --> 01:00:28,844
It's not a possibility that
we've seen in the United States

1380
01:00:28,844 --> 01:00:29,510
in recent years.

1381
01:00:29,510 --> 01:00:31,504
But other countries
have experienced that.

1382
01:00:31,504 --> 01:00:33,670
And when that happens, there
are some really serious

1383
01:00:33,670 --> 01:00:34,389
repercussions.

1384
01:00:34,389 --> 01:00:35,680
So we're going to come to that.

1385
01:00:35,680 --> 01:00:40,420
In fact, in 2004
the US government,

1386
01:00:40,420 --> 01:00:42,430
early on in that year,
was very concerned

1387
01:00:42,430 --> 01:00:44,650
about the possibility
of deflation.

1388
01:00:44,650 --> 01:00:47,260
And it was only
towards the end of 2005

1389
01:00:47,260 --> 01:00:50,320
that inflation became
more of a concern.

1390
01:00:50,320 --> 01:00:51,945
So we're going to
come to that as well.

1391
01:00:51,945 --> 01:00:54,153
AUDIENCE: Would you separate
the concept of inflation

1392
01:00:54,153 --> 01:00:55,745
from the time value of money?

1393
01:00:55,745 --> 01:00:58,120
Would you call those two
different fundamental concepts?

1394
01:00:58,120 --> 01:00:59,150
ANDREW LO: Yes, I would.

1395
01:00:59,150 --> 01:01:00,730
And let's hold off
on inflation for now,

1396
01:01:00,730 --> 01:01:02,230
because I don't want people
to get confused by it.

1397
01:01:02,230 --> 01:01:04,240
It's something I'm going to
bring in at the very end.

1398
01:01:04,240 --> 01:01:05,230
So I will come to that.

1399
01:01:05,230 --> 01:01:10,300
That is a topic for
lectures two and three.

1400
01:01:10,300 --> 01:01:14,800
So we now know how
to value cashflows,

1401
01:01:14,800 --> 01:01:18,650
at least using this very simple
framework with exchange rates.

1402
01:01:18,650 --> 01:01:20,180
And here's an example--

1403
01:01:20,180 --> 01:01:21,820
just a very, very simple one--

1404
01:01:21,820 --> 01:01:26,200
where I've got the two discount
rates, or exchange rates,

1405
01:01:26,200 --> 01:01:27,940
for next year and
the year after.

1406
01:01:27,940 --> 01:01:31,720
It's $0.90 to the dollar
and $0.80 to the dollar.

1407
01:01:31,720 --> 01:01:34,510
Notice that the farther
you go into the future,

1408
01:01:34,510 --> 01:01:38,380
the more of a discount these
exchange rates require.

1409
01:01:38,380 --> 01:01:40,840
That's also human
nature having to do

1410
01:01:40,840 --> 01:01:43,780
with impatience, and
possible inflation,

1411
01:01:43,780 --> 01:01:45,850
and other kinds of phenomena.

1412
01:01:45,850 --> 01:01:48,490
But again, I'm not going to tell
you how we got those numbers.

1413
01:01:48,490 --> 01:01:51,100
I got them from the marketplace.

1414
01:01:51,100 --> 01:01:54,400
Now what's the net present
value of a project requiring

1415
01:01:54,400 --> 01:01:56,650
a current investment
of $10 million

1416
01:01:56,650 --> 01:01:59,170
with cashflows of $5 million
in year 1 and $7 million

1417
01:01:59,170 --> 01:02:01,800
in year 2?

1418
01:02:01,800 --> 01:02:04,050
That's trivial.

1419
01:02:04,050 --> 01:02:05,130
Here you go.

1420
01:02:05,130 --> 01:02:09,990
Minus $10 million today,
$5 million next year,

1421
01:02:09,990 --> 01:02:13,950
but next year's dollars is not
the same as today's dollars,

1422
01:02:13,950 --> 01:02:16,900
so you've got to convert
it to the right currency.

1423
01:02:16,900 --> 01:02:20,400
So that's $0.90 to the
dollar multiplied by 5.

1424
01:02:20,400 --> 01:02:24,000
And then $0.80 to the
dollar multiplied by 7.

1425
01:02:24,000 --> 01:02:29,900
When you add it up you get a
$100,000 of today's dollars.

