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ANDREW LO: These are the
financial highlights of Lehman

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00:00:29,410 --> 00:00:31,780
Brothers as of the end of 2007.

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00:00:31,780 --> 00:00:33,430
Now, you can get more
recent highlights

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00:00:33,430 --> 00:00:35,380
from looking at
their SEC filings,

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00:00:35,380 --> 00:00:38,170
their 10-K and 10-Qs
which are accounting

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00:00:38,170 --> 00:00:41,060
reports that they provide to
the SEC on a quarterly basis.

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00:00:41,060 --> 00:00:44,710
But I just thought we'd take a
look at the annual financials

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00:00:44,710 --> 00:00:46,860
of this business.

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00:00:46,860 --> 00:00:52,840
At the end of 2007, the net
revenues for Lehman Brothers

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00:00:52,840 --> 00:00:56,100
was $19 billion.

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00:00:56,100 --> 00:01:01,560
This is a firm that earned $19
billion in revenues in 2007.

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00:01:01,560 --> 00:01:04,709
We're not talking about
a small little shop here.

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00:01:04,709 --> 00:01:07,170
This is a major
financial institution.

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00:01:07,170 --> 00:01:10,770
And if you look at their
profits, their net income,

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00:01:10,770 --> 00:01:14,670
$4 billion of net
income in 2007.

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00:01:14,670 --> 00:01:20,240
And 2007 was not a great
year, so $4 billion of income

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00:01:20,240 --> 00:01:22,900
is a pretty impressive number.

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00:01:22,900 --> 00:01:28,500
And if you look at their
long-term capital, the capital

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00:01:28,500 --> 00:01:32,140
base, we're looking
at $145 billion.

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00:01:32,140 --> 00:01:37,760
And if you take a look at
their assets under management,

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00:01:37,760 --> 00:01:46,456
the assets under management,
in billions, is $282 billion

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00:01:46,456 --> 00:01:49,830
of assets under management.

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00:01:49,830 --> 00:01:53,780
Now, at the end of
2007, would anybody

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have forecasted that
a company like this

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00:01:57,530 --> 00:01:59,660
could be gone nine months later?

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00:01:59,660 --> 00:02:04,370
Gone-- I mean, just obliterated.

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00:02:04,370 --> 00:02:09,139
28,500 employees, so we're
talking about major disruption

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00:02:09,139 --> 00:02:11,090
to the New York workforce.

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00:02:11,090 --> 00:02:13,400
A number of people are going
to be looking for jobs.

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00:02:13,400 --> 00:02:15,140
Now, a number of
jobs are going to be

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00:02:15,140 --> 00:02:19,120
created as a consequence
of these dislocations.

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00:02:19,120 --> 00:02:21,310
I'll come to that in a minute.

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00:02:21,310 --> 00:02:24,760
But this is an
extraordinary set of events.

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00:02:24,760 --> 00:02:30,300
And one key to what's
going on and why

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00:02:30,300 --> 00:02:34,760
this might have happened
is this number right here,

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00:02:34,760 --> 00:02:37,330
the net leverage ratio.

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00:02:37,330 --> 00:02:40,060
That net leverage
ratio tells you

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00:02:40,060 --> 00:02:46,240
something about how much
exposure Lehman Brothers had

46
00:02:46,240 --> 00:02:52,240
relative to how much capital
they're actually managing.

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00:02:52,240 --> 00:02:55,120
And let me give you an example
of what I mean by that.

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00:02:55,120 --> 00:02:56,630
And I'm going to give you a
personal example that we're

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00:02:56,630 --> 00:02:57,546
going to come back to.

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00:02:57,546 --> 00:02:59,260
We talked about
mortgages last time,

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00:02:59,260 --> 00:03:01,510
and I told you all that
you now have the power

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00:03:01,510 --> 00:03:03,710
to compute mortgage payments.

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00:03:03,710 --> 00:03:05,950
Well, you know that a
mortgage is a loan, right?

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00:03:05,950 --> 00:03:07,450
You're borrowing
money from the bank

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00:03:07,450 --> 00:03:10,950
to buy this beautiful home
that you want to live in.

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00:03:10,950 --> 00:03:13,080
Does anybody know how
much money you typically

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00:03:13,080 --> 00:03:16,350
have to put down
when you buy a home?

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00:03:16,350 --> 00:03:16,850
Yeah.

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00:03:16,850 --> 00:03:17,460
AUDIENCE: [INAUDIBLE]

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00:03:17,460 --> 00:03:19,001
ANDREW LO: 20% is
the typical number,

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00:03:19,001 --> 00:03:21,820
although in recent years,
it's much less than that.

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00:03:21,820 --> 00:03:27,000
For example, when I first
bought my home way back in 1988,

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00:03:27,000 --> 00:03:30,480
my first home, when I
moved here to Boston,

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00:03:30,480 --> 00:03:34,070
I actually only
had to put 5% down

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00:03:34,070 --> 00:03:39,710
because I was able to get a
jumbo loan and, in addition,

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00:03:39,710 --> 00:03:43,610
purchase mortgage insurance
so that the bank was

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00:03:43,610 --> 00:03:48,350
willing to lend me quite a bit
more than they usually would.

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00:03:48,350 --> 00:03:50,570
Now, let's take the 20%
down as the standard number

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00:03:50,570 --> 00:03:54,320
because that is absolutely
industry standard.

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00:03:54,320 --> 00:03:59,137
If you put down 20% for,
let's say, a $500,000 home--

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00:03:59,137 --> 00:04:01,220
which in the Boston area
is a little starter home,

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00:04:01,220 --> 00:04:02,430
I'm afraid--

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00:04:02,430 --> 00:04:07,390
a half a million dollar
home you put down $100,000.

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00:04:07,390 --> 00:04:10,570
And the bank lends you $400,000.

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00:04:10,570 --> 00:04:15,130
The value of your total assets
is, of course, 500,000, right?

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00:04:15,130 --> 00:04:18,310
You've got 100,000 of your own
money, 400,000 of the bank's

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00:04:18,310 --> 00:04:21,010
money, and with that 500,000,
you give it to the other party

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00:04:21,010 --> 00:04:22,040
to buy the home.

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00:04:22,040 --> 00:04:27,070
And now you are the happy
owners of a $500,000 home.

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What kind of leverage ratio do
you have in that circumstance?

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00:04:30,250 --> 00:04:32,567
Anybody calculate that quickly?

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00:04:32,567 --> 00:04:34,555
AUDIENCE: It's 4 to 1?

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00:04:34,555 --> 00:04:37,390
ANDREW LO: Close, but no cigar.

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00:04:37,390 --> 00:04:38,830
5 to 1, right?

85
00:04:38,830 --> 00:04:42,340
5 to 1 in the sense that you
have five times leverage.

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00:04:42,340 --> 00:04:43,930
Your total exposure is 500.

87
00:04:43,930 --> 00:04:45,070
You've got 100.

88
00:04:45,070 --> 00:04:46,600
It's 5 to 1.

89
00:04:46,600 --> 00:04:49,150
Now, what does that
mean, 5 to 1 leverage?

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00:04:49,150 --> 00:04:50,750
That sounds scary.

91
00:04:50,750 --> 00:04:54,460
That sounds like you
are really levered up.

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00:04:54,460 --> 00:04:59,110
Well, it's only scary if
the value of the assets

93
00:04:59,110 --> 00:05:02,230
swings around a lot.

94
00:05:02,230 --> 00:05:04,720
For example, let's do a
simple back-of-the-envelope

95
00:05:04,720 --> 00:05:06,290
calculation.

96
00:05:06,290 --> 00:05:11,590
Suppose house
prices fall by 10%.

97
00:05:11,590 --> 00:05:13,320
That's only 10%, right?

98
00:05:13,320 --> 00:05:14,380
That's not a huge number.

99
00:05:14,380 --> 00:05:17,530
It's significant,
but it's not huge.

100
00:05:17,530 --> 00:05:20,980
What's the return
on your investment?

101
00:05:20,980 --> 00:05:22,780
How much have you
invested in the home?

102
00:05:22,780 --> 00:05:23,530
AUDIENCE: 100,000.

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00:05:23,530 --> 00:05:25,390
ANDREW LO: $100,000.

104
00:05:25,390 --> 00:05:28,750
If the value of the
home falls by 10%,

105
00:05:28,750 --> 00:05:31,340
how much has the value
of your assets fallen by?

106
00:05:31,340 --> 00:05:33,010
50,000, right?

107
00:05:33,010 --> 00:05:37,355
Of that 50,000, how
much does the bank lose?

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00:05:37,355 --> 00:05:37,980
AUDIENCE: None.

109
00:05:37,980 --> 00:05:40,450
ANDREW LO: None, right,
because they've lent you money,

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00:05:40,450 --> 00:05:42,140
and they expect
you to pay it back.

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00:05:42,140 --> 00:05:43,360
They're not equity holders.

112
00:05:43,360 --> 00:05:45,970
They're not looking to
take on any downside risk.

113
00:05:45,970 --> 00:05:48,410
They just want their
money back with interest.

114
00:05:48,410 --> 00:05:51,400
So the bank doesn't
care what the value is.

115
00:05:51,400 --> 00:05:55,540
They still expect you to pay
back the $400,000 that they

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00:05:55,540 --> 00:05:57,200
lent you with interest.

117
00:05:57,200 --> 00:06:02,330
So that $50,000
loss, it's all yours.

118
00:06:02,330 --> 00:06:08,820
And you've put down 100,000,
and you've lost 50--

119
00:06:08,820 --> 00:06:10,980
half of your assets
just got wiped out

120
00:06:10,980 --> 00:06:16,560
with only a 10% move in
the value of the home.

121
00:06:16,560 --> 00:06:18,990
Now, instead of putting 20%
down as a standard, what

122
00:06:18,990 --> 00:06:23,510
if you did what I did,
which is you put down 5%?

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00:06:23,510 --> 00:06:29,490
So 5% of $500,000
is $25,000, right?

124
00:06:29,490 --> 00:06:32,850
The bank lends you $475,000.

125
00:06:32,850 --> 00:06:34,650
So this is not a
conforming loan.

126
00:06:34,650 --> 00:06:38,340
You've got to buy insurance,
and it's subprime,

127
00:06:38,340 --> 00:06:39,900
so on and so forth.

128
00:06:39,900 --> 00:06:44,050
5% is your investment, $25,000.

129
00:06:44,050 --> 00:06:49,920
Now, suppose housing
prices go down by 10%.

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00:06:49,920 --> 00:06:53,098
What's the return
on your capital?

131
00:06:53,098 --> 00:06:54,550
AUDIENCE: Negative.

132
00:06:54,550 --> 00:06:57,530
ANDREW LO: Well, you've
lost everything, right?

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00:06:57,530 --> 00:07:02,840
The $50,000 loss is still
there, but you only put in 25.

134
00:07:02,840 --> 00:07:06,830
So you've now lost all of your
capital, and on top of that,

135
00:07:06,830 --> 00:07:11,180
you're in the hole
for another 25.

136
00:07:11,180 --> 00:07:16,550
So you've actually lost not
only all of your wealth,

137
00:07:16,550 --> 00:07:19,440
but actually, you've
lost more than all of it.

138
00:07:19,440 --> 00:07:23,960
You've lost minus 100% of your
wealth or your total return.

139
00:07:23,960 --> 00:07:28,470
Your net return is minus 200%.

140
00:07:28,470 --> 00:07:32,130
So, if you're a major
financial institution,

141
00:07:32,130 --> 00:07:39,140
and you're leveraged 16 to 1,
and the value of that portfolio

142
00:07:39,140 --> 00:07:46,730
declines by 10% or 20%, you
can go through capital very,

143
00:07:46,730 --> 00:07:47,960
very quickly.

144
00:07:47,960 --> 00:07:49,570
Now let's do a back
of the envelope.

145
00:07:49,570 --> 00:07:51,430
The amount of capital
that they have-- let's

146
00:07:51,430 --> 00:07:53,620
go up and take a look at this.

147
00:07:53,620 --> 00:07:57,520
The amount of capital that
Lehman had is something like--

148
00:07:57,520 --> 00:08:03,120
total long-term capital
$145 billion, OK?

149
00:08:03,120 --> 00:08:10,040
If you leverage that 16 to 1,
and then you ask the question,

150
00:08:10,040 --> 00:08:13,030
with that leverage
amount of capital,

151
00:08:13,030 --> 00:08:18,020
if it drops by, I
don't know, 10%, 5%,

152
00:08:18,020 --> 00:08:22,330
7% of that total
asset base, you can

153
00:08:22,330 --> 00:08:25,120
see how you can go through
$145 billion of capital

154
00:08:25,120 --> 00:08:28,500
pretty quickly with leverage.

155
00:08:28,500 --> 00:08:31,210
Now, you might ask, why on
earth would anybody do this?

156
00:08:31,210 --> 00:08:34,289
Why would you leverage 16 to 1?

157
00:08:34,289 --> 00:08:38,610
Well, why would anybody
buy a house in New England

158
00:08:38,610 --> 00:08:40,820
with 5% down?

159
00:08:40,820 --> 00:08:41,809
That's just as crazy.

160
00:08:41,809 --> 00:08:44,717
What's the leverage
ratio if you put 5% down?

161
00:08:44,717 --> 00:08:45,855
AUDIENCE: 20 to 1.

162
00:08:45,855 --> 00:08:47,230
ANDREW LO: 20 to
1, exactly, so I

163
00:08:47,230 --> 00:08:51,852
was a proud leveraged investor
that had 20 to 1 leverage.

164
00:08:51,852 --> 00:08:52,810
I beat Lehman Brothers.

165
00:08:55,570 --> 00:08:56,440
Why would I do that?

166
00:08:56,440 --> 00:08:58,270
Is that insane?

167
00:08:58,270 --> 00:08:59,032
Well, yeah.

168
00:08:59,032 --> 00:09:01,240
AUDIENCE: So you don't
[? tie ?] up too much capital.

169
00:09:01,240 --> 00:09:02,320
ANDREW LO: Well, yes.

170
00:09:02,320 --> 00:09:04,030
That's a very polite
way of saying it.

171
00:09:04,030 --> 00:09:06,405
Yes, I would tie up too much
capital if I didn't do that.

172
00:09:06,405 --> 00:09:08,420
The fact is, I didn't
have the capital.

173
00:09:08,420 --> 00:09:10,920
So thank you for being kind.

174
00:09:10,920 --> 00:09:12,310
But why wasn't it nuts?

175
00:09:12,310 --> 00:09:13,436
Yeah.

176
00:09:13,436 --> 00:09:16,459
AUDIENCE: [INAUDIBLE]

177
00:09:16,459 --> 00:09:17,250
ANDREW LO: Exactly.

178
00:09:17,250 --> 00:09:20,420
If the value goes
up, then I earn

179
00:09:20,420 --> 00:09:22,800
that kind of money,
the same kind of money.

180
00:09:22,800 --> 00:09:28,340
So if housing prices go up by
10%, then at 20 to 1 leverage,

181
00:09:28,340 --> 00:09:30,410
I look like a hedge
fund manager, right?

182
00:09:30,410 --> 00:09:32,929
Make a ton of money, but
that's not the only reason

183
00:09:32,929 --> 00:09:34,970
that I'm willing to do
that because you're saying

184
00:09:34,970 --> 00:09:37,580
that I want to take that risk.

185
00:09:37,580 --> 00:09:39,170
Why would I do that?

186
00:09:39,170 --> 00:09:40,522
Yeah, Michael.

187
00:09:40,522 --> 00:09:42,230
AUDIENCE: Well, your
risk seems very low.

188
00:09:42,230 --> 00:09:42,963
ANDREW LO: Why?

189
00:09:42,963 --> 00:09:44,463
AUDIENCE: Well, in
the past, there's

190
00:09:44,463 --> 00:09:46,379
nothing to indicate that
prices would go down.

191
00:09:46,379 --> 00:09:47,210
ANDREW LO: Exactly.

192
00:09:47,210 --> 00:09:52,130
The risk of 20 to 1
leverage is only a risk

193
00:09:52,130 --> 00:09:55,460
if the amount of housing
price fluctuation

194
00:09:55,460 --> 00:09:58,310
is such that it could
actually wipe me out.

195
00:09:58,310 --> 00:10:01,580
But up until very
recently, housing prices

196
00:10:01,580 --> 00:10:03,590
have done nothing but this.

197
00:10:03,590 --> 00:10:04,816
They've gone up.

198
00:10:04,816 --> 00:10:06,440
And not only have
they gone up, they've

199
00:10:06,440 --> 00:10:10,160
gone up in a very smooth
and orderly fashion.

