Corporate Finance in a Nutshell: Markets, Risk, Mergers & Acquisitions, Options, and More | Chester Sky | Skillshare

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Corporate Finance in a Nutshell: Markets, Risk, Mergers & Acquisitions, Options, and More

teacher avatar Chester Sky, Entrepreneur and Producer

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Taught by industry leaders & working professionals
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Taught by industry leaders & working professionals
Topics include illustration, design, photography, and more

Lessons in This Class

14 Lessons (2h 9m)
    • 1. Introduction

      1:25
    • 2. History of Finance Financial Markets

      9:18
    • 3. Intellectual Property Protection

      8:29
    • 4. Market Efficiency and Crashes

      12:27
    • 5. Risk and Diversification

      14:49
    • 6. Role of Government

      11:30
    • 7. Call Options

      7:30
    • 8. Long Put Option

      3:23
    • 9. Short Put Options

      2:45
    • 10. Short Call Option

      4:18
    • 11. Mergers and Acquisitions

      25:20
    • 12. Takeovers, Leveraged Buyouts and Defense Tactics

      15:33
    • 13. 2008 Financial Housing Collapse

      11:25
    • 14. Conclusion

      0:52
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About This Class

This class is a non-fiction narrative, taking you on a journey to see where modern finance came from. It describes how financial theories were developed, how ideological and government experiments shaped economies, and the rise and fall of financial markets. It discusses the influential thinkers who shaped the structure of our society, crazy scams that worked (for a while), and demystifies financial concepts into simple ideas the layman can understand and relate to. 

This course will teach you to understand:

  • Financial and Capital Markets. What’s the purpose?
  • The importance of Intellectual Property Protection
  • Market Efficiency and Market Crashes
  • Risk and Diversification, Market Bubbles
  • The Role of Government In Finance. How government can help or hinder markets
  • The Basics of Option Strategies
  • Mergers and Acquisitions
  • Takeovers, Leveraged Buyouts, and Defense Tactics
  • 2008 Financial U.S. Housing Collapse and the financial tools that caused it

And much much more…

By the end of this course, you’ll be able to talk fluently about key financial concepts, unpack financial stories in the news, and recognize financial ideas as they show up in everyday life.

 