1426
01:02:29,900 --> 01:02:31,540
That's what this
investment is worth.

1427
01:02:34,130 --> 01:02:37,990
So the first question is,
should you take this investment?

1428
01:02:37,990 --> 01:02:39,640
Is it a good project?

1429
01:02:39,640 --> 01:02:42,810
Well let me ask you,
do you want a $100,000?

1430
01:02:42,810 --> 01:02:43,310
Yeah.

1431
01:02:43,310 --> 01:02:45,230
If you don't, again,
see me afterwards.

1432
01:02:45,230 --> 01:02:49,640
I will help you
with this problem.

1433
01:02:49,640 --> 01:02:52,010
Remember the first
day, I told you

1434
01:02:52,010 --> 01:02:55,220
that once you figure
out valuation,

1435
01:02:55,220 --> 01:02:58,274
management is trivial.

1436
01:02:58,274 --> 01:02:59,440
Well, I wasn't just kidding.

1437
01:02:59,440 --> 01:03:01,370
This is an example.

1438
01:03:01,370 --> 01:03:03,592
What we've been able to
do is to take a problem.

1439
01:03:03,592 --> 01:03:05,300
What's the net present
value of a project

1440
01:03:05,300 --> 01:03:07,029
requiring this
sequence of cashflows?

1441
01:03:07,029 --> 01:03:08,570
We've been able to
take that problem,

1442
01:03:08,570 --> 01:03:11,484
that management problem,
should you do this or not--

1443
01:03:11,484 --> 01:03:13,650
we've been able to reduce
that to a simple question,

1444
01:03:13,650 --> 01:03:15,770
do you want $100,000?

1445
01:03:15,770 --> 01:03:17,280
I think the answer is yes.

1446
01:03:17,280 --> 01:03:19,580
So that's the management part.

1447
01:03:19,580 --> 01:03:20,970
Let's do this.

1448
01:03:20,970 --> 01:03:22,250
Done.

1449
01:03:22,250 --> 01:03:24,224
The valuation part
is the hard part.

1450
01:03:24,224 --> 01:03:25,640
The management
part, the decision,

1451
01:03:25,640 --> 01:03:29,790
is easy once you have the
right numbers in front of you.

1452
01:03:29,790 --> 01:03:31,920
Second question--
suppose a buyer

1453
01:03:31,920 --> 01:03:34,980
wishes to purchase
this project but pay

1454
01:03:34,980 --> 01:03:38,502
for it two years from now.

1455
01:03:38,502 --> 01:03:40,210
How much should you
ask for this project?

1456
01:03:44,030 --> 01:03:48,010
Now the first thing
you need to do is what?

1457
01:03:48,010 --> 01:03:49,082
AUDIENCE: [INAUDIBLE].

1458
01:03:49,082 --> 01:03:50,790
ANDREW LO: Well, that's
the second thing.

1459
01:03:50,790 --> 01:03:52,410
The first thing you need to do--

1460
01:03:52,410 --> 01:03:54,064
draw a timeline.

1461
01:03:54,064 --> 01:03:56,230
Draw a timeline so you know
exactly what's going on.

1462
01:03:56,230 --> 01:03:57,021
Two years from now.

1463
01:03:57,021 --> 01:04:01,570
Is that next year or is
that two years from today?

1464
01:04:01,570 --> 01:04:03,600
So draw a timeline.

1465
01:04:03,600 --> 01:04:05,970
And you can figure
out, once you have

1466
01:04:05,970 --> 01:04:09,430
the timeline, what the present
values and future values are.

1467
01:04:12,120 --> 01:04:15,420
So when you work
out the numbers,

1468
01:04:15,420 --> 01:04:19,102
you can actually make a decision
and figure out exactly what

1469
01:04:19,102 --> 01:04:20,310
you ought to charge for that.

1470
01:04:23,850 --> 01:04:26,280
That's it for the
time value of money.

1471
01:04:26,280 --> 01:04:28,590
But I want to summarize
by telling you

1472
01:04:28,590 --> 01:04:31,060
what we've learned so far.

1473
01:04:31,060 --> 01:04:34,920
We've learned that we can
value cashflows-- assets, which

1474
01:04:34,920 --> 01:04:36,810
are sequences of cashflows.