200
00:10:10,160 --> 00:10:13,640
You know, if house prices went
up by 15% a year every year,

201
00:10:13,640 --> 00:10:16,289
you might be thrilled,
but also a bit scared.

202
00:10:16,289 --> 00:10:17,330
That's not what happened.

203
00:10:17,330 --> 00:10:19,413
Housing prices have gone
up, maybe, I don't know--

204
00:10:19,413 --> 00:10:23,580
8%, 10%, 7%, 5%, 6%.

205
00:10:23,580 --> 00:10:26,490
It's been relatively smooth.

206
00:10:26,490 --> 00:10:29,610
And so the volatility,
the volatility

207
00:10:29,610 --> 00:10:32,670
of those kinds of
investments were low enough

208
00:10:32,670 --> 00:10:35,130
that the leverage
didn't scare me at all.

209
00:10:35,130 --> 00:10:37,320
And in fact, I
didn't lose money.

210
00:10:37,320 --> 00:10:40,410
I held that house for
about five or six years

211
00:10:40,410 --> 00:10:44,080
and bought another
one, and it was fine.

212
00:10:44,080 --> 00:10:46,680
It was fine because
that kind of leverage

213
00:10:46,680 --> 00:10:49,730
is not a problem as
long as the volatility

214
00:10:49,730 --> 00:10:53,980
of the overall investment
wasn't out of hand.

215
00:10:53,980 --> 00:10:56,830
What happened over the
last two or three years

216
00:10:56,830 --> 00:10:59,540
is that the volatility
has gotten out of hand.

217
00:10:59,540 --> 00:11:01,780
And we're going to talk
about that Wednesday

218
00:11:01,780 --> 00:11:03,040
at that pro seminar.

219
00:11:03,040 --> 00:11:05,620
I'm going to give you a concrete
illustration not only of how

220
00:11:05,620 --> 00:11:09,640
it got out of hand, but
how financial engineering

221
00:11:09,640 --> 00:11:12,220
and the design of
derivative securities

222
00:11:12,220 --> 00:11:16,330
to expand the housing market and
provide people with these loans

223
00:11:16,330 --> 00:11:19,120
exacerbated the problem
on the downside.

224
00:11:19,120 --> 00:11:21,310
But of course, the
purpose of it was

225
00:11:21,310 --> 00:11:22,750
to help people on the upside.

226
00:11:22,750 --> 00:11:24,850
It's exactly looking
at the investments

227
00:11:24,850 --> 00:11:29,210
going up and thinking that,
gee, they could never come down.

228
00:11:29,210 --> 00:11:29,878
Yeah, question.

229
00:11:29,878 --> 00:11:32,253
AUDIENCE: What about the fact
that at the end of the day,

230
00:11:32,253 --> 00:11:33,862
you can live in your house?

231
00:11:33,862 --> 00:11:35,854
And the total valuation
of your house,

232
00:11:35,854 --> 00:11:38,350
if it goes down $100,000,
it's still a [INAUDIBLE]..

233
00:11:38,350 --> 00:11:39,221
ANDREW LO: Right.

234
00:11:39,221 --> 00:11:41,220
AUDIENCE: So you only
have to deal with the mark

235
00:11:41,220 --> 00:11:42,560
to market [? up and down. ?]

236
00:11:42,560 --> 00:11:44,560
ANDREW LO: That's a
very important point.

237
00:11:44,560 --> 00:11:46,190
The mark to market.

238
00:11:46,190 --> 00:11:48,450
What does mark to market mean?

239
00:11:48,450 --> 00:11:49,119
Anybody know?

240
00:11:49,119 --> 00:11:50,910
We've never used that
term in class so far.

241
00:11:50,910 --> 00:11:51,582
Yeah.

242
00:11:51,582 --> 00:11:54,294
AUDIENCE: It's something that
book value gets [? matched ?]

243
00:11:54,294 --> 00:11:55,650
[? together with ?] reality.

244
00:11:55,650 --> 00:11:56,650
ANDREW LO: That's right.

245
00:11:56,650 --> 00:12:00,000
When something that may
have a book value gets

246
00:12:00,000 --> 00:12:04,810
marked to a reality check
in terms of market price.

247
00:12:04,810 --> 00:12:06,660
So for example,
the first lecture,

248
00:12:06,660 --> 00:12:09,450
where I auctioned off
that little tiny box

249
00:12:09,450 --> 00:12:11,400
that you had no idea
what was in there,

250
00:12:11,400 --> 00:12:13,350
it had no market
value beforehand,

251
00:12:13,350 --> 00:12:15,720
at least not to any of you.

252
00:12:15,720 --> 00:12:17,730
But we marked it to market.

253
00:12:17,730 --> 00:12:21,100
We marked it to
market at 45 bucks.

254
00:12:21,100 --> 00:12:23,780
And so it established
a market price.

255
00:12:23,780 --> 00:12:28,300
Now, the question is, who cares
what the value of the house is?

256
00:12:28,300 --> 00:12:30,280
You're living in it,
you're enjoying it,

257
00:12:30,280 --> 00:12:32,039
so what's the big deal?

258
00:12:32,039 --> 00:12:32,830
Well, that's right.

259
00:12:32,830 --> 00:12:36,490
It's not a big deal if you
enjoy living in the house,

260
00:12:36,490 --> 00:12:39,610
and you can afford to pay
the mortgage, and you're OK.

261
00:12:39,610 --> 00:12:43,490
And millions of homeowners
are exactly in that situation.

262
00:12:43,490 --> 00:12:45,440
So we can't forget that.

263
00:12:45,440 --> 00:12:48,190
That the subprime mortgage
has enabled literally

264
00:12:48,190 --> 00:12:51,250
millions of homeowners
to become homeowners

265
00:12:51,250 --> 00:12:53,700
who never could have.

266
00:12:53,700 --> 00:12:57,480
But what if there's a problem
in terms of interest rates going

267
00:12:57,480 --> 00:13:00,180
up and your mortgage
payment going up

268
00:13:00,180 --> 00:13:03,270
because you ended up
getting a very low teaser

269
00:13:03,270 --> 00:13:05,250
rate for your mortgage?

270
00:13:05,250 --> 00:13:06,840
You've got an
adjustable rate mortgage

271
00:13:06,840 --> 00:13:08,880
because they said, gee,
you could buy this house

272
00:13:08,880 --> 00:13:10,650
with virtually no money down.

273
00:13:10,650 --> 00:13:13,560
And you've got
plenty of resources

274
00:13:13,560 --> 00:13:16,500
to be able to pay for it because
your payment is only $300

275
00:13:16,500 --> 00:13:17,280
a month.

276
00:13:17,280 --> 00:13:19,560
And then, a year later,
that mortgage payment

277
00:13:19,560 --> 00:13:20,940
is $1,000 a month.

278
00:13:20,940 --> 00:13:22,710
Then it's a real problem.

279
00:13:22,710 --> 00:13:25,110
OK, then you've got a decision.

280
00:13:25,110 --> 00:13:27,750
The decision is, are
you going to keep

281
00:13:27,750 --> 00:13:32,310
paying all of your income
and have a hard time making

282
00:13:32,310 --> 00:13:37,060
ends meet for a house
that you'll never

283
00:13:37,060 --> 00:13:38,230
get the money back?

284
00:13:38,230 --> 00:13:41,410
It's literally taking
your money and burning it

285
00:13:41,410 --> 00:13:43,450
because you've lost your equity.

286
00:13:43,450 --> 00:13:45,520
And you've lost so much
more beyond your equity

287
00:13:45,520 --> 00:13:47,260
that in order to
make money you'd

288
00:13:47,260 --> 00:13:49,330
have to hold onto the
house for 20 years,

289
00:13:49,330 --> 00:13:52,940
and you can't afford
the house anyway.

290
00:13:52,940 --> 00:13:54,436
Do you do that?

291
00:13:54,436 --> 00:13:56,060
Or do you put the
key in the front door

292
00:13:56,060 --> 00:13:59,150
and move out and say, you know
what, bank, it's all yours.

293
00:13:59,150 --> 00:14:00,990
I'm moving on.

294
00:14:00,990 --> 00:14:02,740
That's what's happened
across the country.

295
00:14:02,740 --> 00:14:05,280
It's the fact that people
can't afford these mortgages

296
00:14:05,280 --> 00:14:08,016
because they got in
at low teaser rates,

297
00:14:08,016 --> 00:14:10,140
and now the rates have come
up because the interest

298
00:14:10,140 --> 00:14:11,490
rates have been going up.

299
00:14:11,490 --> 00:14:14,430
Now, something very significant
is going to happen tomorrow.

300
00:14:14,430 --> 00:14:17,100
Tomorrow, the Fed
is almost surely

301
00:14:17,100 --> 00:14:19,350
going to cut rates
because they want

302
00:14:19,350 --> 00:14:23,580
to reduce the pressure
on the system for exactly

303
00:14:23,580 --> 00:14:24,510
these kinds of issues.

304
00:14:24,510 --> 00:14:28,320
They want to reduce the
kind of default rates.

305
00:14:28,320 --> 00:14:31,020
And by keeping
interest rates low,

306
00:14:31,020 --> 00:14:33,600
they actually are going
to be able to encourage

307
00:14:33,600 --> 00:14:36,300
liquidity and reduce
the kind of pressure

308
00:14:36,300 --> 00:14:37,400
that we've been seeing.

309
00:14:37,400 --> 00:14:39,329
Yeah, question.

310
00:14:39,329 --> 00:14:40,704
AUDIENCE: I was
going to ask what

311
00:14:40,704 --> 00:14:44,220
happens if you put your 5%
down, and the value of the house

312
00:14:44,220 --> 00:14:48,415
goes down, say, 25%,
it's been only a year.

313
00:14:48,415 --> 00:14:50,531
You feel like you're not
going to get-- it's never

314
00:14:50,531 --> 00:14:51,447
going to come back up.

315
00:14:51,447 --> 00:14:55,050
Can you literally just go to
the bank and say it's yours?

316
00:14:55,050 --> 00:14:57,660
ANDREW LO: Well, that depends
on what you signed when you got

317
00:14:57,660 --> 00:14:59,010
your mortgage from the bank.

318
00:14:59,010 --> 00:15:03,090
Most mortgage contracts are
known as non-recourse loans,

319
00:15:03,090 --> 00:15:06,806
meaning that they've got
your house as collateral,

320
00:15:06,806 --> 00:15:07,930
but that's all they've got.

321
00:15:07,930 --> 00:15:09,640
They don't have
your firstborn, they

322
00:15:09,640 --> 00:15:13,129
don't have your pinky finger.

323
00:15:13,129 --> 00:15:15,170
And depending on where
you borrow, in some cases,

324
00:15:15,170 --> 00:15:17,440
you may have to give that up.

325
00:15:17,440 --> 00:15:20,470
But no, the fact of the
matter is the most they can do

326
00:15:20,470 --> 00:15:23,530
is take your house
away and sell it.

327
00:15:23,530 --> 00:15:27,340
And a lot of homeowners are
saying, great, it's all yours.

328
00:15:27,340 --> 00:15:29,022
I'm moving out of
Stockton, California.

329
00:15:29,022 --> 00:15:29,980
I don't need the house.

330
00:15:29,980 --> 00:15:31,870
I don't need to have
these mortgage payments

331
00:15:31,870 --> 00:15:34,670
where I'm throwing in
good money after bad.

332
00:15:34,670 --> 00:15:36,460
That's their perspective.

333
00:15:36,460 --> 00:15:38,410
AUDIENCE: What about
your credit score?

334
00:15:38,410 --> 00:15:40,618
ANDREW LO: Yes, so your
credit score will go to hell.

335
00:15:40,618 --> 00:15:41,520
So you wait.

336
00:15:41,520 --> 00:15:43,450
So you'll wait five
years or seven years,

337
00:15:43,450 --> 00:15:46,360
and then you'll be back again.

338
00:15:46,360 --> 00:15:49,120
There's a finite
limit on how long

339
00:15:49,120 --> 00:15:51,910
they can keep those
kind of credit scores.

340
00:15:51,910 --> 00:15:56,080
And beyond a certain point,
you will have a clean record.

341
00:15:56,080 --> 00:15:58,931
But even with that
bad credit score--

342
00:15:58,931 --> 00:16:01,180
I mean, don't forget, that's
how the subprime mortgage

343
00:16:01,180 --> 00:16:02,110
market got created.

344
00:16:02,110 --> 00:16:03,341
You saw the TV ads, right?

345
00:16:03,341 --> 00:16:04,840
Doesn't matter if
you're in default,

346
00:16:04,840 --> 00:16:06,310
doesn't matter if
you have no credit,

347
00:16:06,310 --> 00:16:07,935
doesn't matter if
you don't have a job,

348
00:16:07,935 --> 00:16:10,110
we'll still give you a loan.

349
00:16:10,110 --> 00:16:13,420
Now, that's not true today,
or not as true today,

350
00:16:13,420 --> 00:16:15,820
but at some point when
the market recovers,

351
00:16:15,820 --> 00:16:17,680
we're going to see
that come back again.

352
00:16:17,680 --> 00:16:21,645
And so you will be
able to borrow again.

353
00:16:21,645 --> 00:16:23,285
Yeah.

354
00:16:23,285 --> 00:16:25,493
AUDIENCE: Given that the
interest rates are now going

355
00:16:25,493 --> 00:16:27,810
up, does that mean
the [INAUDIBLE]----

356
00:16:27,810 --> 00:16:30,370
ANDREW LO: Going down.

357
00:16:30,370 --> 00:16:35,457
AUDIENCE: Despite the fact that
the financial cut [INAUDIBLE],,

358
00:16:35,457 --> 00:16:39,086
the actual interest rate
that homeowners are paying

359
00:16:39,086 --> 00:16:39,900
hasn't changed.

360
00:16:39,900 --> 00:16:40,140
ANDREW LO: Right.

361
00:16:40,140 --> 00:16:42,431
AUDIENCE: So does that mean
that those with good credit

362
00:16:42,431 --> 00:16:44,840
are effectively subsidizing
those with bad credit?

363
00:16:44,840 --> 00:16:47,530
ANDREW LO: Well, yes and no.

364
00:16:47,530 --> 00:16:49,810
I mean, I think that
the subsidization

365
00:16:49,810 --> 00:16:53,500
that you're talking about really
happens very, very indirectly.

366
00:16:53,500 --> 00:16:56,740
The fact that there are
large numbers of defaults

367
00:16:56,740 --> 00:16:59,980
ultimately may mean that it's
harder to get a subprime loan.

368
00:16:59,980 --> 00:17:01,630
So the folks that
are actually good

369
00:17:01,630 --> 00:17:05,710
credits, but don't meet the
prime borrowing rate criteria,

370
00:17:05,710 --> 00:17:07,970
yes, they will suffer.

371
00:17:07,970 --> 00:17:11,660
But at equilibrium-- by
equilibrium I mean when supply

372
00:17:11,660 --> 00:17:13,430
equals demand--

373
00:17:13,430 --> 00:17:15,710
the price is the
price is the price.

374
00:17:15,710 --> 00:17:20,030
So it depends on what kind
of a borrower you are,

375
00:17:20,030 --> 00:17:22,310
but whatever type
of borrower you

376
00:17:22,310 --> 00:17:26,210
are, if you can signal that
that's the type you are,

377
00:17:26,210 --> 00:17:29,090
you will be able to get that
appropriate kind of credit.

378
00:17:29,090 --> 00:17:31,220
All right, so in
that sense, it's

379
00:17:31,220 --> 00:17:33,530
not as if taxpayers
are footing the bill

380
00:17:33,530 --> 00:17:36,590
for the particular interest
rate shifts that are going on.

381
00:17:36,590 --> 00:17:39,050
Taxpayers may end up
footing the bill for what

382
00:17:39,050 --> 00:17:41,450
happened with Bear Stearns,
what happened with Fannie

383
00:17:41,450 --> 00:17:42,740
Mae and Freddie Mac.

384
00:17:42,740 --> 00:17:45,910
And that's one of the reasons
why, over the weekend,

385
00:17:45,910 --> 00:17:48,380
when the Fed was approached
by Lehman Brothers and said,

386
00:17:48,380 --> 00:17:50,480
hey, you've got to
help us out here,

387
00:17:50,480 --> 00:17:52,280
the Fed said, you know what?

388
00:17:52,280 --> 00:17:53,210
We're done with that.

389
00:17:53,210 --> 00:17:56,870
You know, sorry, but we can't
ask the American taxpayer

390
00:17:56,870 --> 00:17:58,400
to foot this bill either.