Meet Your Teacher

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Chester Sky

Entrepreneur and Producer

Teacher

Entrepreneur, Producer and Composer

Official Website: http://chestersky.com

Facebook page: https://www.facebook.com/RealChesterSky/

Twitter page: https://twitter.com/RealChesterSky

Instagram: https://www.instagram.com/iamchestersky/

See full profile

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Transcripts

1. Introduction: welcome to the history of corporate finance. Have you ever wondered where do financial markets comfort? Why is the world run by money anyways? How did financial markets evil? If you really want to understand financial markets, probably learn about what influenced them in the first books. This course you'll learn the answers. We'll talk about financial and capital markets. What is the purpose of talk about the importance of intellectual property protection and its influence on capitalistic economy? Market efficiency? What causes a market bubble in a market crack risk and diversification? The role of government in finance? How can a government health or finger market option strategies, mergers and acquisitions, takeovers, leveraged buyouts and defensive tactics and the 2008 financial US 1000 collapse and financial instruments that product out? So what we're doing is we're bringing together a lot of information from a lot of different fields to give you a bird's eye view of what shaped and influenced our economy. So far, this is history corporate 2. History of Finance Financial Markets: What is the purpose of a financial market? It is a few theories that discuss why we have financial markets. Thomas Malthus was an 18th century British philosopher. He's famous for this idea about why populations grow is it is this. There's resources and those people and people consume these resources, this food, water and so on, and at a certain point, their population grow so much that is not enough food to go around. At this point, people start, they die and the population goes down. At a certain point, there's so few people that the resources start to accumulate and has enough resources for people to survive. So they start to eat more and they start to reproduce more. But then the population keeps growing, until eventually you're back at the start again. So this was a very persuasive idea. Even Charles Darwin go a lot of his ideas from Thomas Malthus, and these ideas became so convincing that the British parliament started enacting laws based around this idea that we don't want the population to grow so much that they outgrow all of the food and resources. So the British Parliament actually created these work houses for the poor with restricted calorie diets for these poor people, and they even spiked the food with certain things to restrict the sexual drive of these people. And this is where you had these awful working conditions. And you have these stories by, for example, Charles Dickens's With All of the Twist. This is essentially the barn orphan, a kid who has no no family. So he's sent to work in a workhouse where people who have no means of any education of money they just have to work now. This was a very unpleasant error to live in. And Charles Dickens also vote book The Christmas Carol, which is a story exactly opposite saying, Why are we living in these conditions and why are we not being kinder to people anyways? So it turns out, Thomas Malthus was actually wrong about a lot of this theory. He made some incorrect assumptions. He assumed that populations grow exponentially, and that's why we would ouch grow our resources. But it turns out they don't do that once you get to a certain income level. Once you meet a middle income level, the number of Children that a family has tends to decrease. Also mouth. It's assumed that output would be constant. But it turns out that the amount that is produced with the population also increases as the population increases. So there's might be more resources to a certain extent as the population grows. So we had to come up with another theory. In 1912 Joseph Schumpeter came up with another theory. Joseph Schumpeter is an interesting fellow. He had three goals in life. He wanted to be the greatest lover, the greatest horsemen writer and the greatest economist. And later on he claims that he accomplished two of those three things. Although he didn't specify which things they were, he was a bit of a re Belus. Well, when he was in school, he kept getting in trouble because he would go around and hang out with prostitutes all the time. One of his professors, they asked them, Please stop associating with prostitutes. And in response, what he did is he hired for prostitutes to go for a ride with him in an open horse carriage and just rolled around town with him anyways, so he turned out to be brilliant, a finance. He went to one of the top financial schools, and his idea is this. There are two ways that companies can compete bacon, either lower prices or they can innovate better. And this idea that comes out of this is now known as creative destruction. And it's the idea that innovative companies win. They win big. They come up with a product that is new, and that product essentially creates a market just for that company. They essentially create a monopoly where they're the only companies selling that product or service. So they get all the business, and every time in the innovative company comes along and doing this, they've disrupted the entire market. So whatever equilibrium there was between the supply demand off the goods is now changed. And thats why this market equilibrium moves all the time is because in a rate of companies coming around, so that's what Schumpeter is our human was about. He was saying that if that's the case, innovative companies will always come around, so we should be fueling this, and that's the purpose of a financial system, he's saying. So let's say we have an entrepreneur who has ideas, but he doesn't have any money. And on the other hand somewhere else. There's a capitalist, a guy with no ideas but a lot of money. The purpose of the financial market is to bring those two together. So let's say we have an example where you have Thomas Edison. He has a company. He's got lots of products and inventions. And he doesn't have enough money to fuel this, though, So someone else will come around like J. P. Morgan and J. P. Morgan will then buy shares in Thomas Edison's Kamini to give him the money he needs to invention. Churn out all of these products, and in return, JP Morgan will get paid back in dividends. So this where stocks essentially came about, where you have stocks that were originally traded actually in British coffeehouses, even had I pose in these Victorian coffee houses and shares came about partly because investors wanted to take money out of the company. But sometimes the company didn't want to let go off their assets. So, for example, that say, you had a supply company and the company would ship off these goods to some other country, and once the goods were shipped, the investors just wanted to get their money back, and they were saying, One day I want to sell the