1475
01:04:36,810 --> 01:04:39,420
And the way we value
that is by making

1476
01:04:39,420 --> 01:04:41,250
some implicit assumptions.

1477
01:04:41,250 --> 01:04:43,710
The assumptions are we know
the cashflows in advance,

1478
01:04:43,710 --> 01:04:46,560
so there's no uncertainty
about what the cashflows are.

1479
01:04:46,560 --> 01:04:49,660
Second, we know
the exchange rates.

1480
01:04:49,660 --> 01:04:51,464
And if you don't know
them, go get them.

1481
01:04:51,464 --> 01:04:52,380
Where do you get them?

1482
01:04:52,380 --> 01:04:54,940
You get them from
the marketplace.

1483
01:04:54,940 --> 01:04:58,900
And finally, there
are no frictions

1484
01:04:58,900 --> 01:05:00,340
in the currency conversions.

1485
01:05:00,340 --> 01:05:01,840
One thing you
didn't ask me about

1486
01:05:01,840 --> 01:05:04,345
is that typically,
when you go abroad

1487
01:05:04,345 --> 01:05:06,220
and you have to convert
your currencies, what

1488
01:05:06,220 --> 01:05:06,670
do you have to do?

1489
01:05:06,670 --> 01:05:08,795
You have to find somebody
that converts it for you.

1490
01:05:08,795 --> 01:05:13,630
And typically they will charge
you a fee for that conversion.

1491
01:05:13,630 --> 01:05:15,940
I've been talking as if
the conversions happen

1492
01:05:15,940 --> 01:05:18,040
without any kind of frictions.

1493
01:05:18,040 --> 01:05:20,890
That's an assumption
that can be tested.

1494
01:05:20,890 --> 01:05:23,800
So we're going to talk about
frictions later in the course.

1495
01:05:23,800 --> 01:05:25,630
But for now, we're
going to assume

1496
01:05:25,630 --> 01:05:28,580
that there are no frictions.

1497
01:05:28,580 --> 01:05:31,640
Now of course, these
are all hypotheticals.

1498
01:05:31,640 --> 01:05:36,260
They're all approximations to
a much more complex reality.

1499
01:05:36,260 --> 01:05:39,050
But once we understand
how the model works

1500
01:05:39,050 --> 01:05:42,090
with these simplifying
assumptions,

1501
01:05:42,090 --> 01:05:44,840
we can then go back and say, OK,
let's make the assumptions more

1502
01:05:44,840 --> 01:05:49,160
realistic, and let's see how
that affects the implications.

1503
01:05:49,160 --> 01:05:53,060
So I'm going to first do the
plain vanilla version of this.

1504
01:05:53,060 --> 01:05:55,130
And then, after we
fully understand it,

1505
01:05:55,130 --> 01:05:58,250
I'm going to come back
make this more complex.

1506
01:05:58,250 --> 01:06:00,740
So until lecture 12--

1507
01:06:00,740 --> 01:06:02,390
that's a long ways away--

1508
01:06:02,390 --> 01:06:05,690
but until lecture 12
I'm going to assume

1509
01:06:05,690 --> 01:06:08,210
that these assumptions hold.

1510
01:06:08,210 --> 01:06:11,030
And after lecture 12 I'm going
to go back and systematically

1511
01:06:11,030 --> 01:06:14,761
question, and expand and
revise, each one of these.

1512
01:06:14,761 --> 01:06:16,760
So when I told you during
the first day of class

1513
01:06:16,760 --> 01:06:19,640
that you can't handle the
truth, this is what I mean.

1514
01:06:19,640 --> 01:06:21,260
We're going to
start simple and try

1515
01:06:21,260 --> 01:06:23,480
to understand the implications
of these simplistic

1516
01:06:23,480 --> 01:06:24,380
assumptions.

1517
01:06:24,380 --> 01:06:25,755
And then, little
by little, we're

1518
01:06:25,755 --> 01:06:29,880
going to make the assumptions
closer to the truth.

1519
01:06:29,880 --> 01:06:34,860
Now more examples-- once we
understand how this exchange

1520
01:06:34,860 --> 01:06:37,410
rate mechanism
works, we can look

1521
01:06:37,410 --> 01:06:41,670
at all sorts of
other alternatives

1522
01:06:41,670 --> 01:06:45,440
to calculating value.