391
00:17:58,400 --> 00:18:01,190
Otherwise there's going
to be tremendous backlash.

392
00:18:01,190 --> 00:18:03,410
And so when Lehman
Brothers was left

393
00:18:03,410 --> 00:18:06,050
without backing
from the Fed, they

394
00:18:06,050 --> 00:18:09,289
went to a number of private
organizations like Barclays.

395
00:18:09,289 --> 00:18:11,330
Barclays said that they
would be willing to do it

396
00:18:11,330 --> 00:18:13,850
if the Fed was able to
provide some kind of backstop.

397
00:18:13,850 --> 00:18:15,766
The Fed was not willing
to provide a backstop,

398
00:18:15,766 --> 00:18:17,690
so Barclays said
thanks, but no thanks.

399
00:18:17,690 --> 00:18:21,410
And at that point, Lehman said,
we have no choice because we

400
00:18:21,410 --> 00:18:26,090
cannot close a sale within a
matter of 24 to 48 hours from

401
00:18:26,090 --> 00:18:27,230
this point on.

402
00:18:27,230 --> 00:18:29,030
And we've got some
notes coming up.

403
00:18:29,030 --> 00:18:32,820
We've got to do something,
so they filed for Chapter 11.

404
00:18:32,820 --> 00:18:33,590
Yeah.

405
00:18:33,590 --> 00:18:35,030
AUDIENCE: If they cut the
rates [? as far as ?] they do,

406
00:18:35,030 --> 00:18:36,470
what's the negative part?

407
00:18:36,470 --> 00:18:37,430
Inflation?

408
00:18:37,430 --> 00:18:38,340
ANDREW LO: Yes.

409
00:18:38,340 --> 00:18:40,490
We're actually going
to talk about that

410
00:18:40,490 --> 00:18:42,860
in this next segment--

411
00:18:42,860 --> 00:18:43,760
inflation.

412
00:18:43,760 --> 00:18:47,210
If the Fed cuts
rates, one could argue

413
00:18:47,210 --> 00:18:49,430
that the reason we're
in the mess that we are

414
00:18:49,430 --> 00:18:51,860
is because the Fed
had kept the Fed funds

415
00:18:51,860 --> 00:18:55,820
rate so low for so long
that even after the stock

416
00:18:55,820 --> 00:18:58,310
market crashed with the
internet bubble bursting,

417
00:18:58,310 --> 00:19:01,790
the housing market
continued on with its bubble

418
00:19:01,790 --> 00:19:03,830
because it was still
so cheap to borrow.

419
00:19:03,830 --> 00:19:06,131
And I'm sure I've
mentioned before

420
00:19:06,131 --> 00:19:08,630
that when I was an assistant
professor at the Wharton School

421
00:19:08,630 --> 00:19:11,550
back in 1986 looking
to buy a house,

422
00:19:11,550 --> 00:19:15,070
the 30-year fixed was at 18%.

423
00:19:15,070 --> 00:19:17,170
18% for a 30-year
fixed mortgage.

424
00:19:17,170 --> 00:19:20,180
I didn't do it because I
couldn't afford it at the time,

425
00:19:20,180 --> 00:19:22,570
but think about
that versus today.

426
00:19:22,570 --> 00:19:27,970
Mortgage rates are maybe at
a recent high of 6%, 7%, 8%.

427
00:19:27,970 --> 00:19:32,320
That's not bad, relative
to historical standards.

428
00:19:32,320 --> 00:19:35,430
OK, so yes, I mean, I
think that's the concern

429
00:19:35,430 --> 00:19:37,810
that if we keep
interest rates too low,

430
00:19:37,810 --> 00:19:39,580
that's going to
encourage inflation.

431
00:19:39,580 --> 00:19:41,530
And inflation will
have its own costs.

432
00:19:41,530 --> 00:19:45,760
Anybody who's from any
Latin American country

433
00:19:45,760 --> 00:19:49,184
will know the ghost of inflation
is tremendously frightening.

434
00:19:49,184 --> 00:19:51,100
And we don't want to let
that get out of hand.

435
00:19:51,100 --> 00:19:53,290
If you remember
back to the 1970s,

436
00:19:53,290 --> 00:19:56,650
we had some inflation in the
US that was a real problem.

437
00:19:56,650 --> 00:20:00,000
So we're going to talk about
that in just a couple minutes.

438
00:20:00,000 --> 00:20:00,970
Any other?

439
00:20:00,970 --> 00:20:01,737
Yes.

440
00:20:01,737 --> 00:20:05,216
AUDIENCE: I mean, is one
thing to do [INAUDIBLE]..

441
00:20:05,216 --> 00:20:07,204
You said that when
the market comes back,

442
00:20:07,204 --> 00:20:10,190
we will still have
another bubble.

443
00:20:10,190 --> 00:20:11,550
ANDREW LO: Absolutely, yes.

444
00:20:11,550 --> 00:20:13,650
AUDIENCE: And do you
think this is reasonable?

445
00:20:13,650 --> 00:20:15,840
ANDREW LO: Do I think
it's reasonable?

446
00:20:15,840 --> 00:20:18,810
You're not allowed to ask
that question to an economist.

447
00:20:18,810 --> 00:20:22,680
Or rather, an economist is
not allowed to answer that.

448
00:20:22,680 --> 00:20:26,580
Reasonable is relative.

449
00:20:26,580 --> 00:20:29,704
And there are moral
and ethical overtones

450
00:20:29,704 --> 00:20:31,620
that economists don't
like to get involved in.

451
00:20:31,620 --> 00:20:33,400
It's human nature.

452
00:20:33,400 --> 00:20:38,017
Is it human to suffer
from fear and greed?

453
00:20:38,017 --> 00:20:39,600
Well, yes, and I
don't think I'm going

454
00:20:39,600 --> 00:20:42,210
to change that any
time soon, nor are you

455
00:20:42,210 --> 00:20:44,590
going to be able to
change that any time soon.

456
00:20:44,590 --> 00:20:47,070
So that's one of
the reasons why we

457
00:20:47,070 --> 00:20:51,140
study finance is to develop an
intellectual and disciplined

458
00:20:51,140 --> 00:20:52,890
framework for thinking
about these issues.

459
00:20:52,890 --> 00:20:54,840
Because if you
don't, if you don't

460
00:20:54,840 --> 00:20:57,180
have a framework for
thinking about this,

461
00:20:57,180 --> 00:21:00,090
then you're left responding
to fear and greed.

462
00:21:00,090 --> 00:21:05,430
Right now, we are in the
absolute grips of fear.

463
00:21:05,430 --> 00:21:07,320
Those of you who aren't
in financial markets,

464
00:21:07,320 --> 00:21:09,210
if you read the papers,
my guess is you'll

465
00:21:09,210 --> 00:21:11,690
start getting scared anyway.

466
00:21:11,690 --> 00:21:13,230
And if you're in
financial markets,

467
00:21:13,230 --> 00:21:15,960
I promise you this
is the scariest time

468
00:21:15,960 --> 00:21:21,660
that we've been in, including
August of '98, October '87,

469
00:21:21,660 --> 00:21:25,050
'94, 2001.

470
00:21:25,050 --> 00:21:28,440
All of the kind of periods
of market dislocation

471
00:21:28,440 --> 00:21:32,102
is trumped by what's been going
on over the last few weeks.

472
00:21:32,102 --> 00:21:34,560
And it's exciting from the
point of view of being a finance

473
00:21:34,560 --> 00:21:36,930
student because you actually
have the opportunity

474
00:21:36,930 --> 00:21:40,160
to understand and do
something about this.

475
00:21:40,160 --> 00:21:43,020
But it requires a certain
discipline to do that.

476
00:21:43,020 --> 00:21:44,110
Yeah, Ingrid.

477
00:21:44,110 --> 00:21:46,610
AUDIENCE: What does it exactly
mean that Lehman Brothers are

478
00:21:46,610 --> 00:21:47,110
bankrupt?

479
00:21:47,110 --> 00:21:51,264
Because everybody, I guess
it's not a written one,

480
00:21:51,264 --> 00:21:54,510
but if I have some
money deposited there,

481
00:21:54,510 --> 00:21:58,410
will they give it back to
me because I am a liability?

482
00:21:58,410 --> 00:22:01,330
ANDREW LO: Well, that's
exactly the problem.

483
00:22:01,330 --> 00:22:03,470
The answer is I don't know.

484
00:22:03,470 --> 00:22:05,970
And that's one of the reasons
why there is this dislocation.

485
00:22:05,970 --> 00:22:07,710
Nobody knows
because nobody knows

486
00:22:07,710 --> 00:22:11,310
how large the losses could be.

487
00:22:11,310 --> 00:22:13,159
And part of the thing
is that the losses

488
00:22:13,159 --> 00:22:14,950
at Lehman and other
financial institutions,

489
00:22:14,950 --> 00:22:15,991
including Merrill Lynch--

490
00:22:15,991 --> 00:22:18,720
Merrill Lynch in some ways has
bigger exposure than Lehman.

491
00:22:18,720 --> 00:22:20,220
The difference is
that Merrill Lynch

492
00:22:20,220 --> 00:22:21,690
has other sources
of revenue that

493
00:22:21,690 --> 00:22:25,440
are able to let it get
through this situation a bit

494
00:22:25,440 --> 00:22:27,330
more gracefully.

495
00:22:27,330 --> 00:22:29,220
But the problem is we
don't know because we

496
00:22:29,220 --> 00:22:32,910
don't know how the value
of these large assets

497
00:22:32,910 --> 00:22:34,080
are going to be valued.

498
00:22:34,080 --> 00:22:37,110
If you value them at zero,
then they're in deep trouble.

499
00:22:37,110 --> 00:22:38,567
And not only are
the shareholders

500
00:22:38,567 --> 00:22:40,650
going to get wiped out,
but a lot of the creditors

501
00:22:40,650 --> 00:22:41,850
are going to get wiped out.

502
00:22:41,850 --> 00:22:44,700
If you value them at
what they're valued now,

503
00:22:44,700 --> 00:22:47,790
well, then there are going to
be some hiccups along the way,

504
00:22:47,790 --> 00:22:49,710
but a number of
people should get out

505
00:22:49,710 --> 00:22:53,127
without outrageous losses.

506
00:22:53,127 --> 00:22:55,626
AUDIENCE: And can't you sort
of declare default, stop paying

507
00:22:55,626 --> 00:23:02,009
now, until thing get better?

508
00:23:02,009 --> 00:23:04,300
I'm sort of applying my Latin
American experience here.

509
00:23:04,300 --> 00:23:05,910
ANDREW LO: Yes, yes.

510
00:23:05,910 --> 00:23:08,970
I mean that's exactly what
filing for bankruptcy does.

511
00:23:08,970 --> 00:23:12,450
When you file for bankruptcy,
you basically go to the courts

512
00:23:12,450 --> 00:23:17,670
and say, I cannot
make good on my IOUs.

513
00:23:17,670 --> 00:23:20,200
And I recognize that
this is a problem.

514
00:23:20,200 --> 00:23:24,420
So I'm going to ask the court
to appoint a conservator

515
00:23:24,420 --> 00:23:29,250
or supervisor to
oversee the disposition

516
00:23:29,250 --> 00:23:32,130
and dissolution of
my assets in order

517
00:23:32,130 --> 00:23:36,540
to make an orderly transition
to pay off all of the creditors.

518
00:23:36,540 --> 00:23:39,440
And you know who's last in line?

519
00:23:39,440 --> 00:23:40,009
Shareholders.

520
00:23:40,009 --> 00:23:40,550
That's right.

521
00:23:40,550 --> 00:23:42,620
So most people think
the shareholders

522
00:23:42,620 --> 00:23:44,670
are going to get
nothing, which is

523
00:23:44,670 --> 00:23:47,850
kind of astonishing because
take a look at their closing

524
00:23:47,850 --> 00:23:49,920
price in 2007.

525
00:23:49,920 --> 00:23:55,300
The closing price of Lehman
Brothers stock, $62 a share

526
00:23:55,300 --> 00:23:57,280
at the end of 2007.

527
00:23:57,280 --> 00:24:00,520
Nine months later,
it's worth zero.

528
00:24:00,520 --> 00:24:03,700
Zero, from $62 a share.

529
00:24:03,700 --> 00:24:07,240
That's a huge
destruction of value.

530
00:24:07,240 --> 00:24:07,990
And you know what?

531
00:24:07,990 --> 00:24:13,870
Part of that loss in value is
really due to the loss of brand

532
00:24:13,870 --> 00:24:17,030
and the loss of
business viability.

533
00:24:17,030 --> 00:24:19,120
It's intangible assets.

534
00:24:19,120 --> 00:24:22,810
It's not like all of a sudden,
the Lehman investment bankers

535
00:24:22,810 --> 00:24:26,380
and proprietary traders
and asset managers,

536
00:24:26,380 --> 00:24:29,150
they had brain damage and
they're a lot stupider

537
00:24:29,150 --> 00:24:30,350
than they used to be.

538
00:24:30,350 --> 00:24:32,980
They're just as smart, just
as savvy, just as experienced,

539
00:24:32,980 --> 00:24:36,100
just as knowledgeable
as ever were.

540
00:24:36,100 --> 00:24:38,560
The problem is that
because of the magnitude

541
00:24:38,560 --> 00:24:41,710
of their exposures,
there is general concern

542
00:24:41,710 --> 00:24:43,870
about their viability
as a business.

543
00:24:43,870 --> 00:24:46,180
And when you don't want to
do business with them, when

544
00:24:46,180 --> 00:24:48,179
everybody doesn't want
to do business with them,

545
00:24:48,179 --> 00:24:50,140
when nobody wants to
do business with them,

546
00:24:50,140 --> 00:24:51,550
they're not a business.

547
00:24:51,550 --> 00:24:55,870
And the value of their
business goes to zero.

548
00:24:55,870 --> 00:24:58,110
And so there's a
chicken and egg problem

549
00:24:58,110 --> 00:25:01,020
and you know the bottom
line is that irrespective

550
00:25:01,020 --> 00:25:03,520
of whether it's the chicken or
the egg, when the egg breaks,

551
00:25:03,520 --> 00:25:05,200
you're done.

552
00:25:05,200 --> 00:25:07,060
Yeah?

553
00:25:07,060 --> 00:25:10,165
AUDIENCE: [INAUDIBLE]
Bear Stearns [INAUDIBLE]

554
00:25:10,165 --> 00:25:10,790
extremely high?

555
00:25:10,790 --> 00:25:12,710
ANDREW LO: Yes, what
happened with Lehman

556
00:25:12,710 --> 00:25:14,600
is quite similar to
what happened with Bear.

557
00:25:14,600 --> 00:25:21,710
Except that with Bear,
there was a panic

558
00:25:21,710 --> 00:25:25,950
that was triggered by what seems
to be some kind of a rumor,

559
00:25:25,950 --> 00:25:28,550
not necessarily large
exposures coming due.

560
00:25:28,550 --> 00:25:30,380
Bear Stearns
actually hedge funds

561
00:25:30,380 --> 00:25:33,740
that were engaged in these kinds
of subprime mortgages, CDOs

562
00:25:33,740 --> 00:25:35,300
and CDSs.

563
00:25:35,300 --> 00:25:38,360
Those funds went under
during the summer.

564
00:25:38,360 --> 00:25:41,540
But Bear Stearns as a business
collapsed because individuals

565
00:25:41,540 --> 00:25:43,760
really didn't want to
do business with it

566
00:25:43,760 --> 00:25:45,140
because of this kind of a risk.

567
00:25:45,140 --> 00:25:47,030
And the same thing
happened at Lehman.

568
00:25:47,030 --> 00:25:48,830
Except Lehman's exposure
was much larger.

569
00:25:48,830 --> 00:25:50,830
They have much larger
exposure to these markets.

570
00:25:50,830 --> 00:25:52,610
They're one of the
biggest players

571
00:25:52,610 --> 00:25:55,130
in these particular
kinds of securities.

572
00:25:55,130 --> 00:25:57,705
OK, because we're
running short on time,

573
00:25:57,705 --> 00:25:59,330
I'd like to just take
one more question

574
00:25:59,330 --> 00:26:00,962
and then let me go
on with our lecture.

575
00:26:00,962 --> 00:26:02,420
And believe it or
not, we are going

576
00:26:02,420 --> 00:26:04,700
to cover material
exactly related

577
00:26:04,700 --> 00:26:07,200
to this when we start talking
about fixed income securities.