ships now because I invested money in you to buy those ships and the products and you live with pride has got the money. Now sell the ships and the company said, I don't want to sell the ship's I'm gonna keep the ship's I'm gonna keep doing business. So they went to the court and the judge essentially said investors should just sell off their shares to some other investors, and that way the company can keep their ships and the investors and can collect their money . Prince Rupert came along, and he realized that the North America's had lots of furs that could be sold for profit because first were in high demand at this time. So what he decided to do was raise money for the Hudson's Bay Company through shares. So he gathered a bunch of interest in this company and said, Hey, we're going to go to North America That's lots of furs, their furs, a selling like crazy here in Europe. Let's make a company Willis, fund it through shares and then we will collect our money back through dividends so this goes on for a while, and the Hudson's Bay becomes a reasonably successful company. John Churchill was the third governor of the Hudson's Bay Company, and he really he raised the dividend of three times each time he raised the dividend. Shareholders back in Europe became extremely excited because they were collecting more money for these dividends. So they wanted to buy more shares and more shares that they bought. The price of the stock went up because it was more demand for that stock. But what it turned out was that the Hudson's Bay Committee members, what they were actually doing was quietly selling off their shares until the committee was empty. And the way they'd be funding the dividend was that the company had actually been selling off their ships. They've been selling off their ships and assets to pay the diffident. They actually hadn't been making as much money as investors thought they had Beene. Rather, they were just selling all of their assets without telling investors. So this turned out to be a limitation to a trumpeters financial system. The money flowing from capitalists, entrepreneurs and back. And this limitation was trust there had to be trust. In order for the financial market to function without trust, someone could take the money and run. Either the entrepreneur could take the money from the capitalist or whoever was funding the transaction between the capitalism, the entrepreneur and they could be taking money and running. So there had to be trust. This is where we will lead into our next section is that trust relies on intellectual property rights. 3. Intellectual Property Protection: Karl Marx was a German philosopher who wants to prove that capitalism didn't work and he wanted to prove this in a mathematical way. One of his argument is this. Let's say you have a firm in the market and that firm has a very profitable product. What that's going to do is other firms are going to notice there's profit in the market, so they're going to enter the market as they enter. The market is going to be more competition. How do you deal with competition? Well, you lower your price as you lower your price, you become more competitive, but you also cause your own profits to fall. So this is going to keep continuing. More firms are going to keep entering the market, and then that's going to cause use with lower your price more and more and your profits going to go down and down until they get to zero. At a certain point, that means that if your profit zero, then investors no longer have a reason to invest in your company because they're not going to get any additional returns. They're going to get a break even return. So if investment has no incentive than not going to invest. Investment falls if investment falls, employment false. And essentially you killed your own financial market just by having competition. So that is what Karl Marx's ideas now it's We can see there is a flaw with this, and that flaw is that profits don't actually go to zero, and it turns out he's missing one important factor. And that factor is technology and innovation. If you have technology and innovation, you can keep increasing profits. So this innovation and technology needs to be supported in the financial system to keep profits high. How do you do that? Well, it turns out you need tohave the development of a legal system that can support innovation and support the financial system. In 17 76 Adam Smith came along, and he's given credit for essentially inventing economics because he put a lot of different ideas about economics together for the first time. One of his ideas is this. If people are allowed to trade freely, then self interested traders in the market will compete with one another by competing. They leave markets towards a positive output, as though there were some kind of invisible hands guiding you can have an example. Let's say you have a vendor selling ice cream and another vendor selling ice cream. If you're going to buy from one of the other, they're going to compete in Price, and they're going to keep lowering their price just to stay competitive. So you're gonna get a product for the best price just by being in a market with competition . Now this idea of Adam Smith was accepted for a little while. Yeah, okay, there's an invisible hand guiding prices and making products better in the market. But there was a few examples where they seem to be exceptions. John Nash came around with his ideas on game theory and started to point out some of the flaws in this. For example, in the Middle Ages you had the tragedy of the comments where publicly owned lands would always be overgrazed by farmers compared to private land reasons because a farmer. But know that if I don't let my cattle graze on this public land, I know the firm is gonna grace, so I may as well do it so that land always got over graced. There's a bunch of other examples that John Nash came about with his well. But the most important takeaways. This. We need to have something to deal with the case where people acting in their own self interest causes and negative repercussion in the market. And so this comes down to innovation. Now, if you want tohave innovation and technology in the market, you need to have some kind off legal system to protect this. But there's a fine line. If two week, then you've discouraged innovation because there isn't enough incentive to do research in development. But if it's too strong, then companies may not innovate anymore, and products may remain expensive. Too long has given example. Here. Let's say you invents a pharmaceutical cook and this drug is really good, but it's really hard to get it to market. You find it really difficult to get it onto the shelves in stores, and it's going to take a long time to do that. But you've already patented this product, but you aren't able to get it to market in time that the patent expires. So what happens now Will a large pharmaceutical drug company will be looking through the patents patent picking, and they will now come across your pattern and see all the instructions of how to make this drug so they'll be able to take it to market, and they'll get all the