1523
01:06:45,440 --> 01:06:48,410
So in particular, one
question that you might ask,

1524
01:06:48,410 --> 01:06:53,510
that was asked, is $1 today
should be worth more than $1

1525
01:06:53,510 --> 01:06:55,280
in the future because
of impatience,

1526
01:06:55,280 --> 01:06:58,520
because of inflation, because
of all the reasons we described.

1527
01:06:58,520 --> 01:07:00,260
But the bottom line
is supply and demand.

1528
01:07:00,260 --> 01:07:04,190
More people want money
today than money tomorrow.

1529
01:07:04,190 --> 01:07:06,470
And so supply and
demand, bottom line,

1530
01:07:06,470 --> 01:07:10,790
dictates that there is this
difference between the two.

1531
01:07:10,790 --> 01:07:13,670
So we can actually
figure out what

1532
01:07:13,670 --> 01:07:16,670
that difference is by looking
at the exchange rates.

1533
01:07:16,670 --> 01:07:21,290
So in particular, $1 in year 0--

1534
01:07:21,290 --> 01:07:27,230
if you hold it for a year it'll
turn into $1 times something,

1535
01:07:27,230 --> 01:07:32,720
the reverse of the exchange
rate of $1 in year 1

1536
01:07:32,720 --> 01:07:35,600
brought back to year 0.

1537
01:07:35,600 --> 01:07:40,760
But I'm going to write it in
this format, 1 plus something.

1538
01:07:40,760 --> 01:07:43,220
Because remember, when
we're going the other way,

1539
01:07:43,220 --> 01:07:45,260
when we have $1 in
year 1 and we want

1540
01:07:45,260 --> 01:07:48,860
to figure out what is it
worth in today's dollars,

1541
01:07:48,860 --> 01:07:50,210
that's a discount.

1542
01:07:50,210 --> 01:07:51,707
It's a number less than 1.

1543
01:07:51,707 --> 01:07:53,540
So if you want to go
the opposite direction,

1544
01:07:53,540 --> 01:07:55,910
if I have $1 today
and I want to know

1545
01:07:55,910 --> 01:07:58,940
how much is that dollar
worth a year from now,

1546
01:07:58,940 --> 01:08:00,860
it should be greater than 1.

1547
01:08:00,860 --> 01:08:03,650
In fact, it should be the
reciprocal of the exchange

1548
01:08:03,650 --> 01:08:04,830
rate going the other way.

1549
01:08:04,830 --> 01:08:07,220
Instead of looking at
pounds, you look at yen.

1550
01:08:07,220 --> 01:08:11,240
And so it's the opposite
of the same exchange rate.

1551
01:08:11,240 --> 01:08:16,220
But the way I'm going
to write it is 1 plus r.

1552
01:08:16,220 --> 01:08:19,010
Because it'll be greater
than 1, typically, so r

1553
01:08:19,010 --> 01:08:22,670
will be a number
typically greater than 0.

1554
01:08:22,670 --> 01:08:24,439
What about for two years?

1555
01:08:24,439 --> 01:08:30,649
I'm going to simply write it
as 1 plus r quantity squared.

1556
01:08:30,649 --> 01:08:33,470
And the reason I do
that is because I'm

1557
01:08:33,470 --> 01:08:37,340
thinking about taking
that same growth rate

1558
01:08:37,340 --> 01:08:41,180
and applying it
two years in a row.

1559
01:08:41,180 --> 01:08:44,210
I could have written 1 plus z.

1560
01:08:44,210 --> 01:08:50,149
And z then would be the rate of
growth over a two year period.

1561
01:08:50,149 --> 01:08:53,569
But I like to think in
terms of annual frequencies.

1562
01:08:53,569 --> 01:08:55,370
So I'm going to
just simply assume

1563
01:08:55,370 --> 01:08:59,450
that a year is my
unit of account.

1564
01:08:59,450 --> 01:09:02,990
And then-- looking at
a one year, two year,

1565
01:09:02,990 --> 01:09:05,840
three year growth period--

1566
01:09:05,840 --> 01:09:12,050
I'm going to simply take
powers of this factor 1 plus r.

1567
01:09:12,050 --> 01:09:19,100
So $1 in year 0 is going
to be worth $1 times

1568
01:09:19,100 --> 01:09:22,680
1 plus r to the
T-th power in year

1569
01:09:22,680 --> 01:09:31,680
T. This r is often called the
opportunity cost of capital.