578
00:26:07,200 --> 00:26:09,282
So this is very much apropos.

579
00:26:09,282 --> 00:26:11,553
Yeah, [INAUDIBLE].

580
00:26:11,553 --> 00:26:13,365
AUDIENCE: How do you
think this affects us

581
00:26:13,365 --> 00:26:15,630
in terms of the people
that want to [? be bias? ?]

582
00:26:15,630 --> 00:26:18,490
ANDREW LO: Yeah, great question.

583
00:26:18,490 --> 00:26:22,910
AUDIENCE: [? 25,000 ?] people
from Lehman [INAUDIBLE] jobs

584
00:26:22,910 --> 00:26:23,974
[INAUDIBLE].

585
00:26:23,974 --> 00:26:24,890
ANDREW LO: Absolutely.

586
00:26:24,890 --> 00:26:26,670
So this is a great question.

587
00:26:26,670 --> 00:26:29,220
I'm actually talk about that
specifically Wednesday evening.

588
00:26:29,220 --> 00:26:32,220
But let me let me give
you the short answer now.

589
00:26:32,220 --> 00:26:35,940
The short answer is that within
the next two or three months,

590
00:26:35,940 --> 00:26:38,550
Wall Street will be frozen.

591
00:26:40,994 --> 00:26:43,160
They're going to be a deer
caught in the headlights.

592
00:26:43,160 --> 00:26:44,687
They won't know what's going on.

593
00:26:44,687 --> 00:26:46,520
They won't know what
their hiring plans are.

594
00:26:46,520 --> 00:26:48,750
They won't know the
number of slots.

595
00:26:48,750 --> 00:26:50,590
There's resumes
flying back and forth.

596
00:26:50,590 --> 00:26:53,090
So it's going to be a bit of
chaos for the next two or three

597
00:26:53,090 --> 00:26:54,660
months.

598
00:26:54,660 --> 00:26:57,240
It's not clear that that's
going to affect you.

599
00:26:57,240 --> 00:27:00,450
Because internships
still have to be filled.

600
00:27:00,450 --> 00:27:05,250
Entry level positions are
actually of least concern

601
00:27:05,250 --> 00:27:07,260
to businesses because
those are the ones

602
00:27:07,260 --> 00:27:10,140
that they want to fill
because the new generation are

603
00:27:10,140 --> 00:27:12,120
hungry and smart.

604
00:27:12,120 --> 00:27:14,519
Ready to do anything, take
on anything, and cheap.

605
00:27:14,519 --> 00:27:15,060
That's right.

606
00:27:15,060 --> 00:27:18,960
I didn't want to say
that but you said that.

607
00:27:18,960 --> 00:27:19,622
Good value.

608
00:27:19,622 --> 00:27:20,580
Let me put it that way.

609
00:27:20,580 --> 00:27:23,251
You're a good value.

610
00:27:23,251 --> 00:27:24,750
So what's going to
happen is it will

611
00:27:24,750 --> 00:27:27,420
be virtually impossible
for a senior managing

612
00:27:27,420 --> 00:27:29,970
director from one
firm to easily get

613
00:27:29,970 --> 00:27:31,890
a job at another firm
within the next two

614
00:27:31,890 --> 00:27:34,320
or three months until
things settle down.

615
00:27:34,320 --> 00:27:37,110
At the entry level job
market, I suspect that there

616
00:27:37,110 --> 00:27:38,730
will be some disruption.

617
00:27:38,730 --> 00:27:41,370
For example, just
a simple indication

618
00:27:41,370 --> 00:27:44,580
of that today after
my 4 o'clock session,

619
00:27:44,580 --> 00:27:47,370
I was supposed to meet with
the CFO of Bank of America, Joe

620
00:27:47,370 --> 00:27:48,090
Price.

621
00:27:48,090 --> 00:27:49,650
As many of you
know, we established

622
00:27:49,650 --> 00:27:51,108
a relationship with
Bank of America

623
00:27:51,108 --> 00:27:54,750
just recently-- the Laboratory
for Financial Engineering

624
00:27:54,750 --> 00:27:57,750
to work with B of A to do
some interesting research

625
00:27:57,750 --> 00:28:00,570
and to get access to
their tremendous database.

626
00:28:00,570 --> 00:28:02,880
And we were going to launch
that set of discussions

627
00:28:02,880 --> 00:28:05,730
today with Joe Price.

628
00:28:05,730 --> 00:28:07,920
Not surprisingly, at
3:00 in the morning,

629
00:28:07,920 --> 00:28:09,990
I got an email from
a B of A employee

630
00:28:09,990 --> 00:28:12,904
saying that he will not be
coming to MIT today after all.

631
00:28:12,904 --> 00:28:14,070
He was a little bit tied up.

632
00:28:16,710 --> 00:28:21,360
By the way, B of A also looked
at Lehman over the weekend.

633
00:28:21,360 --> 00:28:25,664
So over the weekend, B of A
folks wee pretty busy shopping.

634
00:28:25,664 --> 00:28:26,580
They looked at Lehman.

635
00:28:26,580 --> 00:28:30,600
But again, when the
Fed wouldn't guarantee

636
00:28:30,600 --> 00:28:35,260
any kind of a backstop for
Lehman, B of A passed as well.

637
00:28:35,260 --> 00:28:37,610
So that's an example of
the kind of dislocation

638
00:28:37,610 --> 00:28:38,360
I'm talking about.

639
00:28:38,360 --> 00:28:41,520
There will be scheduling
glitches and things like that.

640
00:28:41,520 --> 00:28:45,580
Going forward though, after
the two or three months,

641
00:28:45,580 --> 00:28:48,130
I actually think this
is a fantastic time

642
00:28:48,130 --> 00:28:49,600
to get into the industry.

643
00:28:49,600 --> 00:28:53,290
Because when you have
these kind of dislocations,

644
00:28:53,290 --> 00:28:55,480
opportunities get created.

645
00:28:55,480 --> 00:28:58,540
And opportunities for
people that are smart,

646
00:28:58,540 --> 00:29:00,610
that are hungry, that are
willing to work hard--

647
00:29:00,610 --> 00:29:02,740
I mean, that's exactly
the kind of situation

648
00:29:02,740 --> 00:29:03,880
that you want to be in.

649
00:29:03,880 --> 00:29:06,850
When things are going
well, they don't need you.

650
00:29:06,850 --> 00:29:09,130
They're going to hire
people just to be clerks

651
00:29:09,130 --> 00:29:10,900
and to get people lunch.

652
00:29:10,900 --> 00:29:14,180
But now is the time where you
can actually have a big impact.

653
00:29:14,180 --> 00:29:16,690
So rather than be discouraged,
I think all of you

654
00:29:16,690 --> 00:29:20,524
have perfect timing in terms
of being in school now.

655
00:29:20,524 --> 00:29:21,940
In two years time,
you'll get out.

656
00:29:21,940 --> 00:29:23,620
That's when all
of the businesses

657
00:29:23,620 --> 00:29:26,500
are going to be recovering and
certainly doing quite well,

658
00:29:26,500 --> 00:29:27,460
I suspect.

659
00:29:27,460 --> 00:29:29,450
And even within the
next six months,

660
00:29:29,450 --> 00:29:31,302
you're going to see
that a number of firms

661
00:29:31,302 --> 00:29:32,260
are going to be hiring.

662
00:29:32,260 --> 00:29:34,385
And by the way, the
dislocation we're talking about

663
00:29:34,385 --> 00:29:35,980
is on the broker-dealer side.

664
00:29:35,980 --> 00:29:39,310
On the asset management side,
hedge funds, pension funds,

665
00:29:39,310 --> 00:29:42,070
asset management companies,
foundations, endowments,

666
00:29:42,070 --> 00:29:44,650
non-financial corporations--
they're hiring

667
00:29:44,650 --> 00:29:47,320
and they need people
with financial expertise

668
00:29:47,320 --> 00:29:50,050
to deal with these kind
of market dislocations.

669
00:29:50,050 --> 00:29:52,090
So I think that the job
prospects are actually

670
00:29:52,090 --> 00:29:55,030
quite bright for this
class and the class after.

671
00:29:55,030 --> 00:29:57,910
The folks that are going to be
in a little bit of a tough bind

672
00:29:57,910 --> 00:30:00,757
are the second years who will
be interviewing for their jobs

673
00:30:00,757 --> 00:30:02,090
in the next two or three months.

674
00:30:02,090 --> 00:30:04,274
They may end up having to
wait a little bit longer.

675
00:30:04,274 --> 00:30:06,190
And I suspect that they
will take a little bit

676
00:30:06,190 --> 00:30:07,510
longer to settle on their jobs.

677
00:30:07,510 --> 00:30:10,030
But even then, MIT
students end up having

678
00:30:10,030 --> 00:30:12,130
a bit of an advantage
over other MBAs simply

679
00:30:12,130 --> 00:30:15,900
because of the expertise
that we bring to the table.

680
00:30:15,900 --> 00:30:16,430
OK.

681
00:30:16,430 --> 00:30:18,430
So sorry about taking
them so much of your time,

682
00:30:18,430 --> 00:30:21,699
but I think this is relevant and
will be useful for what we're

683
00:30:21,699 --> 00:30:22,990
going to be talking about next.

684
00:30:26,830 --> 00:30:30,070
Let me turn to what we ended
with in the last class, which

685
00:30:30,070 --> 00:30:32,710
is the inflation topic.

686
00:30:32,710 --> 00:30:38,350
Last class, you'll recall, we
talked about the two formulas

687
00:30:38,350 --> 00:30:40,690
that you're going
to know very well

688
00:30:40,690 --> 00:30:42,640
by the end of this
course, perpetuities

689
00:30:42,640 --> 00:30:45,070
and annuities and compounding.

690
00:30:45,070 --> 00:30:48,490
And where we ended with was
this notion of inflation.

691
00:30:48,490 --> 00:30:51,670
How many of you already know
what inflation is and you've

692
00:30:51,670 --> 00:30:54,220
talked about it in macro?

693
00:30:54,220 --> 00:30:55,340
OK, some of you.

694
00:30:55,340 --> 00:30:57,580
So let me go over it briefly.

695
00:30:57,580 --> 00:31:00,070
And I think you'll see
very quickly exactly

696
00:31:00,070 --> 00:31:01,900
what the idea is.

697
00:31:01,900 --> 00:31:06,040
It's really meant to capture
the fact that the purchasing

698
00:31:06,040 --> 00:31:11,380
power of your money can
vary over time, irrespective

699
00:31:11,380 --> 00:31:14,230
of the time value of money.

700
00:31:14,230 --> 00:31:16,510
And let me explain it this way--

701
00:31:16,510 --> 00:31:20,440
at a particular point in
time, let's say time t,

702
00:31:20,440 --> 00:31:23,230
you've got a certain
amount of wealth, wt.

703
00:31:23,230 --> 00:31:28,330
And the value of the kinds of
things that you like to buy

704
00:31:28,330 --> 00:31:29,890
is given by an index.

705
00:31:29,890 --> 00:31:30,580
Call it I sub t.

706
00:31:30,580 --> 00:31:34,240
So you could think about that
as the price of the basket

707
00:31:34,240 --> 00:31:36,210
of goods that you enjoy.

708
00:31:36,210 --> 00:31:37,210
OK?

709
00:31:37,210 --> 00:31:43,510
So this will include consumer
items, food, clothing.

710
00:31:43,510 --> 00:31:46,610
As well, it may include other
items-- leisure, entertainment,

711
00:31:46,610 --> 00:31:48,480
and so on.

712
00:31:48,480 --> 00:31:52,310
And the fact that you have
a certain amount of wealth

713
00:31:52,310 --> 00:31:55,730
doesn't really tell
you how happy you are.

714
00:31:55,730 --> 00:31:58,370
It's really how much
you're able to consume.

715
00:31:58,370 --> 00:32:01,220
How you use that wealth that
tells you how happy you are.

716
00:32:01,220 --> 00:32:03,470
So economists
really like to focus

717
00:32:03,470 --> 00:32:07,700
not on total wealth as a measure
of your standard of living,

718
00:32:07,700 --> 00:32:10,070
but how you are able
to consume that wealth.

719
00:32:10,070 --> 00:32:12,620
So we're going to come up with
a basket of consumption goods

720
00:32:12,620 --> 00:32:18,080
and call that price of that
basket, I sub t, all right?

721
00:32:18,080 --> 00:32:20,360
Now let's move from time
t to a different point

722
00:32:20,360 --> 00:32:21,740
in time, t plus k.

723
00:32:21,740 --> 00:32:24,440
So k periods from
now, you're going

724
00:32:24,440 --> 00:32:26,600
to have a different
amount of wealth.

725
00:32:26,600 --> 00:32:28,580
Hopefully bigger.

726
00:32:28,580 --> 00:32:32,620
And presumably, you're going
to be able to consume more.

727
00:32:32,620 --> 00:32:37,120
Well, that's presuming
that the prices of what you

728
00:32:37,120 --> 00:32:41,220
like to consume don't change.

729
00:32:41,220 --> 00:32:44,320
But if those prices do
change, then in fact,

730
00:32:44,320 --> 00:32:48,470
you might not be really
better off in any way.

731
00:32:48,470 --> 00:32:50,840
And so in order for you
to tell whether or not

732
00:32:50,840 --> 00:32:53,420
you're better off
or worse off, you

733
00:32:53,420 --> 00:32:56,790
need to know not only
how much wealth you have,

734
00:32:56,790 --> 00:32:59,790
but how much that wealth can
buy you in terms of the stuff

735
00:32:59,790 --> 00:33:01,780
that you like to consume.

736
00:33:01,780 --> 00:33:07,440
So the idea behind inflation
is to measure the purchasing

737
00:33:07,440 --> 00:33:10,500
power of your dollar.

738
00:33:10,500 --> 00:33:14,680
And that's completely different
from time value of money.

739
00:33:14,680 --> 00:33:17,550
Time value of money simply
says that people are impatient

740
00:33:17,550 --> 00:33:20,660
and they prefer money
now to money later.

741
00:33:20,660 --> 00:33:25,820
But inflation is a comment
about the purchasing

742
00:33:25,820 --> 00:33:30,080
power of that dollar
now versus later.

743
00:33:30,080 --> 00:33:31,440
And it can go either way.

744
00:33:31,440 --> 00:33:35,630
In other words, it's possible
that a dollar next year

745
00:33:35,630 --> 00:33:39,440
will buy you more
than a dollar today

746
00:33:39,440 --> 00:33:43,400
because if prices decline, as
they have right now for energy,

747
00:33:43,400 --> 00:33:44,000
for example.

748
00:33:44,000 --> 00:33:46,340
Energy is below $100 a barrel.

749
00:33:46,340 --> 00:33:49,290
Just a few months ago,
it was at $130 a barrel.

750
00:33:49,290 --> 00:33:52,220
So if we had a winter
a few months ago,

751
00:33:52,220 --> 00:33:55,100
that would have been really bad
because home heating oil would

752
00:33:55,100 --> 00:33:56,683
have been a lot more
expensive than it

753
00:33:56,683 --> 00:33:57,890
looks like it's going to be.

754
00:33:57,890 --> 00:34:00,140
However, it's still going
to be more expensive than it

755
00:34:00,140 --> 00:34:05,070
was two years ago, when
oil was at $40 a barrel.

756
00:34:05,070 --> 00:34:06,910
So you need to know
what you're going

757
00:34:06,910 --> 00:34:09,409
to consume in order to get a
sense of whether you are better

758
00:34:09,409 --> 00:34:10,174
or worse off.

759
00:34:10,174 --> 00:34:11,840
And that's what we
measure by this price

760
00:34:11,840 --> 00:34:15,280
index, I of t plus k.

761
00:34:15,280 --> 00:34:17,889
So when you're looking
at your portfolio,

762
00:34:17,889 --> 00:34:19,270
you might ask the
question what's

763
00:34:19,270 --> 00:34:21,250
my return on my portfolio.

764
00:34:21,250 --> 00:34:23,110
And the way you
calculate that return

765
00:34:23,110 --> 00:34:27,010
is look at your wealth at time
t plus k divided by your wealth

766
00:34:27,010 --> 00:34:30,540
at time t, subtract 1 from it.

767
00:34:30,540 --> 00:34:32,670
And that's your return, right?

768
00:34:32,670 --> 00:34:36,120
That's often called
the nominal return

769
00:34:36,120 --> 00:34:39,510
because it's in
name only, meaning

770
00:34:39,510 --> 00:34:43,350
it's the actual
number of dollar bills

771
00:34:43,350 --> 00:34:45,120
that your wealth will grow to.

