• How to Do Well In This ClassHow to Do Well In This Class

• Spend enough time on the homework problems and articles so that you feel comfortable with the topic.

• This does not necessarily mean you get everything correct – but complete ignorance will not be bliss when it comes time for the exam.

• Listen and participate in class by answering and asking questions. Studies show that people remember much more of what they hear than what they read, so simply reading the notes and book may not be enough for many students.

• Active participation is also a better way to remember the material we cover. For those who often struggle on exams, it shows me that you may still be competent in the subject matter and are at least trying.

Introduction

• COURSE SYLLABUS

• COURSE OUTLINE

• Objective valuation - tools and models

• Choose investments - rules for choosing

• Finance investments - debt vs. equity, long vs. short

Goal of the Lecture:

Understand how important economic variables change and impact business.

ECONOMY ANALYSIS

IMPORTANT VARIABLES TO FORECAST

• GNP - gives cash flows

• Interest rates - gives discount rate

• Both used to get present value of cash flows

QUESTION: Why try to predict the near future in the business cycle?

Because different investments are best performers in each part / few can successfully predict the business cycle.

STOCK PRICES FLUCTUATE MORE THAN GNP

QUESTION: Why?

• firm profits swings are usually amplified in comparison to GNP swings.

• profit margin fluctuates - input costs rise faster than output price heading into a recession.

• input prices fall or rise slower than output prices heading into an expansion.

PROFIT MODEL

= PQ - CQ

where = Total profit P = output price per unit Q = output in units C = input price per unit of output

Profit margin = P - C

C fluctuates with capacity and labor utilization rates and technology.

MONETARY MODEL OF GNP - QUANTITY THEORY

GNP = MV = PQ

GNP = GROSS NATIONAL PRODUCTM = MONEY SUPPLYV = GNP/M = VELOCITY OR TURNOVER -

some assume V is constantP = OUTPUT PRICEQ = QUANTITY OF OUTPUT

QUESTION: What happens when fed increases M?

• Q rises, P rises, or both

• larger Q increase when capacity is underutilized

• otherwise if at full capacity then only P increases - inflation.

• watch Fed numbers for money supply in WSJ - Credit Market section.

INTEREST RATESINTEREST RATES HAVE 3 COMPONENTS

Rg =Rr + I + P

where Rg = gross nominal interest rateRr = real interest rate - compensation for saving

I = expected inflation rate - compensation for expected inflation

P = compensation for business, financial, liquidity, and exchange rate risks

EXAMPLES Rg Rr I PTbill .002 = .025 - 0.023 + .00Tbond .035 = .025 + .010 + .00Junk .105 = .025 + .010 + .07

DEFICIT EFFECTS ON INTERNATIONAL TRADE

TWO DEFINITIONS OF GROSS NATIONAL PRODUCT (GNP)

output GNP = C + I + G + EX

income GNP = C + S + T + IM

C = CONSUMPTION I = INVESTMENTEX = EXPORTSG = GOVERNMENT SPENDINGS = SAVINGST = TAXESIM = IMPORTS

1. What is the output definition of GNP?

• The total dollar value of everything produced in the nation, including services, in one year.

• This is the most commonly understood and used definition.

• Goods are produced for consumers, for investment (plant and equipment), for government, and for export.

2. What is the income definition of GNP?

• The total dollar value of income spent in the nation in one year.

• This definition is seldom used by the public and less understood.

• Production generates income for the factors of production and that income is spent on consumer goods, savings, taxes, and imported good.

IMPLICATIONS OF GNP DEFINITIONS

SET THE TWO DEFINITIONS EQUAL

GNP = C + I + G + EX = C + S + T + IM

I + G + EX = S + T + IM

or (EX - IM) = (T - G) + (S - I)

trade (def / surplus) = gov (def / surplus) +household (def / sur)

This shows that the trade, government, and household budgets are connected.

(EX - IM) = (T - G) + (S - I)

Simple Example: -$600 = -$400 + ?

More Complex Example: Consider the following information. Recently, the U.S. Treasury announced that it expects tax revenues to be $500 billion smaller this year than last year. Also, the recession is causing people to save more this year, by about $100 billion. Furthermore, government spending is expected to increase by $700 billion and companies are expected to invest $100 billion less than last year. What change can we expect for the trade deficit? What might happen to interest rates and the dollar’s value given this scenario?

Adding the Capital Budget – International Financial Flows

(EX - IM) = (T - G) + (S - I)

= (capital out - capital in)

= capital(surplus/deficit)

Example: Suppose that our President throws up on the Chinese President and the next day the Chinese President decides to sell $100 billion U.S. Treasury bonds. What will happen to the U.S. trade deficit assuming that U.S. investors hold their foreign investment constant? What might happen to U.S. interest rates and the dollar?