1570
01:09:31,680 --> 01:09:34,740
In fact there are like, five
different names for this r.

1571
01:09:34,740 --> 01:09:36,479
It's called the interest rate.

1572
01:09:36,479 --> 01:09:38,069
It's called the growth rate.

1573
01:09:38,069 --> 01:09:39,747
It's called the cost of capital.

1574
01:09:39,747 --> 01:09:41,580
It's called the opportunity
cost of capital.

1575
01:09:41,580 --> 01:09:44,100
John Maynard Keynes
called it the user cost.

1576
01:09:44,100 --> 01:09:46,005
There are tons of
names for this quantity

1577
01:09:46,005 --> 01:09:51,602
but the basic idea is it's the
reverse of the exchange rates

1578
01:09:51,602 --> 01:09:54,060
that we were looking at before
when we were trying to bring

1579
01:09:54,060 --> 01:09:57,557
everything to today's dollars.

1580
01:09:57,557 --> 01:09:59,140
Now the reason I'm
showing this to you

1581
01:09:59,140 --> 01:10:01,150
is because it turns
out that we're

1582
01:10:01,150 --> 01:10:05,170
going to want to move money
back and forth through time.

1583
01:10:05,170 --> 01:10:07,450
And in order to do that, we
need to sometimes multiply

1584
01:10:07,450 --> 01:10:08,710
and sometimes divide.

1585
01:10:08,710 --> 01:10:11,590
And I want to come up with
just one set of notation,

1586
01:10:11,590 --> 01:10:14,740
as opposed to all these
exchange rates floating around.

1587
01:10:14,740 --> 01:10:17,092
So remember when
we had T periods

1588
01:10:17,092 --> 01:10:19,300
and I wanted to figure out
what the value of an asset

1589
01:10:19,300 --> 01:10:21,010
was today given T periods.

1590
01:10:21,010 --> 01:10:23,130
We had to have T exchange rates.

1591
01:10:23,130 --> 01:10:27,130
That's a pain in the neck
to carry around T numbers.

1592
01:10:27,130 --> 01:10:29,830
And moreover, there
are exchange rates

1593
01:10:29,830 --> 01:10:33,610
that you have to deal with
between dates T plus k and T

1594
01:10:33,610 --> 01:10:35,170
plus j.

1595
01:10:35,170 --> 01:10:37,420
So any two dates,
you've got to have

1596
01:10:37,420 --> 01:10:39,680
an exchange rate between them.

1597
01:10:39,680 --> 01:10:41,790
So pretty soon the
number of exchanges

1598
01:10:41,790 --> 01:10:45,520
you've got to keep in
your head is ridiculous.

1599
01:10:45,520 --> 01:10:47,500
That's why they came
up with the Euro.

1600
01:10:47,500 --> 01:10:50,440
They tried to unify some
of these exchange rates.

1601
01:10:50,440 --> 01:10:54,400
So here is a way to unify all
of the exchange rates into one

1602
01:10:54,400 --> 01:10:57,530
number, little r.

1603
01:10:57,530 --> 01:10:59,990
Once you know little
r you know everything.

1604
01:10:59,990 --> 01:11:03,020
You know all the exchange rates
for every possible two dates

1605
01:11:03,020 --> 01:11:05,560
that you care about.

1606
01:11:05,560 --> 01:11:07,420
Now where do we get
a little r from?

1607
01:11:07,420 --> 01:11:08,650
AUDIENCE: The market.

1608
01:11:08,650 --> 01:11:09,460
ANDREW LO: Exactly.

1609
01:11:09,460 --> 01:11:10,450
You're learning.

1610
01:11:10,450 --> 01:11:12,430
So we get it from the market.

1611
01:11:12,430 --> 01:11:15,160
Now it's going to be a little
bit more complicated than that.

1612
01:11:15,160 --> 01:11:18,170
It turns out that the market's
going to give us many different

1613
01:11:18,170 --> 01:11:19,270
r's.

1614
01:11:19,270 --> 01:11:21,160
So we're not going
to get to that yet.

1615
01:11:21,160 --> 01:11:25,690
So for now, let's just assume
that the market gives us one

1616
01:11:25,690 --> 01:11:28,450
r, this r.