772
00:34:45,120 --> 00:34:47,820
So if you've got
$1,000 this year,

773
00:34:47,820 --> 00:34:51,719
next year you've got
$1,100, your nominal return

774
00:34:51,719 --> 00:34:53,610
for your wealth is 10%.

775
00:34:53,610 --> 00:34:55,739
That's the number
of dollar bills

776
00:34:55,739 --> 00:34:58,050
you'll have more than
you had this year.

777
00:34:58,050 --> 00:35:00,240
10% more.

778
00:35:00,240 --> 00:35:02,500
Now if you want
to know how you're

779
00:35:02,500 --> 00:35:04,860
doing in terms of your
level of happiness,

780
00:35:04,860 --> 00:35:07,290
your purchasing power,
your cost of living,

781
00:35:07,290 --> 00:35:09,030
your standard of
living, you've got

782
00:35:09,030 --> 00:35:13,020
to look at what's going on
with a cost of living increase.

783
00:35:13,020 --> 00:35:16,530
I sub t plus k
divided by I sub t.

784
00:35:16,530 --> 00:35:23,860
And we can write that as a
fixed growth rate, pi, per year.

785
00:35:23,860 --> 00:35:26,790
1 plus pi to the k

786
00:35:26,790 --> 00:35:29,610
So let's suppose that all
the prices of the things

787
00:35:29,610 --> 00:35:32,120
you love and enjoy--

788
00:35:32,120 --> 00:35:35,650
they go up by 10% as well.

789
00:35:35,650 --> 00:35:37,750
Well, then have
you made any money?

790
00:35:37,750 --> 00:35:39,400
Have you made any progress?

791
00:35:39,400 --> 00:35:41,890
You've made money, but
you haven't made progress.

792
00:35:41,890 --> 00:35:46,960
You've made 10% in terms of your
return on your initial $1,000.

793
00:35:46,960 --> 00:35:52,270
But the stuff that you like
to eat and buy and use--

794
00:35:52,270 --> 00:35:54,530
that's also gone up by 10%.

795
00:35:54,530 --> 00:35:59,420
So in fact, you can't do any
more consumption next year

796
00:35:59,420 --> 00:36:01,150
than you could have this year.

797
00:36:01,150 --> 00:36:04,030
Because while your wealth went
up by 10%, the cost of living

798
00:36:04,030 --> 00:36:06,400
went up by 10%.

799
00:36:06,400 --> 00:36:09,070
So from a real perspective--

800
00:36:09,070 --> 00:36:12,660
real meaning what you
really care about--

801
00:36:12,660 --> 00:36:15,950
you haven't really
made any progress.

802
00:36:15,950 --> 00:36:19,370
Inflation is a measure of
how much progress we've made.

803
00:36:19,370 --> 00:36:23,210
And so when you
engage in analysis

804
00:36:23,210 --> 00:36:26,900
of these kinds of
present value problems,

805
00:36:26,900 --> 00:36:29,810
you've got to ask the
question whether or not

806
00:36:29,810 --> 00:36:36,320
you're focusing on nominal
returns or real returns, OK?

807
00:36:36,320 --> 00:36:40,190
And ultimately, as a consumer,
what you all care about

808
00:36:40,190 --> 00:36:42,570
is real returns.

809
00:36:42,570 --> 00:36:45,830
You want to know whether you're
getting better off in terms

810
00:36:45,830 --> 00:36:48,770
of what you can really consume.

811
00:36:48,770 --> 00:36:51,780
So how do you do that.

812
00:36:51,780 --> 00:36:55,620
Well, first of all, you
have to change the units.

813
00:36:55,620 --> 00:36:57,256
Sorry, question?

814
00:36:57,256 --> 00:36:59,110
AUDIENCE: Why pi?

815
00:36:59,110 --> 00:37:01,352
ANDREW LO: Why that letter?

816
00:37:01,352 --> 00:37:02,807
AUDIENCE: [INAUDIBLE]

817
00:37:02,807 --> 00:37:03,890
ANDREW LO: Oh, no, no, no.

818
00:37:03,890 --> 00:37:06,050
I'm sorry.

819
00:37:06,050 --> 00:37:08,090
Thank you for pointing it out.

820
00:37:08,090 --> 00:37:11,630
No, by pi, I just mean a
variable name called pi.

821
00:37:11,630 --> 00:37:15,550
I don't mean 3.14159.

822
00:37:15,550 --> 00:37:18,796
Only at MIT would I
get that question.

823
00:37:18,796 --> 00:37:20,170
I've taught at
other universities

824
00:37:20,170 --> 00:37:22,870
and they ask me what
that funny-looking symbol

825
00:37:22,870 --> 00:37:25,640
looks like.

826
00:37:25,640 --> 00:37:27,490
So yeah, sorry about that.

827
00:37:27,490 --> 00:37:31,030
This is just a Greek letter
that denotes a variable.

828
00:37:31,030 --> 00:37:32,661
It's like r or something.

829
00:37:32,661 --> 00:37:33,160
All right?

830
00:37:33,160 --> 00:37:34,690
Thank you.

831
00:37:34,690 --> 00:37:38,050
So here, what I've
done is to define

832
00:37:38,050 --> 00:37:42,700
a variable called your real
wealth at time t plus k.

833
00:37:42,700 --> 00:37:45,550
Real meaning this
is what you really

834
00:37:45,550 --> 00:37:49,060
can do with your money
in terms of consuming.

835
00:37:49,060 --> 00:37:52,730
What it is is your
nominal wealth divided

836
00:37:52,730 --> 00:37:56,400
by the rate of inflation.

837
00:37:56,400 --> 00:37:58,610
So in the case of the
example I gave you,

838
00:37:58,610 --> 00:38:02,150
where your nominal
wealth goes up by 10%

839
00:38:02,150 --> 00:38:07,440
and your inflation rate
goes up by 10%, when

840
00:38:07,440 --> 00:38:10,530
you take your nominal
wealth and you divide it

841
00:38:10,530 --> 00:38:14,430
by that growth rate in
inflation, what do you get?

842
00:38:17,530 --> 00:38:20,160
You get $1,000.

843
00:38:20,160 --> 00:38:24,060
In other words, your wealth
hasn't changed in real terms.

844
00:38:24,060 --> 00:38:24,840
OK?

845
00:38:24,840 --> 00:38:28,530
So in the example that I gave
you your wealth went up by 10%.

846
00:38:28,530 --> 00:38:32,470
Your inflation rate
for a year is also 10%.

847
00:38:32,470 --> 00:38:38,334
So if you divide your
total wealth by that index,

848
00:38:38,334 --> 00:38:39,750
you're basically
going to get back

849
00:38:39,750 --> 00:38:43,560
to your original amount
of wealth, right?

850
00:38:43,560 --> 00:38:47,100
So here's the general framework.

851
00:38:47,100 --> 00:38:51,990
Your real wealth is going to
be your nominal wealth divided

852
00:38:51,990 --> 00:38:54,350
by the rate of inflation.

853
00:38:54,350 --> 00:38:55,880
You're dividing by
it because you're

854
00:38:55,880 --> 00:39:01,460
using, as your units of
comparison, today's consumption

855
00:39:01,460 --> 00:39:02,816
basket.

856
00:39:02,816 --> 00:39:05,390
Right?

857
00:39:05,390 --> 00:39:10,100
So the way you can look at your
real return, which is denoted 1

858
00:39:10,100 --> 00:39:15,710
plus r real to the k-th power,
your real return over k years

859
00:39:15,710 --> 00:39:19,520
is equal to the real wealth at
the end of year k years divided

860
00:39:19,520 --> 00:39:20,475
by your wealth today.

861
00:39:20,475 --> 00:39:22,100
That's your real rate
of return, right?

862
00:39:22,100 --> 00:39:27,630
Because it's how much real
dollars you have at time k.

863
00:39:27,630 --> 00:39:32,070
That's just given
by your nominal rate

864
00:39:32,070 --> 00:39:34,880
of return of your wealth.

865
00:39:34,880 --> 00:39:38,750
And then divided by
the rate of inflation.

866
00:39:38,750 --> 00:39:40,080
OK?

867
00:39:40,080 --> 00:39:43,200
So this is the
expression that is

868
00:39:43,200 --> 00:39:49,080
the basic relationship between
real and nominal consumption

869
00:39:49,080 --> 00:39:50,260
goods.

870
00:39:50,260 --> 00:39:54,480
And then we
approximate this ratio

871
00:39:54,480 --> 00:39:57,510
with this very, very
simple relationship here.

872
00:39:57,510 --> 00:40:00,910
The real rate of
return is approximately

873
00:40:00,910 --> 00:40:06,160
equal to the nominal rate of
return minus the inflation

874
00:40:06,160 --> 00:40:07,630
rate-- not divided by anything.

875
00:40:07,630 --> 00:40:09,610
That's the approximation.

876
00:40:09,610 --> 00:40:11,970
So getting back to my example.

877
00:40:11,970 --> 00:40:14,920
My example of if you
have a 10% nominal growth

878
00:40:14,920 --> 00:40:20,060
rate for your investment and
you have a 10% inflation rate,

879
00:40:20,060 --> 00:40:23,570
then in that case,
there's no approximation.

880
00:40:23,570 --> 00:40:26,720
In fact, your inflation rate,
your real rate of return,

881
00:40:26,720 --> 00:40:28,100
is zero, right?

882
00:40:28,100 --> 00:40:30,300
10% minus 10% is zero.

883
00:40:30,300 --> 00:40:31,850
Where the approximation
happens is

884
00:40:31,850 --> 00:40:34,080
when you have something
a little bit different.

885
00:40:34,080 --> 00:40:38,640
For example, suppose the
inflation rate were 10%

886
00:40:38,640 --> 00:40:41,846
and suppose your nominal
rate of return was 15%.

887
00:40:41,846 --> 00:40:43,470
According to this
approximation, what's

888
00:40:43,470 --> 00:40:45,990
your real rate of return?

889
00:40:45,990 --> 00:40:46,900
5%, right.

890
00:40:46,900 --> 00:40:56,470
It's not exactly 5% because if
you take 1.15 divided by 1.10,

891
00:40:56,470 --> 00:40:58,780
it's not exactly 5%.

892
00:40:58,780 --> 00:41:00,970
But it's approximately
equal to that.

893
00:41:00,970 --> 00:41:02,980
OK?

894
00:41:02,980 --> 00:41:07,080
What this says is that you ought
to think, as a consumer, not

895
00:41:07,080 --> 00:41:09,480
just about the
total dollars that's

896
00:41:09,480 --> 00:41:14,040
growing but the purchasing
power of those dollars.

897
00:41:14,040 --> 00:41:15,220
OK.

898
00:41:15,220 --> 00:41:19,810
For the purposes of
doing NPV calculations,

899
00:41:19,810 --> 00:41:23,710
I want to just mention
one rule of thumb that

900
00:41:23,710 --> 00:41:26,500
will do you in good
stead, no matter what kind

901
00:41:26,500 --> 00:41:28,870
of calculations you do.

902
00:41:28,870 --> 00:41:32,050
And that is simply to keep
track of whether you're using

903
00:41:32,050 --> 00:41:36,880
nominal or real cash flows.

904
00:41:36,880 --> 00:41:41,180
And then to use nominal or
real discount rates to match.

905
00:41:41,180 --> 00:41:42,910
In other words,
nominal cash flow

906
00:41:42,910 --> 00:41:45,940
should be divided by
nominal discount rates.

907
00:41:45,940 --> 00:41:50,830
And real cash flow should be
denominated by real discount

908
00:41:50,830 --> 00:41:52,270
rates.

909
00:41:52,270 --> 00:41:56,020
Most of the cash flows that you
will get in your analysis will

910
00:41:56,020 --> 00:41:58,411
typically be nominal.

911
00:41:58,411 --> 00:42:01,210
Nominal meaning that's the
actual number of dollars

912
00:42:01,210 --> 00:42:03,700
you will see on those dates.

913
00:42:03,700 --> 00:42:06,370
But occasionally, you
may get a forecast

914
00:42:06,370 --> 00:42:08,510
that is made in real terms--

915
00:42:08,510 --> 00:42:11,704
in terms of purchasing power.

916
00:42:11,704 --> 00:42:13,120
And in that case,
you have to just

917
00:42:13,120 --> 00:42:14,830
be careful to use the
right interest rate when

918
00:42:14,830 --> 00:42:16,080
you're doing your discounting.

919
00:42:16,080 --> 00:42:18,890
You have to take into
account inflation.

920
00:42:18,890 --> 00:42:22,590
Nominal gets discounted by
nominal, real gets discounted

921
00:42:22,590 --> 00:42:23,090
by real.

922
00:42:23,090 --> 00:42:27,359
That's all you have
to remember, OK?

923
00:42:27,359 --> 00:42:28,400
Any questions about that?

924
00:42:31,606 --> 00:42:32,980
OK.

925
00:42:32,980 --> 00:42:35,320
We're now done with
lecture 3 and we're

926
00:42:35,320 --> 00:42:38,680
moving on to lecture 4, which
is fixed income securities.

927
00:42:38,680 --> 00:42:43,360
And this is the focus of much
of the dislocation in markets

928
00:42:43,360 --> 00:42:44,260
today.

929
00:42:44,260 --> 00:42:46,120
So this is very topical.

930
00:42:46,120 --> 00:42:48,010
And something that
I think you'll

931
00:42:48,010 --> 00:42:50,740
find very useful
when we start trying

932
00:42:50,740 --> 00:42:53,425
to understand exactly what's
been going on in these markets.

933
00:42:55,930 --> 00:42:58,540
Let me start with a little
bit of an industry overview.

934
00:43:01,120 --> 00:43:04,810
And the industry
overview will give you

935
00:43:04,810 --> 00:43:09,945
a sense of why these markets
are so important as well as so

936
00:43:09,945 --> 00:43:10,445
large.

937
00:43:13,860 --> 00:43:14,910
OK.

938
00:43:14,910 --> 00:43:16,690
So we're going to
start, as I said,

939
00:43:16,690 --> 00:43:21,090
with an overview of
markets and participants.

940
00:43:21,090 --> 00:43:23,610
And then I'm going to talk
about evaluation of fixed income

941
00:43:23,610 --> 00:43:24,720
securities.

942
00:43:24,720 --> 00:43:28,110
It turns out that all of the
hard work that we've done just

943
00:43:28,110 --> 00:43:30,180
over the last three
lectures are going

944
00:43:30,180 --> 00:43:32,970
to be able to get us
through all of valuation

945
00:43:32,970 --> 00:43:34,230
for fixed income securities.

946
00:43:34,230 --> 00:43:36,900
In other words, you
now know all that you

947
00:43:36,900 --> 00:43:40,560
need to know to price
virtually any fixed income

948
00:43:40,560 --> 00:43:44,160
security without default.
Without uncertainty.

949
00:43:44,160 --> 00:43:48,960
Remember, we said no
uncertainty until lecture 12.

950
00:43:48,960 --> 00:43:50,630
It's a pretty significant
accomplishment

951
00:43:50,630 --> 00:43:53,275
because there are lots and
lots of securities out there

952
00:43:53,275 --> 00:43:54,650
that are fixed
income securities.

953
00:43:54,650 --> 00:43:56,180
And you now have the
tools-- you don't

954
00:43:56,180 --> 00:43:58,054
know that you have the
tools yet, but you do,

955
00:43:58,054 --> 00:44:00,757
believe me, to price them all.

956
00:44:00,757 --> 00:44:02,840
So we're going to go over
the valuation principles

957
00:44:02,840 --> 00:44:06,355
and apply them to discount
bonds and coupon bonds.

958
00:44:06,355 --> 00:44:07,730
And then I'm going
to talk to you

959
00:44:07,730 --> 00:44:09,290
a little bit about uncertainty.

960
00:44:09,290 --> 00:44:13,250
I want to bring in interest
rate risk in a very simple way.

961
00:44:13,250 --> 00:44:14,900
I want to simply
talk about the fact

962
00:44:14,900 --> 00:44:17,690
that interest rates
do change over time

963
00:44:17,690 --> 00:44:21,530
and that change can actually
cause some concern as well

964
00:44:21,530 --> 00:44:22,550
as some opportunities.

965
00:44:22,550 --> 00:44:25,910
I want to discuss what those
opportunities and concerns are.

966
00:44:25,910 --> 00:44:28,474
And then I'm going to conclude
by talking about default.

967
00:44:28,474 --> 00:44:30,140
I'm going to talk
about corporate bonds.

