Designing a Nexus of Contracts - PowerPoint Presentation

Slide1

Designing a Nexus of ContractsSlide2

Crucial Glue

FINITE

CommunicationSlide3

Thinking BigOrganizations live in MarketsProduct MarketsLabor MarketsFinancial MarketsHow much is iPhone worth to you? What disclosures did Uber need to raise $500 million?You go to a store and find that apples have increased in prices, but not oranges. What would you do? Slide4

Thinking BigEcon 101 Demand and supply curvesElasticityConsumer and Producer SurplusDeadweight lossOpportunity CostsEcon 102Allocation role of prices (prices don’t tell you about value)Information role of prices (they do tell you about value)Slide5

Thinking Big – Long RunWhat glues all markets in the long run?Freedom from extraction by elite/governmentSocial compact and social norms (Spinoza)Be tolerant, but punish the outliersUniversal education (to cultivate said norms)Slide6

Thinking Big: Long-run World PopulationSlide7

Thinking Big Long-run: World GDP per capitaSlide8

Thinking Big – Long RunWhat glues all markets in the long run?Freedom from extraction by elite/governmentSocial compact and social norms (Spinoza)Be tolerant, but punish the outliersUniversal education (to cultivate said norms)In the long run, we are also deadFocus on short/medium runSlide9

Thinking Big – Medium RunOrganizations live in MarketsProduct MarketsLabor MarketsFinancial MarketsWhat glues all these markets?Market for MoneyMoney is the yardstick by which everything is measuredThe financial crisis has made macro important to all CEOsGoal is not to become a macro expertNot to be completely cowed when meeting macro “experts” in the boardroomSlide10

Three Roles of MoneyUnit of AccountMedium of ExchangeStore of ValueUS GDP is $14 trillion, but there is only $800 billion in hard cash floating around (a considerable amount of which is outside the US with mobs and such)Money multiplier and money velocity (role playing with: a company, a supplier, a bank)Slide11

Simulation of an EconomyBakerYoga InstructorHair stylistYou won’t remember any formula, but you will remember baker-stylist-yogi My spending is your income and your spending is my incomeI save more and spend less; I am better offYou save more and spend less: I am worse offEveryone saves more and spends less: everyone is worse offSlide12

Prices vs QuantityHow should the markets respond to lower demand? Cut prices and wages (Chicago)Markets adjust and life goes onCannot cut wages (Keynes)It is a huge psychological headache to cut wages across the company (as opposed to cutting, say, the price of steel)Therefore firms cut employment and quantity produced and demandedLayoff 10% of workforce, not cut all salaries by 10%Markets fail and need government interventionSlide13

Role of Government and Fed (two independent entities)MoneySocial contrivanceGroup sociology and beliefs about beliefs and trustFiscal PolicyBecome an active participant in the economyShort and long run effects? Fiscal Policy is the job of the US government who is like you and me, in that it has to borrow money if spends more than it makes.Monetary PolicyIntervene in the yardstick or the money marketShort and long run effects? Monetary policy is run by the Fed which is a) independent of the US government and b) can print or burn money whenever it wishes. Slide14

Monetary PolicyFed independent of GovernmentFed buys a lot of bondsFed pays for these bonds with moneyWhere does this money come from? More money in the economy and low interest rateBaker, Hair stylist, Yoga InstructorMore demand, more construction and expansionYou are are the CEO: To expand or not to expand? Slide15

Fed Pours Money into the Economy During periods inflation: A dollar buys a lot less than beforeYardstick changes hit everyone, and hit everyone differentlyInflation typically refers to prices of goods and services (e.g., rent)Asset prices (housing, stock, bonds) are not includedImpact of easy money on consumables vs. assetsSlide16

Quantitative Easing ($MM)Slide17

A Money GraphSlide18

The “Price” of MoneyAll else equal, suppose there is an oversupply of potatoes The price of potatoes will fall.When the Fed floods the market with moneyThe “price” of money should fallWhat is this “price”?What do you lose out by holding sacks of cash in your home? Slide19

Interest Rate and Asset PricesWhen Fed buys a lot of bonds from Americans (these bonds pay $X next period, e.g.)Price P goes upInterest rate R goes downThe economy is flooded with money from the FedEnglish story: People are lining up to lend money to company Joe (i.e., they want to buy Joe’s bonds). Joe will say, “Okay, I will borrow money from y’all, but I will pay very low interest rates.” And people will say, “Ok.”What will happen to R if there are many Joes who want to borrow, and these Joes overwhelm the people who want to lend? Slide20