1617
01:11:28,450 --> 01:11:31,360
Once you have this
one number, r,

1618
01:11:31,360 --> 01:11:35,450
it will allow you to do
all of these calculations

1619
01:11:35,450 --> 01:11:36,176
back and forth.

1620
01:11:36,176 --> 01:11:37,550
You can move money
back and forth

1621
01:11:37,550 --> 01:11:40,550
through time because you
will know what the exchange

1622
01:11:40,550 --> 01:11:44,265
rate is between any two points
in your cashflow sequence.

1623
01:11:47,480 --> 01:11:50,210
Now that we have
the r, let's go back

1624
01:11:50,210 --> 01:11:52,324
and figure out what
the exchange rates are,

1625
01:11:52,324 --> 01:11:54,740
what we were talking about in
terms of bringing stuff back

1626
01:11:54,740 --> 01:11:57,440
to date 0.

1627
01:11:57,440 --> 01:12:00,200
And it turns out that
there's a really simple form.

1628
01:12:00,200 --> 01:12:04,460
It turns out that $1 in year 1--

1629
01:12:04,460 --> 01:12:07,197
if you paid me $1
in year 1, and I

1630
01:12:07,197 --> 01:12:08,780
wanted to figure out
what it was worth

1631
01:12:08,780 --> 01:12:13,840
today given this r
number that I used,

1632
01:12:13,840 --> 01:12:18,240
it's actually just equal
to $1 divided by 1 plus r.

1633
01:12:20,750 --> 01:12:22,804
So what's the exchange rate?

1634
01:12:22,804 --> 01:12:23,462
AUDIENCE: O.

1635
01:12:23,462 --> 01:12:24,420
ANDREW LO: What's that?

1636
01:12:24,420 --> 01:12:25,400
AUDIENCE: O.

1637
01:12:25,400 --> 01:12:27,410
ANDREW LO: That's not
the exchange rate.

1638
01:12:27,410 --> 01:12:32,120
What's the exchange rate that
allows us to take $1 next year

1639
01:12:32,120 --> 01:12:34,344
and bring it to $1 today?

1640
01:12:34,344 --> 01:12:35,610
AUDIENCE: Is it 1 over--

1641
01:12:35,610 --> 01:12:37,976
ANDREW LO: It's 1 over 1 plus r.

1642
01:12:37,976 --> 01:12:40,410
1 over 1 plus r.

1643
01:12:40,410 --> 01:12:43,100
Remember, r is a
number greater than 0.

1644
01:12:43,100 --> 01:12:47,420
So 1 over 1 plus r is a
number less than 1, like $0.97

1645
01:12:47,420 --> 01:12:48,840
to the dollar.

1646
01:12:48,840 --> 01:12:51,950
So the exchange rate between
next year's dollar and today's

1647
01:12:51,950 --> 01:12:56,120
dollar is 1 over 1 plus r.

1648
01:12:56,120 --> 01:12:59,120
What about the exchange
rate between $1 two years

1649
01:12:59,120 --> 01:13:00,410
from now and today.

1650
01:13:00,410 --> 01:13:02,950
What is that?

1651
01:13:02,950 --> 01:13:04,740
1 over 1 plus r-squared.

1652
01:13:04,740 --> 01:13:05,940
That's right.

1653
01:13:05,940 --> 01:13:07,830
And so on.

1654
01:13:07,830 --> 01:13:11,970
So the exchange rates,
or discount factors,

1655
01:13:11,970 --> 01:13:16,050
are simply related to the
little r's in this manner.

1656
01:13:21,560 --> 01:13:26,660
That's the mechanics and
mathematics of present value.

1657
01:13:26,660 --> 01:13:29,300
Now this might seem intuitive.

1658
01:13:29,300 --> 01:13:31,460
And when I say it you
might understand it

1659
01:13:31,460 --> 01:13:33,290
or you might think you do.

1660
01:13:33,290 --> 01:13:37,070
Please, go back-- between
today and Wednesday

1661
01:13:37,070 --> 01:13:40,940
go over this and test yourself.

1662
01:13:40,940 --> 01:13:43,910
Try to figure out
for a given r--

1663
01:13:43,910 --> 01:13:48,450
if you have $100
today, and r is 7%,

1664
01:13:48,450 --> 01:13:50,870
what is $100 worth
three years from now?