968
00:44:30,140 --> 00:44:33,350
And I probably won't talk
about the subprime issues

969
00:44:33,350 --> 00:44:37,610
in this class because I want
to focus on the material that's

970
00:44:37,610 --> 00:44:38,580
required.

971
00:44:38,580 --> 00:44:41,310
But I will talk about it in this
pro seminar, which is optional.

972
00:44:41,310 --> 00:44:43,280
So you're welcome
to come on Wednesday

973
00:44:43,280 --> 00:44:45,854
and we'll go over that material.

974
00:44:45,854 --> 00:44:48,020
And if you want, you can
take a look at it yourself.

975
00:44:48,020 --> 00:44:51,950
It's pretty self-explanatory so
I think you'll see how it goes.

976
00:44:51,950 --> 00:44:55,470
For readings, I'd like you all
to read chapters 23 through 25

977
00:44:55,470 --> 00:44:56,990
of Brealey, Myers, and Allen.

978
00:44:56,990 --> 00:44:59,540
You'll have three
lectures to do that.

979
00:44:59,540 --> 00:45:02,390
Lectures 4, 5, and 6
will all be focused

980
00:45:02,390 --> 00:45:04,430
on fixed income securities.

981
00:45:04,430 --> 00:45:07,550
So let me talk to you a
bit about the industry now.

982
00:45:07,550 --> 00:45:11,000
The name fixed income securities
means exactly what it says.

983
00:45:11,000 --> 00:45:14,420
What we're going to do now is
to focus on pieces of paper

984
00:45:14,420 --> 00:45:21,830
where the payoffs are
fixed and known in advance.

985
00:45:21,830 --> 00:45:25,820
Unlike a stock where you buy
a stock and you don't know

986
00:45:25,820 --> 00:45:29,060
whether it's going to pay off
at all and the cash flows,

987
00:45:29,060 --> 00:45:34,400
the dividends or repurchases or
capital gains are uncertain--

988
00:45:34,400 --> 00:45:38,180
you don't have any idea what the
cash flows may or may not be--

989
00:45:38,180 --> 00:45:42,140
in contrast of those securities,
fixed income instruments

990
00:45:42,140 --> 00:45:44,810
have fixed incomes.

991
00:45:44,810 --> 00:45:49,850
So they have very, very
clearly stated payoffs

992
00:45:49,850 --> 00:45:51,710
that you know in advance.

993
00:45:51,710 --> 00:45:54,800
So from a pricing
perspective, these

994
00:45:54,800 --> 00:45:58,340
are probably the simplest
kind of securities that could

995
00:45:58,340 --> 00:46:01,580
possibly be constructed, right?

996
00:46:01,580 --> 00:46:04,160
Couldn't be simpler than
a piece of paper that

997
00:46:04,160 --> 00:46:10,190
says every year on this
date, I will pay you $10,000

998
00:46:10,190 --> 00:46:13,190
of nominal currency, right?

999
00:46:13,190 --> 00:46:15,800
That's a fixed income security.

1000
00:46:15,800 --> 00:46:21,380
Examples are anything
from treasury securities,

1001
00:46:21,380 --> 00:46:24,290
securities issued by the
United States Treasury

1002
00:46:24,290 --> 00:46:29,240
and other foreign treasuries,
to federal agent securities.

1003
00:46:29,240 --> 00:46:30,800
We know about those now, right?

1004
00:46:30,800 --> 00:46:33,100
Fannie Mae and Freddie
Mac securities.

1005
00:46:33,100 --> 00:46:34,790
To corporate
security-- securities

1006
00:46:34,790 --> 00:46:37,250
issued not by the government
or by government sponsored

1007
00:46:37,250 --> 00:46:40,220
entities, but by
private corporations

1008
00:46:40,220 --> 00:46:41,930
and public corporations.

1009
00:46:41,930 --> 00:46:44,210
And then municipal
securities, these

1010
00:46:44,210 --> 00:46:47,370
are securities issued
by local governments.

1011
00:46:47,370 --> 00:46:51,380
And then mortgage backed
securities, securities

1012
00:46:51,380 --> 00:46:56,340
that are payoffs of pools
of other securities,

1013
00:46:56,340 --> 00:46:58,040
including mortgages.

1014
00:46:58,040 --> 00:47:02,360
And then the whole mix
of collateralized debt

1015
00:47:02,360 --> 00:47:06,800
obligations, collateralized
loan obligations, credit default

1016
00:47:06,800 --> 00:47:12,060
swaps, and other
complex instruments.

1017
00:47:12,060 --> 00:47:14,850
That's a lot of securities.

1018
00:47:14,850 --> 00:47:20,060
And to get a sense of how many
securities we're talking about.

1019
00:47:20,060 --> 00:47:22,890
let me show you the market.

1020
00:47:22,890 --> 00:47:25,320
This is as of the end
of 2006 because that's

1021
00:47:25,320 --> 00:47:30,370
the only data that I
could get that is timely.

1022
00:47:30,370 --> 00:47:35,140
At the end of 2006,
the US bond market

1023
00:47:35,140 --> 00:47:41,620
consisted of just tremendous,
tremendous amount of assets.

1024
00:47:41,620 --> 00:47:45,400
So $6.4 trillion in
mortgage-related securities,

1025
00:47:45,400 --> 00:47:47,200
24% of the market.

1026
00:47:47,200 --> 00:47:51,360
$2.3 trillion in municipals.
$4.2 trillion in treasuries.

1027
00:47:51,360 --> 00:47:53,920
$2 trillion in asset
backed securities.

1028
00:47:53,920 --> 00:47:55,660
$3.8 trillion money market.

1029
00:47:55,660 --> 00:47:58,900
$2.6 trillion in federal
agencies, securities,

1030
00:47:58,900 --> 00:48:01,420
and so on.

1031
00:48:01,420 --> 00:48:05,130
These numbers-- they
dwarf the stock market.

1032
00:48:05,130 --> 00:48:10,440
So we're traditionally
focused in financial analysis

1033
00:48:10,440 --> 00:48:13,500
on pricing stocks
and analyzing stocks.

1034
00:48:13,500 --> 00:48:16,170
And we get all excited
when Google tries

1035
00:48:16,170 --> 00:48:20,440
to take over Yahoo and so on.

1036
00:48:20,440 --> 00:48:24,310
But the size of the markets,
the size of equity markets

1037
00:48:24,310 --> 00:48:28,120
are dwarfed by fixed
income securities.

1038
00:48:28,120 --> 00:48:31,260
And again, these are
apples and oranges.

1039
00:48:31,260 --> 00:48:34,180
And I'm just saying that there
is a hell of a lot more apples

1040
00:48:34,180 --> 00:48:36,040
and there are oranges.

1041
00:48:36,040 --> 00:48:38,530
You can figure out what
you want from that,

1042
00:48:38,530 --> 00:48:41,140
but these are
really big markets.

1043
00:48:41,140 --> 00:48:44,080
And on this slide, I
show you the evolution

1044
00:48:44,080 --> 00:48:46,870
of these markets-- how
they've integral over time

1045
00:48:46,870 --> 00:48:49,930
from 1985 to 2006.

1046
00:48:49,930 --> 00:48:55,360
And what you'll see is that
the mortgage-related market

1047
00:48:55,360 --> 00:49:02,200
has just grown by tremendous,
tremendous amounts.

1048
00:49:02,200 --> 00:49:04,450
As well as federal
agency securities--

1049
00:49:04,450 --> 00:49:06,760
that's Fannie Mae
and Freddie Mac.

1050
00:49:06,760 --> 00:49:10,780
And asset backed markets
was nothing in 1985.

1051
00:49:10,780 --> 00:49:13,510
It didn't exist in '85.

1052
00:49:13,510 --> 00:49:17,500
And now we're talking about
a $2 trillion market here.

1053
00:49:17,500 --> 00:49:20,680
So a lot has happened
in the last 20 years.

1054
00:49:20,680 --> 00:49:23,990
It's been exciting times
for financial markets.

1055
00:49:23,990 --> 00:49:25,570
And right now,
we're in the midst

1056
00:49:25,570 --> 00:49:31,710
of some market turmoil because
of that unbridled growth.

1057
00:49:31,710 --> 00:49:35,920
Now this is the
amount outstanding.

1058
00:49:35,920 --> 00:49:38,560
This chart shows
you the issuance

1059
00:49:38,560 --> 00:49:41,530
that is the amount of
debt that's being issued

1060
00:49:41,530 --> 00:49:42,740
at any given point in time.

1061
00:49:42,740 --> 00:49:48,550
So the first was an example
of the stock of debt

1062
00:49:48,550 --> 00:49:50,050
at any point in time.

1063
00:49:50,050 --> 00:49:56,300
And now, I'm talking about
the flow of debt year by year.

1064
00:49:56,300 --> 00:50:02,080
And you can see that as of
2006, mortgage-related bonds

1065
00:50:02,080 --> 00:50:08,050
were the fastest
growing segment, by far.

1066
00:50:08,050 --> 00:50:11,890
And that continued up
until 2007 and then

1067
00:50:11,890 --> 00:50:15,710
the brakes started being
put on to that market.

1068
00:50:15,710 --> 00:50:16,810
OK?

1069
00:50:16,810 --> 00:50:20,680
And you can see over
time, the growth

1070
00:50:20,680 --> 00:50:23,860
of these various different
markets and the fact

1071
00:50:23,860 --> 00:50:26,350
that federal agency
securities grew

1072
00:50:26,350 --> 00:50:29,230
but mortgage-related
securities probably

1073
00:50:29,230 --> 00:50:34,097
was the fastest growing subject
to the asset backed market

1074
00:50:34,097 --> 00:50:35,180
as well, which is related.

1075
00:50:35,180 --> 00:50:36,266
Yeah?

1076
00:50:36,266 --> 00:50:38,710
AUDIENCE: [INAUDIBLE] asset
backed and mortgage-related?

1077
00:50:38,710 --> 00:50:40,890
ANDREW LO: Mortgage-related is
specifically about mortgages.

1078
00:50:40,890 --> 00:50:42,370
Asset backed could be any asset.

1079
00:50:42,370 --> 00:50:45,460
So for example, consumer
credit card loans--

1080
00:50:45,460 --> 00:50:49,240
you can package that up
and sell claims on that

1081
00:50:49,240 --> 00:50:51,820
and that would be under
asset backed securities,

1082
00:50:51,820 --> 00:50:53,590
not under mortgages.

1083
00:50:53,590 --> 00:50:56,630
But they're related, obviously.

1084
00:50:56,630 --> 00:50:57,740
OK.

1085
00:50:57,740 --> 00:50:59,510
So these numbers
will give you an idea

1086
00:50:59,510 --> 00:51:04,110
of what's out there, what's
significant and what's not.

1087
00:51:04,110 --> 00:51:07,340
This gives you a sense of the
amount of trading that goes on.

1088
00:51:07,340 --> 00:51:15,260
While these securities are
large in size and large in flow,

1089
00:51:15,260 --> 00:51:19,860
they are not that large
in terms of transactions.

1090
00:51:19,860 --> 00:51:24,720
So unlike stocks that
trade all the time,

1091
00:51:24,720 --> 00:51:30,960
we don't have an organized US
bond exchange like the NYSE,

1092
00:51:30,960 --> 00:51:33,810
where people trade bonds
every minute of the day.

1093
00:51:33,810 --> 00:51:37,950
There are bonds being traded
every minute of the day,

1094
00:51:37,950 --> 00:51:40,710
but they aren't
typically the same ones.

1095
00:51:40,710 --> 00:51:43,800
Whereas I would argue
that Microsoft and Google

1096
00:51:43,800 --> 00:51:48,120
are traded every minute
of the trading day.

1097
00:51:48,120 --> 00:51:50,790
So typically, bonds do
trade, but they don't

1098
00:51:50,790 --> 00:51:54,310
trade on organized exchanges.

1099
00:51:54,310 --> 00:51:56,860
And that makes them less liquid.

1100
00:51:56,860 --> 00:52:03,400
Even the very, very safest
and most liquid bonds

1101
00:52:03,400 --> 00:52:08,170
do not trade as frequently
as equities and futures.

1102
00:52:08,170 --> 00:52:11,424
So the liquidity characteristics
can be very, very different

1103
00:52:11,424 --> 00:52:12,340
for these instruments.

1104
00:52:12,340 --> 00:52:15,820
And these complex securities,
like collateralized debt

1105
00:52:15,820 --> 00:52:17,890
obligations, mortgage
backed securities--

1106
00:52:17,890 --> 00:52:21,400
they trade even less frequently
because they are highly complex

1107
00:52:21,400 --> 00:52:24,490
and it's not easy to figure
out what their prices are

1108
00:52:24,490 --> 00:52:28,350
from minute to minute every day.

1109
00:52:28,350 --> 00:52:31,030
Now the fixed income
market participants

1110
00:52:31,030 --> 00:52:35,350
that we're going to be focused
on fall into three groups--

1111
00:52:35,350 --> 00:52:40,260
issuers, intermediaries,
and investors.

1112
00:52:40,260 --> 00:52:45,300
Issuers, of course, are the
end users of these instruments.

1113
00:52:45,300 --> 00:52:48,030
They include everything
from governments

1114
00:52:48,030 --> 00:52:51,010
down to foreign institutions.

1115
00:52:51,010 --> 00:52:54,840
These are the folks that issue
pieces of paper that are IOUs

1116
00:52:54,840 --> 00:52:57,000
and they get cash
in return for that

1117
00:52:57,000 --> 00:52:59,320
to finance their operations.

1118
00:52:59,320 --> 00:53:03,240
And in return, they
pay interest, OK?

1119
00:53:03,240 --> 00:53:05,830
The investors, of
course, are the folks

1120
00:53:05,830 --> 00:53:11,320
that are buying the paper or
essentially providing loans.

1121
00:53:11,320 --> 00:53:13,090
So every once in a
while, when I go out

1122
00:53:13,090 --> 00:53:15,970
with my colleagues for
lunch in the finance group,

1123
00:53:15,970 --> 00:53:19,060
one of my colleagues will
say, can I sell you a bond,

1124
00:53:19,060 --> 00:53:20,650
I didn't go to the
cash machine today,

1125
00:53:20,650 --> 00:53:23,440
and I need you to help
me finance my lunch.

1126
00:53:23,440 --> 00:53:28,720
These are how finance
professors speak, unfortunately.

1127
00:53:28,720 --> 00:53:32,830
The idea about
buying somebody bond

1128
00:53:32,830 --> 00:53:36,070
is you're lending
them money, right?

1129
00:53:36,070 --> 00:53:38,870
So instead of saying could
you let me $5, we have to say,

1130
00:53:38,870 --> 00:53:41,650
well, I'm going to issue a
bond, can you buy my bond.

1131
00:53:44,640 --> 00:53:47,380
The investors are the
ones that are loaning

1132
00:53:47,380 --> 00:53:50,260
the money to the issuers.

1133
00:53:50,260 --> 00:53:50,920
OK?

1134
00:53:50,920 --> 00:53:53,510
And these include, as I said,
governments, pension funds,

1135
00:53:53,510 --> 00:53:58,300
insurance companies, banks,
hedge funds, and so on.

1136
00:53:58,300 --> 00:54:02,590
In the middle of all of
this are the intermediaries.

1137
00:54:02,590 --> 00:54:05,630
Primary dealers, other
kinds of dealers,

1138
00:54:05,630 --> 00:54:09,490
investment banks, the
credit rating agencies,

1139
00:54:09,490 --> 00:54:10,840
the credit enhancers.

1140
00:54:10,840 --> 00:54:12,520
What do I mean by
credit enhancers?

1141
00:54:12,520 --> 00:54:17,350
Folks that help credit
markets by providing insurance

1142
00:54:17,350 --> 00:54:20,470
to the credit, like
private mortgage insurance.

1143
00:54:20,470 --> 00:54:21,910
And liquidity enhancers.

1144
00:54:21,910 --> 00:54:23,380
These are the
counter-parties that

1145
00:54:23,380 --> 00:54:25,660
try to bring buyers
and sellers together

1146
00:54:25,660 --> 00:54:28,930
to increase the
liquidity of the markets.

1147
00:54:28,930 --> 00:54:33,530
The dislocation has been going
on in the intermediary sector

1148
00:54:33,530 --> 00:54:37,250
and of course, the issuers
are having some difficulties

1149
00:54:37,250 --> 00:54:39,290
now because they're going
to have to make good

1150
00:54:39,290 --> 00:54:40,610
on these kind of claims.