This shows that the trade, government, and household budgets are also connected to capital flows into deficit countries and out of surplus countries.

Note:Note: Capital flows move quicker than goods flows so Capital flows move quicker than goods flows so trade and capital accounts may not match exactly on a trade and capital accounts may not match exactly on a quarterly basis but should be close on an annual basis. quarterly basis but should be close on an annual basis.

Note:Note: There could be a difference between the trade There could be a difference between the trade account balance and the capital account balance due to account balance and the capital account balance due to unrecorded transactions or mis-measured transactions. unrecorded transactions or mis-measured transactions. This could involve illegal or black market transactions.This could involve illegal or black market transactions.

Like MV = PQ, financial side = goods side of transaction. But otherwise, the models are not related even though they both start with GNP.

Ordinarily, when a country has a trade surplus (deficit) its currency appreciates (depreciates).

What is going on at the micro level?

Illustration 1: Assume that Japan’s Toyota exports $50 billion in cars to the U.S. They could take the cash and buy $50 billion in parts from U.S. manufactures. If they don’t do this, they need to spend the $50 billion somehow, say by buying U.S. real estate, stocks or bonds. Hence, a deficit in goods trade implies a surplus in financial flows.

Illustration 2: The U.S. government has recently made it clear that it wants to reduce the value of the dollar. How might Toyota’s decision change if Toyota believes this?

Question: U.S. investors are buying more foreign stocks because they have high returns. What could be the effects? Trivia Question: Why are there so many old sunken ships with gold in them, which salvagers try to recover?

Steps in the 1997-1998Asian Financial Crisis

1.1. Thailand experiences major financial collapseThailand experiences major financial collapse

2.2. Russia defaults on government debtRussia defaults on government debt

3.3. World-wide rush to buy U.S. Treasury bonds (caused World-wide rush to buy U.S. Treasury bonds (caused ITCM collapse – Fed - banks - bail out).ITCM collapse – Fed - banks - bail out).

4.4. Dollar appreciates – intermediate mechanismDollar appreciates – intermediate mechanism

5.5. Real U.S. export (import) prices increase (decrease)Real U.S. export (import) prices increase (decrease)

6.6. U.S. exports (imports) fall (rise)U.S. exports (imports) fall (rise)

7.7. U.S. interest rates fall – intermediate mechanismU.S. interest rates fall – intermediate mechanism

8.8. U.S. consumption (savings) rises (falls), investment U.S. consumption (savings) rises (falls), investment risesrises

Graphing the relevant data for Asian Financial Crisis

1.1. Go to economagic.com, click on Federal Reserve, St. Go to economagic.com, click on Federal Reserve, St. LouisLouis

2.2. Click U.S. Balance of Payments DataClick U.S. Balance of Payments Data

3.3. Click Balance on Current Account (this is quarterly)Click Balance on Current Account (this is quarterly)

4.4. Click Gif Chart or PDF Chart (see recent – and to 1960)Click Gif Chart or PDF Chart (see recent – and to 1960)

5.5. Click Foreign Assets in the United States, Net Capital Click Foreign Assets in the United States, Net Capital Inflows (US Assets Abroad, Net Outflows)Inflows (US Assets Abroad, Net Outflows)

6.6. Click U.S. Interest Rate Data. Then click on 30-Year Click U.S. Interest Rate Data. Then click on 30-Year Treasury Constant Maturity – or another maturityTreasury Constant Maturity – or another maturity

7.7. Click Exchange Rate Data. Then click Trade-Weighted Click Exchange Rate Data. Then click Trade-Weighted Exchange Index: BroadExchange Index: Broad

8. For Export and Import Prices – go to 8. For Export and Import Prices – go to www.bls.gov

9. Click Import/Export Price Indexes9. Click Import/Export Price Indexes

10. Under History Tables: Complete Historical Index10. Under History Tables: Complete Historical Index

11. Click under U.S. Import Price Index, Table 1, By End 11. Click under U.S. Import Price Index, Table 1, By End UseUse

12. Click under U.S. Export Price Index, Table 2, By End 12. Click under U.S. Export Price Index, Table 2, By End UseUse

13. Copy and paste “All Commodities” data and use the 13. Copy and paste “All Commodities” data and use the December figures to calculate year-to-year changes.December figures to calculate year-to-year changes.

14. You can see that import prices fell faster than export 14. You can see that import prices fell faster than export prices around 1997-1998.prices around 1997-1998.