1665
01:13:50,870 --> 01:13:53,151
Or if you have $180
three years from now,

1666
01:13:53,151 --> 01:13:55,400
and you want to figure out
what it's going to be worth

1667
01:13:55,400 --> 01:14:01,190
not three years from now but a
year from now, and the r is 8%,

1668
01:14:01,190 --> 01:14:02,600
what is it equal to?

1669
01:14:02,600 --> 01:14:05,120
Test yourself by coming
up with little examples

1670
01:14:05,120 --> 01:14:08,444
to challenge your own
understanding of this concept.

1671
01:14:08,444 --> 01:14:09,860
Because it's going
to be critical.

1672
01:14:09,860 --> 01:14:11,810
We have to get this
right, because everything

1673
01:14:11,810 --> 01:14:14,000
that we build from
here on in is going

1674
01:14:14,000 --> 01:14:19,280
to rest on the foundations
of these calculations.

1675
01:14:19,280 --> 01:14:21,740
Now, with these r's,
I'm going to leave you

1676
01:14:21,740 --> 01:14:23,810
with this one last
concept, which

1677
01:14:23,810 --> 01:14:27,470
is that the value of
the cashflows that we've

1678
01:14:27,470 --> 01:14:30,530
been talking about
at time 0 is simply

1679
01:14:30,530 --> 01:14:32,670
equal to the cashflows
multiplied by the exchange

1680
01:14:32,670 --> 01:14:33,170
rates.

1681
01:14:33,170 --> 01:14:36,530
And now, with this definition
of r, this opportunity,

1682
01:14:36,530 --> 01:14:40,640
cost of capital, this interest
rate, this discount rate,

1683
01:14:40,640 --> 01:14:44,690
we then have an expression for
what this value operator ought

1684
01:14:44,690 --> 01:14:45,190
to be.

1685
01:14:48,260 --> 01:14:52,040
Using this expression,
any cashflow in the world

1686
01:14:52,040 --> 01:14:54,980
can be valued under
perfect certainty

1687
01:14:54,980 --> 01:14:57,110
and under the assumptions
that we described.

1688
01:14:57,110 --> 01:14:59,600
Any cashflow can be
valued, therefore

1689
01:14:59,600 --> 01:15:02,550
any asset can be valued.

1690
01:15:02,550 --> 01:15:06,260
So what we've done in
the space of a lecture

1691
01:15:06,260 --> 01:15:09,320
is to create a
valuation operator that

1692
01:15:09,320 --> 01:15:12,040
works for virtually
anything under the sun

1693
01:15:12,040 --> 01:15:14,240
in certain simplified
circumstances.

1694
01:15:14,240 --> 01:15:15,420
That's a major achievement.

1695
01:15:15,420 --> 01:15:18,990
You can congratulate yourself
that we've reached this level.

1696
01:15:18,990 --> 01:15:20,939
But we're going to have
to do some more work

1697
01:15:20,939 --> 01:15:22,230
to think about how to use this.

1698
01:15:22,230 --> 01:15:23,310
So we're not done yet.

1699
01:15:23,310 --> 01:15:25,820
We have some additional
analysis to do.

1700
01:15:25,820 --> 01:15:27,960
But this is a wonderful
starting point.

1701
01:15:27,960 --> 01:15:31,550
Next time, we're going to focus
on how to take this and apply

1702
01:15:31,550 --> 01:15:35,660
it to two very, very special
cashflows, an annuity

1703
01:15:35,660 --> 01:15:36,510
and a perpetuity.

1704
01:15:36,510 --> 01:15:37,730
And you know what
this is going to do?

1705
01:15:37,730 --> 01:15:40,188
This is going to allow you to
figure out what your mortgage

1706
01:15:40,188 --> 01:15:42,980
payments are every month, when
you go apply for a mortgage.

1707
01:15:42,980 --> 01:15:45,260
You'd be surprised at how
subtle that calculation is

1708
01:15:45,260 --> 01:15:47,420
and how many bankers
don't know how to do it.

1709
01:15:47,420 --> 01:15:48,560
Well, you will.

1710
01:15:48,560 --> 01:15:50,870
All right, I'll
see you next time.

1711
01:15:50,870 --> 01:15:53,920
[APPLAUSE]