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SOME THINK FAST, SOME SLOW JUST THINK! SIC PRESENTATION, 9/12/2013 THREE IMPORTANT IDEAS FRAMED INCORRECTLY Size of the derivatives market Disappearance on IPOs Options expensing OMG ?? EXAMPLE • I own 5,000 shares of IBM, worth about $1,000,000. • Hedge drop in price, long 50 put contracts, X = 170, price of $0.27 per share (put contract = 100 shares) • Long side, notional value $1,000,000 • Short side, notional value $1,000,000 • Short side was dealer putting a bigger deal together, buys an offsetting put, X = 170, for $0.25 per share • Long side, notional value $1,000,000 • Short side, notional value $1,000,000 • Short side is a PE firm with a short position on 50,000 shares sold @ $200 (ignoring rest of hedge). EXAMPLE • Finally, price of IBM drops to $185 a share. I sell my 5,000 shares of IBM, for $925,000. And to eliminate my put, I entering into an offsetting put, price is now $7.00 per share (netting me $35,000). • Short side, notional value $925,000 • Long side, notional value $925,000 • Total derivatives outstanding (notional amount) is $5,850,000. Note that $3,850,000 is perfectly offsetting (no risk to system). Remaining short is covered by short position (net no risk). EXAMPLE • 5,000 shares of IBM, worth $925,000. • Total derivatives outstanding (notional amount) is $5,850,000. • Appears that derivatives market is 6.32 times the size of the asset market. • And none of this has anything to do with GDP! THE ASSET APPROACH http://www.zerohedge.com/news/2013-03-07/us-households-have-never-been-more-reliant-stock-market-their-net-worth COMMERCIAL REAL ESTATE GDP? • Again, perspective is (partially) wrong. • Treat world GDP as a perpetuity – an asset! • $50 trillion / 10% = $500 trillion. That is was is at play, not the annual nominal cash flows from that asset. • Is it more correct to think of total derivatives positions (especially repeats) as a stock or a flow? Consumption GDP? GDP? • Again, perspective is (partially) wrong. • Treat world GDP as a perpetuity – an asset! Not entirely correct, but not entirely wrong either. • $50 trillion / 10% = $500 trillion. That is was is at play, not the annual nominal cash flows from that asset. • Is it more correct to think of total derivatives positions (especially repeats) as a stock or a flow? Consumption GDP? HOW DOES GDP PLAY? MLB postseason chances • http://mlb.mlb.com/mlb/standings/probability.jsp WHERE HAVE IPOS GONE? CAUSES • Popular view: drop in public market valuations of tech companies, heavy-handed regulation such as Sarbanes-Oxley (SOX), and a drop in analyst coverage of small companies • Jay’s view: declining profitability of small firms IMPLICATIONS? • Popular view: 10m – 20m “lost” jobs • Jay’s view: (research) assume(s) that thousands of companies that didn’t go public would have grown as fast as companies such as Google if they had! This assumption, which I would tend to categorize as completely ridiculous … IMPLICATIONS? • Popular view: fix SEC, Wall Street, etc. • Jay’s view: fewer investor protections can potentially result in more fraud • Eg., S. 1791 “Democratizing Access to Capital Act of 2011” and S. 1970 “Capital Raising Online While Deterring Fraud and Unethical Non-Disclosure Act of 2011” OPTIONS EXPENSING • Short video “Stock options should be charged to earnings.” OPTIONS EXPENSING • Think about Cisco example • $2.6 billion profit cut in half. Implications for the firm? • Does this “expense” smell right? • What do all other expenses have in common? • Do options? OPTIONS EXPENSING • Scenario A: Whiz computer programmer leaves IBM for a start-up. Was making $300K (assume this is “fair”). Offered $100K plus deferred options package. B-S puts package at $500K. • Scenario B: Whiz computer programmer leaves IBM for a start-up. Was making $300K (assume this is “fair”). Offered $300K . Has right at end of year to buy same options package as Scenario A. ACCOUNTING Scenario A Salary Exp Cash Scenario B $100,000 $100,000 Opt Expense $500,000 Cont Eq $500,000 Salary Exp Cash Cash $300,000 $300,000 $200,000 Opt Revenue $200,000 Cont Cash $XX Cont Equity $XX “Fair value” is NOT a finance question. It is an HR question! And even if you disagree with that point, still ignoring Revenue! IMPORTANT QUESTION • How messed up are financial statements for firms that were forced to expense options? • How can we profit from this?