1151
00:54:40,610 --> 00:54:44,240
And the people that are
going to be hurt ultimately

1152
00:54:44,240 --> 00:54:47,630
will be the investors who are
holding pieces of paper that

1153
00:54:47,630 --> 00:54:50,070
may not be worth as
much as possible.

1154
00:54:50,070 --> 00:54:52,670
And so the efforts now
at trying to shore up

1155
00:54:52,670 --> 00:54:56,540
the finances of Fannie Mae and
Freddie Mac, Lehman, Merrill,

1156
00:54:56,540 --> 00:54:59,060
and all of these
other institutions

1157
00:54:59,060 --> 00:55:01,540
is really aimed at
trying to help out

1158
00:55:01,540 --> 00:55:05,240
a combination of the
intermediaries and the issuers.

1159
00:55:05,240 --> 00:55:07,850
Because if you don't help out
this group, then what happens

1160
00:55:07,850 --> 00:55:11,120
is that this group
is going to get hit.

1161
00:55:11,120 --> 00:55:14,430
So Lehman Brothers, for
example, is an intermediary.

1162
00:55:14,430 --> 00:55:16,212
They are one of
the biggest dealers

1163
00:55:16,212 --> 00:55:17,420
in these kinds of securities.

1164
00:55:17,420 --> 00:55:20,330
Merrill Lynch is also one
of the biggest dealers

1165
00:55:20,330 --> 00:55:21,530
in these kind of securities.

1166
00:55:21,530 --> 00:55:26,930
As dealers, they end up taking
exposure on their own books.

1167
00:55:26,930 --> 00:55:30,050
That's not a great
idea in general

1168
00:55:30,050 --> 00:55:33,710
because the best
of all worlds is

1169
00:55:33,710 --> 00:55:36,624
you're the toll collector
that's collecting tolls

1170
00:55:36,624 --> 00:55:38,790
for traffic going back and
forth and back and forth.

1171
00:55:38,790 --> 00:55:40,630
You don't take any risk.

1172
00:55:40,630 --> 00:55:43,870
But if not everybody
wants to go back and forth

1173
00:55:43,870 --> 00:55:45,910
and back and forth and
back and forth, you

1174
00:55:45,910 --> 00:55:49,690
might stand ready to do
one side of the business

1175
00:55:49,690 --> 00:55:52,880
and let other folks do the
other side of the business.

1176
00:55:52,880 --> 00:55:56,170
But if you're not careful
in laying off your exposure

1177
00:55:56,170 --> 00:55:58,810
you can end up getting
hurt pretty badly.

1178
00:55:58,810 --> 00:56:02,050
An example of this that happened
in equity markets in 1987

1179
00:56:02,050 --> 00:56:04,010
was when the stock
market crashed.

1180
00:56:04,010 --> 00:56:07,750
That was a very serious
event on October 19, 1987,

1181
00:56:07,750 --> 00:56:11,560
where in one single day,
the US stock market lost

1182
00:56:11,560 --> 00:56:13,990
approximately 20% of its value.

1183
00:56:13,990 --> 00:56:15,550
In one day.

1184
00:56:15,550 --> 00:56:17,680
Now, that's a
serious dislocation.

1185
00:56:17,680 --> 00:56:19,480
We're going to talk
about that this Friday

1186
00:56:19,480 --> 00:56:20,920
when we run this trading game.

1187
00:56:20,920 --> 00:56:23,770
I'm going to have all of you
engage in trading over a very

1188
00:56:23,770 --> 00:56:24,770
short period of time.

1189
00:56:24,770 --> 00:56:27,130
So you're going to be under
tremendous pressure as well.

1190
00:56:27,130 --> 00:56:29,920
You tell me how easy it
is to think on the fly.

1191
00:56:29,920 --> 00:56:32,680
What happened that morning
of October 19, 1987,

1192
00:56:32,680 --> 00:56:34,942
is that the specialists,
the dealers, who

1193
00:56:34,942 --> 00:56:36,400
are supposed to be
making markets--

1194
00:56:36,400 --> 00:56:38,140
their job is to
buy when everybody

1195
00:56:38,140 --> 00:56:42,120
wants to sell and to sell
when everybody wants to buy.

1196
00:56:42,120 --> 00:56:44,670
They got it there in
the morning at 9:30

1197
00:56:44,670 --> 00:56:49,120
and were overwhelmed with
everybody wanting to sell.

1198
00:56:49,120 --> 00:56:50,530
So they ended up buying--

1199
00:56:50,530 --> 00:56:51,950
the specialists.

1200
00:56:51,950 --> 00:56:52,720
And they bought.

1201
00:56:52,720 --> 00:56:56,360
And as they bought, what
happened to the price?

1202
00:56:56,360 --> 00:56:57,170
Kept going down.

1203
00:56:57,170 --> 00:56:58,753
That means more
people wanted to sell.

1204
00:56:58,753 --> 00:56:59,630
So they kept buying.

1205
00:56:59,630 --> 00:57:01,770
And as they bought,
what happened?

1206
00:57:01,770 --> 00:57:03,200
Price kept going down.

1207
00:57:03,200 --> 00:57:04,820
And it kept going
down all the way.

1208
00:57:04,820 --> 00:57:07,460
So the stuff that they
bought in the morning

1209
00:57:07,460 --> 00:57:11,390
was worth 20% less
in the afternoon.

1210
00:57:11,390 --> 00:57:15,710
And these market makers
also used leverage.

1211
00:57:15,710 --> 00:57:18,770
So many of their capital
bases were wiped out

1212
00:57:18,770 --> 00:57:22,340
by that 20% decline in a
day because they were just

1213
00:57:22,340 --> 00:57:24,620
doing their job.

1214
00:57:24,620 --> 00:57:27,630
In fact, there was a story--

1215
00:57:27,630 --> 00:57:30,830
the floor of the New York Stock
Exchange was literally packed.

1216
00:57:30,830 --> 00:57:33,980
I mean, it was tighter
than a Tokyo subway train

1217
00:57:33,980 --> 00:57:35,510
during rush hour, OK?

1218
00:57:35,510 --> 00:57:36,180
It was packed.

1219
00:57:36,180 --> 00:57:40,880
I mean literally, you were
elbow to elbow against others.

1220
00:57:40,880 --> 00:57:43,060
Unfortunately, one
of the market makers

1221
00:57:43,060 --> 00:57:47,890
had a heart attack
around 1 or 2 o'clock.

1222
00:57:47,890 --> 00:57:53,470
And he wasn't able
to fall to the ground

1223
00:57:53,470 --> 00:57:56,980
until the market closed at
four because he was propped up

1224
00:57:56,980 --> 00:58:01,480
by everybody else desperate
to try to transact.

1225
00:58:01,480 --> 00:58:03,550
And he died.

1226
00:58:03,550 --> 00:58:10,780
And somebody who was near
him said, you know, look,

1227
00:58:10,780 --> 00:58:12,061
I knew the guy was in trouble.

1228
00:58:12,061 --> 00:58:13,310
But what was I supposed to do.

1229
00:58:13,310 --> 00:58:17,530
I was 100,000 shares long and
I had to unload my portfolio.

1230
00:58:17,530 --> 00:58:19,000
I mean, they were trading.

1231
00:58:19,000 --> 00:58:22,540
That's how desperate
it was on that day.

1232
00:58:22,540 --> 00:58:28,420
So this kind of intermediation
can be extraordinarily high

1233
00:58:28,420 --> 00:58:29,140
pressure.

1234
00:58:29,140 --> 00:58:32,920
And when you're engaged in
an unwinding of portfolios,

1235
00:58:32,920 --> 00:58:34,310
dislocation can occur.

1236
00:58:34,310 --> 00:58:36,760
So we're seeing that
right now play out.

1237
00:58:36,760 --> 00:58:39,296
And it's a little different
because we're dealing

1238
00:58:39,296 --> 00:58:40,420
with fixed income security.

1239
00:58:40,420 --> 00:58:42,940
So I'm going to come
back and talk about that.

1240
00:58:42,940 --> 00:58:43,660
OK.

1241
00:58:43,660 --> 00:58:45,130
That's the background
to what we're

1242
00:58:45,130 --> 00:58:47,980
going to study-- these fixed
income markets and fixed income

1243
00:58:47,980 --> 00:58:48,654
instruments.

1244
00:58:48,654 --> 00:58:51,070
I'm going to ask you to read
Brealey and Myers so that you

1245
00:58:51,070 --> 00:58:52,945
can get up to speed on
institutional details.

1246
00:58:52,945 --> 00:58:54,520
And there are quite
a few, so I would

1247
00:58:54,520 --> 00:58:56,530
urge you to please
do that reading

1248
00:58:56,530 --> 00:58:59,320
and make sure that you
understand the basic terms

1249
00:58:59,320 --> 00:59:00,970
of these markets.

1250
00:59:00,970 --> 00:59:04,600
What I want to talk about,
though, is the framework.

1251
00:59:04,600 --> 00:59:08,050
I want to give you a framework
for thinking about evaluating

1252
00:59:08,050 --> 00:59:09,065
fixed income securities.

1253
00:59:09,065 --> 00:59:10,690
And really, as I
said, it's a framework

1254
00:59:10,690 --> 00:59:11,606
that you already know.

1255
00:59:11,606 --> 00:59:13,330
You already have
that in your mind.

1256
00:59:13,330 --> 00:59:16,900
I've already changed the way you
think about financial markets

1257
00:59:16,900 --> 00:59:20,860
by asking you to focus on cash
flows and timing and the time

1258
00:59:20,860 --> 00:59:21,590
value of money.

1259
00:59:21,590 --> 00:59:24,220
That's all you need in order to
value fixed income securities.

1260
00:59:24,220 --> 00:59:26,680
The rest is just
institutional detail,

1261
00:59:26,680 --> 00:59:29,470
which, while very
important, is not something

1262
00:59:29,470 --> 00:59:31,570
that we need to
worry about in class.

1263
00:59:31,570 --> 00:59:34,240
But I'll leave to
you to focus on.

1264
00:59:34,240 --> 00:59:37,620
So let me give you an example
of valuation and how to do it.

1265
00:59:37,620 --> 00:59:38,920
It will be a very short one.

1266
00:59:38,920 --> 00:59:41,090
You all know how to do this.

1267
00:59:41,090 --> 00:59:45,630
We've got a sequence of cash
flows for a particular security

1268
00:59:45,630 --> 00:59:47,750
that I'm going to call a bond.

1269
00:59:47,750 --> 00:59:50,720
And in particular, I'm going
to call this a coupon bond.

1270
00:59:50,720 --> 00:59:53,300
Now with a coupon
bond, there are

1271
00:59:53,300 --> 00:59:54,780
two things you need to know.

1272
00:59:54,780 --> 00:59:57,020
You need to know
what the coupon is

1273
00:59:57,020 --> 01:00:00,020
and you need to know
the maturity-- how

1274
01:00:00,020 --> 01:00:02,450
many dates that it pays off.

1275
01:00:02,450 --> 01:00:04,910
One of the institutional
details that you'll need to know

1276
01:00:04,910 --> 01:00:09,500
is that coupon bonds
typically pay semiannually.

1277
01:00:09,500 --> 01:00:12,530
Some coupon bonds can pay
quarterly, but most of them,

1278
01:00:12,530 --> 01:00:14,960
as a matter of convention,
pay semiannually.

1279
01:00:14,960 --> 01:00:16,670
But that changes
depending on the market.

1280
01:00:16,670 --> 01:00:18,878
So you'll need to learn a
little bit about those kind

1281
01:00:18,878 --> 01:00:20,246
of conventions.

1282
01:00:20,246 --> 01:00:21,620
I'm not going to
worry about that

1283
01:00:21,620 --> 01:00:23,078
and I'm going to
abstract from that

1284
01:00:23,078 --> 01:00:27,590
and simply say that here's a
three year coupon bond that

1285
01:00:27,590 --> 01:00:31,740
has a principal of $1,000.

1286
01:00:31,740 --> 01:00:35,510
That's the typical
principal or face value

1287
01:00:35,510 --> 01:00:37,400
that a bond comes with.

1288
01:00:37,400 --> 01:00:40,220
So this piece of
paper is an IOU.

1289
01:00:40,220 --> 01:00:46,700
And it says, I owe you $1,000
at the end of three years, OK?

1290
01:00:46,700 --> 01:00:49,730
But I'm not going to
pay you just $1,000

1291
01:00:49,730 --> 01:00:51,110
at the end of three years.

1292
01:00:51,110 --> 01:00:57,330
I'm going to pay you $50 every
year for those three years.

1293
01:00:57,330 --> 01:01:02,910
So the coupon is a 5% coupon.

1294
01:01:02,910 --> 01:01:07,770
So when you hear of a coupon
bond that's a 5% three year

1295
01:01:07,770 --> 01:01:11,830
bond, that term
that I just uttered

1296
01:01:11,830 --> 01:01:17,050
means that it pays off $1,000
at the end of three years.

1297
01:01:17,050 --> 01:01:21,609
And in the interim, it pays
off $50 a year as it's coupons.

1298
01:01:21,609 --> 01:01:22,900
Why is it called a coupon bond?

1299
01:01:22,900 --> 01:01:25,840
In the old days, the bond
was actually a piece of paper

1300
01:01:25,840 --> 01:01:28,900
and on the bottom of
it were little coupons.

1301
01:01:28,900 --> 01:01:31,630
And you'd clip the
coupons and mail them in.

1302
01:01:31,630 --> 01:01:33,880
And once a year when you
mail them in, or twice a year

1303
01:01:33,880 --> 01:01:37,521
when you mail them
in, you get back $50.

1304
01:01:37,521 --> 01:01:38,020
OK?

1305
01:01:38,020 --> 01:01:40,330
Nowadays, it's all
done electronically.

1306
01:01:40,330 --> 01:01:44,220
So first thing you do in order
to value of the cash flow--

1307
01:01:44,220 --> 01:01:46,060
draw a time line, OK?

1308
01:01:46,060 --> 01:01:48,460
We're here sitting at
zero, that's today.

1309
01:01:48,460 --> 01:01:50,140
And you've got
three years to go.

1310
01:01:50,140 --> 01:01:52,240
One year, two year, three years.

1311
01:01:52,240 --> 01:01:55,500
At the end of three years,
you get paid your principal--

1312
01:01:55,500 --> 01:01:57,250
$1,000--

1313
01:01:57,250 --> 01:01:58,860
plus the coupon.

1314
01:01:58,860 --> 01:02:01,460
There are three coupons
for three years.

1315
01:02:01,460 --> 01:02:07,170
And so at the end of this
bond, when the bond matures,

1316
01:02:07,170 --> 01:02:09,660
you get paid $1,050.

1317
01:02:09,660 --> 01:02:13,770
And then $50, $50, and
here we are at date zero.

1318
01:02:13,770 --> 01:02:17,040
Question-- what is this worth?

1319
01:02:17,040 --> 01:02:18,435
Yeah?

1320
01:02:18,435 --> 01:02:20,760
AUDIENCE: It depends
on the interest rate.

1321
01:02:20,760 --> 01:02:21,500
ANDREW LO: Right.

1322
01:02:21,500 --> 01:02:25,648
AUDIENCE: [INAUDIBLE] interest
rates are exactly 5%, so it's

1323
01:02:25,648 --> 01:02:27,762
worth just $1000, the same.

1324
01:02:27,762 --> 01:02:28,470
ANDREW LO: Right.

1325
01:02:28,470 --> 01:02:32,700
If the interest rate is 5%,
it's worth $1,000 today.

1326
01:02:32,700 --> 01:02:33,810
That's par.

1327
01:02:33,810 --> 01:02:37,107
But if the interest rate
is worth less than that--

1328
01:02:37,107 --> 01:02:40,320
AUDIENCE: Worth
more [INAUDIBLE]..

1329
01:02:40,320 --> 01:02:41,490
ANDREW LO: Right, exactly.

1330
01:02:41,490 --> 01:02:45,970
So in general, how do you figure
out the price of this thing?

1331
01:02:45,970 --> 01:02:47,561
Yeah.

1332
01:02:47,561 --> 01:02:51,489
AUDIENCE: [INAUDIBLE]
vice versa [INAUDIBLE]??

1333
01:02:56,865 --> 01:02:59,490
ANDREW LO: Well no, I was asking
a somewhat different question,

1334
01:02:59,490 --> 01:03:01,948
which is, how do I figure out
the market value of this bond

1335
01:03:01,948 --> 01:03:03,405
today times 0.

1336
01:03:03,405 --> 01:03:05,830
AUDIENCE: [INAUDIBLE]

1337
01:03:05,830 --> 01:03:09,110
ANDREW LO: Yeah, compute
the net present value, NPV.