profit from it even though you invented it. But you weren't able to profit off in time. Now there are some solutions to this. For example, venture capitalists can come along and help remove the problems that early stage companies might have been needing cash. And this is where you see Silicon Valley and Route 1 28 in the Research triangle, which is just a bunch of tech universities in that area. And one of the questions that were asked for a while is, Why is areas like Silicon Valley successful? Is it just socializing of bright people in that area? That doesn't seem to be a good enough explanation wise and not helping elsewhere. Well, as a few things will, there's easily transferable job skills. People are experts in that area. There's a dense concentration of research universities in that area, but that wasn't enough to stop some countries from trying. For example, Canada tried to incentivize venture capital funds. They said, we're gonna have lots of money for entrepreneurs were just going to give them money. Now there was an issue, a lot more projects, got money. A lot more of these projects failed, and venture capitalists didn't trust the projects that got funded now. And the reason is because it was hard to distinguish good innovations from bad ones, whereas in Silicon Valley, only good project got funded. But in Canada, bad projects got funded as well. So it was hard to know where you should stick your money. And if you were an entrepreneur in you had a product that was really good. Were you better off investing in Canada where you would get easy money or going to Silicon Valley, where money was may be obtainable and maybe not? Well, if you went to Silicon Valley, they likely had experts who understood right here and would give you even more venture capital money than if you went to Canada and took the easy money. So these are one of the reasons why Silicon Valley was able to stays as a lead for such a long time. Economist and Kruger also points out that if the NPV of bribing a politician is higher than the NPV of competing and innovating and coming up with new technology. Then a firm will probably bribed the politician rather than compete if they can succeed in bribing politicians and probably means there's a weak rule of law. And that's why in rich countries you might have a lot of technology and innovation because that's a lot more profitable than driving politicians. Where is in some Third World countries? It's a lot more profitable to describe the politician rather the thin to try to come up with some kind of technology so we can see that having legal regulation is important in a financial market. But there's a fine line because if you have too much regulation, then you might have a big corporation that will survive forever and prevent entrepreneurs from getting past legal hurdles and regulations. So the role that government plays in the financial system is extremely important, and that's what we'll get into more in the next section 4. Market Efficiency and Crashes: market efficiency is the idea that market prices reflect all the available information. If a market is efficient, then that means all the information is already reflected in the price. So there should be no way to beat the market because there's no over price to underprice securities. This was an idea that was developed by the economist Eugene Fama in 1970 he called this idea the big title of efficient market hypothesis. And the idea is that you should stick your money in passively managed funds index funds that just track the overall market rather than sticking your money in a actively managed funds. People are selecting which stocks pick because those people actually aren't picking any better than just a random index. There's a few proponents of efficiency. Lucas Roth, a professor of economics points at Let's Say Markets were inefficient, and someone came up with a strategy off guaranteed profits by doing this ex strategy, whatever it is, while other people gonna notice. And as soon as they noticed that this strategy is being used, they're going to copy. They're going to jump aboard and do the same thing until profits disappear. So as soon as people realize they're being modelled, the profits will go away and the market will return to being efficient. Lucas Roth is an interesting fellow. Actually, he's wife. When he got married, she wrote into the marriage agreement that if Lucas Roth ever won the Nobel Prize, she would get half well. A few years later, they got divorced, but Lucas Roth won the Nobel Price, so she got half of the money. So here's the reasons. Four. Market efficiency. Often they point at how mutual funds, hedge funds and pension funds they often don't outperformed the market or an index that the whole market if you were just randomly selecting stocks and throwing that in the portfolio . Often that does better than fundamental or technical analysis. Which is bad for me when I'm doing fundamental analysis, essentially the saying I'm wrong. Jacob A. Newly points at the law of large numbers where he says the average of a large number of guesses is more accurate than an individual. The average market decision is actually a better predictor than any one person. James. Sure, we EC e is a professional likes to experiment with his students in this class and me has a jar of jellybeans in front of the class that he then gets all of his students to make a guess of how many jellybeans air in this jar, and if the students are able to guess correctly, the student wins in a bottle of expensive wine. But the professor, what he does is he takes the average of all of the guests of the students in the class. And if that guests is closer than any individual student, guests in the profession just keeps the mine. The professor has never had to give out one. Lawrence Henry Summers says that that doesn't actually mean much, though. Hedge funds, mutual funds and pension funds out, not outperforming the market. That doesn't actually mean that the market is efficient. What we have is evidence that investors don't beat the market. But that doesn't mean necessarily that the market is efficient is a few other arguments. So Simon Herbert and Joseph Stiglitz they focus on these ideas of how, if you were to invest more and more money to learn more information about securities, there's going to be a certain point where the benefit is going to be less than the cost of getting more information. So there's actually some kind of equilibrium there where people are going to keep seeking out more information about securities until it's no longer beneficial. But people don't often think in these temps, especially not investors, not thinking about how much does it cost to get this information versus how much profit? Um, I'm gonna get Myron Scholes. Official Black argue that if markets are inefficient, then there would be no arbitrageurs. Arbitrage in this definition is referring to the idea that you can buy a security at a price that is different than the value of the security. So over time that stock should, in an efficient market, return to the correct value of that security. And they're saying that if markets are inefficient, that