Prices and QuantitiesWhen companies want to invest in real stuff, they need moneyThe price of money or interest rate goes upWhen people hoard moneyThe price of money or interest rate is lowThe prices of hoarded stuff --- stocks and houses --- goes upReal versus Financial InvestmentsSlide21

Interest RatesSlide22

The importance of IncomeIf you’re broke, should you double your debt? Government issues bonds to finance its spending Government sells bondsP goes down, R goes upImpact on other borrowers such as firmsImpact on economyWhat is the optimal level of government debt? Slide23

Prices and Quantity RevisitedWhen the Fed pours money and (rich) people hoardPrice of money (interest rates) stays fallenStocks and other rich peoples’ assets boomThere is no trickle-down (i.e., there is no job creation)Inflation, i.e., prices of goods that people buy, stays lowWhen the Fed pours money and the economy picks upPrice of money, i.e., interest rate, rises (people need to borrow money to build plants, etc.)Prices of goods rise (because people have more money to buy things)Stocks and Assets? Slide24

Key Disagreements on MarketsChicagoan self-correcting marketsPrices and wages adjust: unemployed bid the prices and wages downNo forced unemploymentKeynesian markets subject to occasional breakdowns Prices and wages too highInvoluntary unemploymentMagneto troubles and the importance of backing offSlide25

International EconomicsNot one type of money, but many typesDollar, Euros, etc.,Interactions between many money marketsEach country’s financial marketsEach country’s labor marketsEach country’s product marketsAmerican exceptionalismWe all borrow in dollarsWhen dollar is strong:We pay the same in interest (unlike Indian companies)We export less and import more (GM vs. Tata)Slide26

Flight to SafetyWhy do you need “safe” assets? You sell your company to IBM. They pay you $100MWhere to park that money? Flight to safetyEveryone is freaked outEveryone is hoarding “safe” government bondsPrice P goes upInterest rate R on government bonds goes down (almost zero)No one wants to buy corporate bondsSo their P is low and their R is high So no company wants to borrow and invest in new factoriesEveryone is hoarding anyways; so no point building factoriesSlide27

Summary of MacroMacro is hardRests on unpredictable “mass psychology”No clear guidanceMacro funds have lost much money (Pimco, Paulson, etc.)Reiterating the goalNot to be a macro “expert”Not to be cowed in the boardroomYou won’t remember any formula, but you will remember baker-stylist-yogiCan the “expert” explain their story in this toy economy? Larry Summers:

http://

larrysummers.com

/2016/02/17/the-age-of-secular-stagnation/Slide28

Many many R’sMany types of interest ratesInterest on short-term government bondsInterest on long-term government bondsInterest on corporate bondsWhy are the interest rates different across these bond classes?RiskSlide29

Finance: Risk and ReturnTwo strangers: Stefanie and YuliaSame age, race, gender, socioeconomic, risk preference, and wealth statusBoth have no insider information in IBM stockBoth receive $200,000 inheritance at the same timeWhy is Stefanie much more reluctant to invest $200,000 in IBM stock than Yulia? Slide30

Finance: Risk and ReturnStefanie works for IBM (or has other IBM exposure)When IBM tanks, she loses both her savings and her jobYulia works for a hedge fundWhen IBM tanks, she still has her jobRisk is not the volatility of IBM stockRisk of IBM is how that stock fits into the person’s whole lifeRisk of a project is the relation between that project and everything else the person owns Slide31

Finance: Risk and ReturnA risky project is one which increases your overall riskYou pay less for it upfront (compared to some other person)That is why your returns on the project are higher (compared to the other person)Meaning of “High risk high return”An insurance is a project that decreases your overall riskYou pay a lot for it upfrontYour returns on the insurance are low (often -100%)Meaning of “Low risk low return”Another name for Expected Return of a Project: Cost of CapitalSlide32

Risk and Return --- OaktreeSlide33

Risk and Return --- OaktreeSlide34

Finance: Risk and ControlAnother reason why IBM risk could be lower for Stefanie than JuliaStefanie has control over IBM So when things start going badly for IBM, she can fix itThe valuation and riskiness of a firmPassive investorActive investorSlide35

Risk and Control – Day 1 of Class

Assets

Owners’

Equity

LiabilitySlide36

Ownership and Control – Day 1 of ClassWhen firm does wellCashflow rights: Bondholders get their interest, shareholders get the restControl rights: Shareholders control the firmWhen firm does poorly and goes bankruptCashflow rights: Bondholders get nothing, shareholders get nothingControl rights: Bondholders control the firmA firm looks likely to go into bankruptcy and you have money to investHow should you attack? What after you win? Slide37

An Organization Floating in Markets

FINITE

Communication