1338
01:03:09,110 --> 01:03:10,560
That's one answer.

1339
01:03:10,560 --> 01:03:13,130
That was the correct
textbook answer.

1340
01:03:13,130 --> 01:03:15,910
What's another answer of how do
I figure out the market value?

1341
01:03:15,910 --> 01:03:16,790
AUDIENCE: Through the market.

1342
01:03:16,790 --> 01:03:17,581
ANDREW LO: Exactly.

1343
01:03:17,581 --> 01:03:18,450
Auction it off.

1344
01:03:18,450 --> 01:03:21,230
How many people want to pay
me $1,000 for this today?

1345
01:03:21,230 --> 01:03:22,630
No? $1,001?

1346
01:03:22,630 --> 01:03:23,630
a thousand and whenever.

1347
01:03:23,630 --> 01:03:25,430
We can auction it off
and figure out what

1348
01:03:25,430 --> 01:03:27,300
the price is from the market.

1349
01:03:27,300 --> 01:03:30,170
But in fact, what
we're doing by doing so

1350
01:03:30,170 --> 01:03:31,760
is computing the present value.

1351
01:03:31,760 --> 01:03:34,070
And the way we're doing
it is by figuring out

1352
01:03:34,070 --> 01:03:38,450
what the price of a dollar
is in date one today.

1353
01:03:38,450 --> 01:03:41,420
What the price of a dollar
in year two is today.

1354
01:03:41,420 --> 01:03:44,420
And what the price of a
dollar is in year three today.

1355
01:03:44,420 --> 01:03:46,760
Getting those exchange
rates and then

1356
01:03:46,760 --> 01:03:51,710
converting all of those
different currencies to dollars

1357
01:03:51,710 --> 01:03:52,531
today.

1358
01:03:52,531 --> 01:03:53,030
Right?

1359
01:03:53,030 --> 01:03:56,090
We know this we've
done this many times.

1360
01:03:56,090 --> 01:04:05,400
So the way that you
figure out valuation

1361
01:04:05,400 --> 01:04:11,590
is by using discount rates
that we get from the market

1362
01:04:11,590 --> 01:04:14,200
and applying them to compute
present values, right?

1363
01:04:14,200 --> 01:04:15,650
Very simple.

1364
01:04:15,650 --> 01:04:19,420
So really, the components
of evaluation for bonds,

1365
01:04:19,420 --> 01:04:22,130
if there's no uncertainty,
you already know.

1366
01:04:22,130 --> 01:04:22,750
We've done it.

1367
01:04:22,750 --> 01:04:24,610
That was last lecture.

1368
01:04:24,610 --> 01:04:30,130
And for special cash flows like
annuities and perpetuities,

1369
01:04:30,130 --> 01:04:32,350
we've got closed form solutions.

1370
01:04:32,350 --> 01:04:35,944
Formulas, which you can program
up in Excel to figure out.

1371
01:04:35,944 --> 01:04:37,360
The kind of risks
that we're going

1372
01:04:37,360 --> 01:04:42,310
to focus on later on in this
lecture and in the lectures

1373
01:04:42,310 --> 01:04:45,850
after we talk about
uncertainty is inflation risk.

1374
01:04:45,850 --> 01:04:47,230
We talked about that, right?

1375
01:04:47,230 --> 01:04:50,110
The fact that when you buy
a bond or you sell a bond,

1376
01:04:50,110 --> 01:04:52,180
if the purchasing
power changes, that's

1377
01:04:52,180 --> 01:04:55,840
going to introduce a
new kind of unknown

1378
01:04:55,840 --> 01:04:57,460
that we need to grapple with.

1379
01:04:57,460 --> 01:04:58,610
Credit risk.

1380
01:04:58,610 --> 01:05:00,490
That's a major form
of risk that we're

1381
01:05:00,490 --> 01:05:02,680
dealing with in
financial markets today

1382
01:05:02,680 --> 01:05:05,380
and that we're likely to be
dealing with for years to come.

1383
01:05:05,380 --> 01:05:10,100
You might like to borrow
from me or lend to me,

1384
01:05:10,100 --> 01:05:12,500
but what about credit issues.

1385
01:05:12,500 --> 01:05:14,000
How do you know
that I'm still going

1386
01:05:14,000 --> 01:05:17,900
to be around a year from
now, two years from now.

1387
01:05:17,900 --> 01:05:20,960
Timing, which we'll come back
to a little bit later on.

1388
01:05:20,960 --> 01:05:21,920
Liquidity.

1389
01:05:21,920 --> 01:05:23,480
And then of course,
what currency.

1390
01:05:23,480 --> 01:05:25,230
If we're doing
international borrowing,

1391
01:05:25,230 --> 01:05:28,790
we have an extra dimension of
risk, which is fluctuations

1392
01:05:28,790 --> 01:05:30,830
in the exchange rate, OK?

1393
01:05:30,830 --> 01:05:33,980
So for the next
couple of lectures,

1394
01:05:33,980 --> 01:05:37,760
I want to keep life simple and
talk just about riskless debt.

1395
01:05:37,760 --> 01:05:41,330
Riskless in terms of
default. So in particular I'm

1396
01:05:41,330 --> 01:05:44,610
going to be talking about
US government bonds.

1397
01:05:44,610 --> 01:05:45,380
All right?

1398
01:05:45,380 --> 01:05:47,120
And I'll come back
to risky debt later.

1399
01:05:47,120 --> 01:05:51,050
But for now, let's just focus
on the debt that will not

1400
01:05:51,050 --> 01:05:54,500
default because you can always
print up dollars to pay off

1401
01:05:54,500 --> 01:05:56,180
your creditors, right?

1402
01:05:56,180 --> 01:05:57,800
Those dollars may
not be worth as much

1403
01:05:57,800 --> 01:06:00,590
as you would like them to be
if you do too much of that,

1404
01:06:00,590 --> 01:06:04,980
but for now, we're not
going to focus on default.

1405
01:06:04,980 --> 01:06:08,980
OK so the first kind
of bond that we're

1406
01:06:08,980 --> 01:06:13,870
going to try to price is what's
called a pure discount bond.

1407
01:06:13,870 --> 01:06:16,780
This is a bond that is different
from a coupon bond in the sense

1408
01:06:16,780 --> 01:06:18,190
that there are no coupons.

1409
01:06:18,190 --> 01:06:23,530
So it only pays off
one payment at the end.

1410
01:06:23,530 --> 01:06:25,410
And the reason it's
called the discount bond

1411
01:06:25,410 --> 01:06:28,170
is because it is
what it sounds like--

1412
01:06:28,170 --> 01:06:32,160
the price of the bond today
is going to be at a discount

1413
01:06:32,160 --> 01:06:34,050
from the face value.

1414
01:06:34,050 --> 01:06:37,980
If the face value is $1,000
and there's nothing in between,

1415
01:06:37,980 --> 01:06:41,640
then the price of the banters
can't be greater than $1,000

1416
01:06:41,640 --> 01:06:46,240
because money today is worth
more than money next year.

1417
01:06:46,240 --> 01:06:49,410
So the price today is going
to be lower than $1,000.

1418
01:06:49,410 --> 01:06:52,380
It's going to be a
discount over $1,000, hence

1419
01:06:52,380 --> 01:06:54,150
the term pure discount bond.

1420
01:06:54,150 --> 01:06:56,850
Now there are pure
discount bonds out there.

1421
01:06:56,850 --> 01:07:00,120
US treasury bills
are examples, where

1422
01:07:00,120 --> 01:07:03,450
there's one payoff at the
end and nothing in between.

1423
01:07:03,450 --> 01:07:07,140
But awhile ago,
financial engineers

1424
01:07:07,140 --> 01:07:08,994
came up with a rather
brilliant idea,

1425
01:07:08,994 --> 01:07:11,160
which you may not think is
so brilliant because it's

1426
01:07:11,160 --> 01:07:12,870
so painfully obvious.

1427
01:07:12,870 --> 01:07:15,760
The government issues
coupon bonds as well.

1428
01:07:15,760 --> 01:07:17,790
And typically, for
longer maturities,

1429
01:07:17,790 --> 01:07:21,780
like five years,
15 and 30 years,

1430
01:07:21,780 --> 01:07:25,980
there are no pure discount bonds
for those longer maturities.

1431
01:07:25,980 --> 01:07:30,279
When the government issues them,
they issue them with coupons.

1432
01:07:30,279 --> 01:07:31,820
But you can imagine
a situation where

1433
01:07:31,820 --> 01:07:36,990
somebody would like to have
a discount bond for 30 years.

1434
01:07:36,990 --> 01:07:38,910
And so some clever
financial engineer said,

1435
01:07:38,910 --> 01:07:41,090
hey, here's what
I'm going to do.

1436
01:07:41,090 --> 01:07:46,070
I'm going to buy up a lot of
these treasury coupon bonds

1437
01:07:46,070 --> 01:07:50,480
and I'm going to issue
discount bonds that

1438
01:07:50,480 --> 01:07:55,430
match exactly the coupon
payments from my treasury

1439
01:07:55,430 --> 01:07:56,240
bonds.

1440
01:07:56,240 --> 01:07:58,190
In other words, I'm
going to take the coupons

1441
01:07:58,190 --> 01:08:03,840
and strip them and offer them
up as separate securities.

1442
01:08:03,840 --> 01:08:08,070
And I'm going to
call these STRIPS.

1443
01:08:08,070 --> 01:08:11,910
And these STRIPS, which
stands for separate trading

1444
01:08:11,910 --> 01:08:15,600
of registered interest
and principal securities,

1445
01:08:15,600 --> 01:08:20,100
created a huge market
for essentially

1446
01:08:20,100 --> 01:08:23,040
what are government
bonds, but that

1447
01:08:23,040 --> 01:08:26,790
have been pre-processed in
a relatively simple way.

1448
01:08:26,790 --> 01:08:29,500
Now, this didn't
happen that long ago.

1449
01:08:29,500 --> 01:08:32,550
Maybe, I don't know, 15 or 20
years ago they created STRIPS.

1450
01:08:32,550 --> 01:08:35,146
So this is why I'm so excited
about financial markets

1451
01:08:35,146 --> 01:08:37,520
and why I think all of you
have tremendous opportunities.

1452
01:08:37,520 --> 01:08:40,500
It's because there
are so many ideas that

1453
01:08:40,500 --> 01:08:44,640
may seem obvious to you but
are not obvious to the market.

1454
01:08:44,640 --> 01:08:47,910
And there's no
patent on good ideas.

1455
01:08:47,910 --> 01:08:49,830
There's no monopoly
on good ideas.

1456
01:08:49,830 --> 01:08:52,920
You can actually
create tremendous value

1457
01:08:52,920 --> 01:08:54,660
by coming up with
what you might think

1458
01:08:54,660 --> 01:08:56,970
of as so simple a
solution but that

1459
01:08:56,970 --> 01:09:01,220
solves problems for very
large financial institutions.

1460
01:09:01,220 --> 01:09:02,630
Now how do we
price these things.

1461
01:09:02,630 --> 01:09:05,569
Well, this is just a one liner.

1462
01:09:05,569 --> 01:09:08,600
The price of a
discount on is simply

1463
01:09:08,600 --> 01:09:11,270
equal to its face
value discounted

1464
01:09:11,270 --> 01:09:15,529
to the present by the
appropriate interest rate.

1465
01:09:15,529 --> 01:09:16,670
That's it.

1466
01:09:16,670 --> 01:09:17,740
Pure and simple.

1467
01:09:17,740 --> 01:09:21,430
We're now done with pricing
pure discount bonds.

1468
01:09:21,430 --> 01:09:23,800
There's nothing else to it.

1469
01:09:23,800 --> 01:09:25,720
OK.

1470
01:09:25,720 --> 01:09:29,290
It turns out that this is a
really wonderful relationship

1471
01:09:29,290 --> 01:09:32,830
because if you've got two
of these three variables

1472
01:09:32,830 --> 01:09:36,189
in this equation,
you've got the third.

1473
01:09:36,189 --> 01:09:38,260
If I tell you what
the face value is

1474
01:09:38,260 --> 01:09:40,580
and what the interest rate
is, you've got the price.

1475
01:09:40,580 --> 01:09:43,122
If I tell you what the price
is and what the face value is,

1476
01:09:43,122 --> 01:09:44,330
you've got the interest rate.

1477
01:09:44,330 --> 01:09:46,960
And if I give you the
interest rate of the price,

1478
01:09:46,960 --> 01:09:50,229
you can actually figure out what
the face value is, all right?

1479
01:09:50,229 --> 01:09:52,779
So this relationship is
going to be very handy when

1480
01:09:52,779 --> 01:09:55,150
we look at the prices
of these instruments

1481
01:09:55,150 --> 01:09:59,710
and we want to now infer
what that says about what's

1482
01:09:59,710 --> 01:10:01,420
going on with interest rates.

1483
01:10:01,420 --> 01:10:04,150
In fact, what I'm going to
show you next time is that when

1484
01:10:04,150 --> 01:10:06,190
we look at the
newspaper and we take

1485
01:10:06,190 --> 01:10:10,210
a look at the prices of
discounted coupon bonds,

1486
01:10:10,210 --> 01:10:14,755
implicit in those prices is
a forecast of the future.

1487
01:10:14,755 --> 01:10:16,380
This is as close as
any of you are ever

1488
01:10:16,380 --> 01:10:18,270
going to get to a crystal ball.

1489
01:10:18,270 --> 01:10:19,170
I'm serious.

1490
01:10:19,170 --> 01:10:21,970
By looking at prices,
you can tell the future.

1491
01:10:21,970 --> 01:10:24,570
You can't do it
perfectly, but neither

1492
01:10:24,570 --> 01:10:27,720
can Jean Dixon or any of the
other astrologers, right?

1493
01:10:27,720 --> 01:10:31,680
The point is that this is
our way of figuring out

1494
01:10:31,680 --> 01:10:35,500
the collective intelligence
of all market participants

1495
01:10:35,500 --> 01:10:38,040
and what they think of
what was going to happen.

1496
01:10:38,040 --> 01:10:43,980
And because of that, because of
that kind of market knowledge,

1497
01:10:43,980 --> 01:10:46,980
I can tell you that
with 99.5% confidence,

1498
01:10:46,980 --> 01:10:49,500
tomorrow, the Fed will
cut its interest rate.

1499
01:10:49,500 --> 01:10:50,790
Now how do I know that.

1500
01:10:50,790 --> 01:10:51,840
I don't know that.

1501
01:10:51,840 --> 01:10:53,460
The Fed may not.

1502
01:10:53,460 --> 01:10:55,309
But if you look at
financial markets today,

1503
01:10:55,309 --> 01:10:56,850
if you look at
treasury prices today,

1504
01:10:56,850 --> 01:11:00,980
if you look at the Fed funds
features, all of those prices--

1505
01:11:00,980 --> 01:11:03,710
if you know how to read that,
if you can decipher those tea

1506
01:11:03,710 --> 01:11:05,120
leaves--

1507
01:11:05,120 --> 01:11:07,500
it will tell you that tomorrow,
the Fed will cut rates.

1508
01:11:07,500 --> 01:11:10,450
So I want you to watch tomorrow
to see if I'm right, OK?

1509
01:11:10,450 --> 01:11:14,360
It would be very embarrassing
and potentially catastrophic

1510
01:11:14,360 --> 01:11:16,280
if I'm wrong.

1511
01:11:16,280 --> 01:11:19,120
So listen carefully.

1512
01:11:19,120 --> 01:11:21,344
Any questions?

1513
01:11:21,344 --> 01:11:22,820
Yeah.

1514
01:11:22,820 --> 01:11:24,296
AUDIENCE: [INAUDIBLE].

1515
01:11:30,741 --> 01:11:31,740
ANDREW LO: That's right.

1516
01:11:31,740 --> 01:11:34,140
In other words, if they
cut rates tomorrow,

1517
01:11:34,140 --> 01:11:36,390
then they're going
to be shooting

1518
01:11:36,390 --> 01:11:39,840
one of the very few remaining
bullets that they have.

1519
01:11:39,840 --> 01:11:42,172
The question is, if a
bear is charging at you

1520
01:11:42,172 --> 01:11:44,130
and you've got one bullet
left, you're probably

1521
01:11:44,130 --> 01:11:45,840
going to use it anyway, right?

1522
01:11:45,840 --> 01:11:48,340
So why don't we return to
this issue on Wednesday

1523
01:11:48,340 --> 01:11:49,340
since we're out of time?

1524
01:11:49,340 --> 01:11:51,290
All right, thank you.