security will never return to the correct value. So if a market is inefficient, there would be no arbitragers. Andre Schieffer point out that this doesn't actually seem to be the case, so we don't see large arbitrage positions. So why would this be? Well, there's a few reasons. In order to take a large arbitrage position, you have undivided defied risk. You have holding period risk, which means you have mispricing that might be getting worse before it gets better. Also, you might have contractual problems such as you might borrow, but if it takes too long, then investors are gonna want their money back and that you might be able to not capitalize on your arbitrage position before investors want their money back. Charles Lee, Andre Shipper and Richard Taylor. They point out that there's a lot of evidence for market inefficiency and what they point as their examples is looking at closed and funds. This is where you have a fund that the only purpose is to invest in other companies shares . So in theory, the value of the shareholdings should be the price. You should have the same prices, the value of the shareholdings minus the management costs. There shouldn't be any deviation between the price and the actual value of those securities . What we find is this doesn't happen to reality, so investors air, in this case irrational. Otherwise, it would make sense that the overrunning price of a closed end fund has to be just noise. It has to be randomness. It doesn't make any sense because you're buying something for a different price in its value. Here's another example. When a stock it's added to the S and P index, the value of that stock isn't actually changing, but we find that the stock price changes just because it was added to the index. The values the same now, even more interestingly, is that this happens not on the announcement day, but on the day that is added to the index. Really, it should be on the announcement day that we say that the stock's gonna be at City S and P index. If you want to be more about stuff like this, you can check out the book by Andrei Shleifer, which is called Inefficient Markets and introduction to behavioral finance, extraordinary popular delusions and the madness of the crowds. In 16 hundreds, there was something called tulip mania where people for some reason decided that juleps were worth a lot of money and people would pay a lot of money for tulips. I guess this is similar to what we experienced in these last few years over a Bitcoin and other Cryptocurrency where we just decide this thing has money for some reason anyway. So people essentially, they started purchasing futures contracts on tulips. And at a certain point, someone defaulted on these futures contracts of tulips and the market completely collapsed . The Dutch government then had to step in and honor to look contracts at 10% the face value . And remember, we're just talking about flowers here. It's just a tulip. The South Seas company was a scam me wannabe Hudson's Bay Company, and they claimed to have a perpetual motion machine. Isaac Newton was around this time, and he was curious about this perpetual motion machine. That's interesting. So he stuck some money in there, and then he realized that this is completely against physics. So this is impossible. So he took his money out. But then he noticed the company kept going up in price. People still kept investing in it, so we thought, Well, geez, if they're investing in it, I may as well. So he stuck his money into this company talking about a perpetual motion machine, which he knew was garbage. But he did it anyways because the price kept going up. And, of course, the's South Seas company went bankrupt at a certain point, and Isaac Newton lost all of his money. John Law created the Mississippi company, which was a company that had a trade monopoly granted by the French on the condition that John Lowe would pay off France's national debt. Well, he did this, and he raise stock prices to extremely high heights, just using complete bogus rumors talking about how there was cities of gold. If you've seen the movie Eldorado, you'll know what they're talking about, all of these ideas of these places of wealth somewhere in the world. Anyways, the stock eventually collapsed and John Locke disappeared. So here's the cycle that we see when we're talking about a stock crash. Here's the steps that we often find. First of all, there's an expansion of credit. There's deregulation, and this allows people to fund entrepreneurs with their crazy, wild, innovative ideas. Then there's a lot of over trading is high leverage the speculation. There's borrowing at high interest rates because it makes more sense to ball and stick your money in a stock and get higher returns and then use that high return to pay back the interest of your borrowing. So you see a lot of high borrowing, then you have some mania where people just assume profit to gonna increase forever, and this is where scams and frauds start to begin. But people don't notice and hash just keep pouring in, even though the opportunities are getting smaller and smaller. And then, at a certain point, the bubble pops when people realize that something is odd, and we often claim this event caused the whole crash. But really, this bubble has been building up for a while. Then there's some panic, and people start to analyze the market and analyze stocks, and they realize that there's some significant problems here. There's a lot of negative views, all the scams and frauds. They start to come unravels and everyone tries to exit the market at once. And that's when you have to crash. Then is a collapse. Often there's an overreaction, and companies go bankrupt people unable to get funding for reinvestment and taxpayers and voters, they start demanding regulation. Often overregulation is a few examples when I mean by scams the frauds. In 1920 Charles Ponzi, he took money from investors. He bought stuff for himself and then used some of that money to pay investors and claimed that his company was actually making the money rather than just passing the money from one investor to the other. There's other examples, such as Bernie Madoff and Gary So rings and they did this exact same approach. But people fell for it and the market wasn't able to. I realized that this was a scam until it was too late. So here's the real question. Our markets efficient in theory they should be. But in practice we find tons of examples showing that they are inefficient. 5. Risk and Diversification: Let's talk about risk and diversification. If you were to go and buy a product and you weren't sure what the quality of that product is, you'd probably want to get a cheaper price than if you were buying something that you knew that what the quality waas So this risk in quality is called a discount, and we apply the same idea toe. When you're purchasing securities, you're going to pay or want to pay a little bit less for securities that have more risk associated with them. Let's take this with another example. Let's say you were selling insurance to people. If you were selling insurance to people, you have to think about what is the risk of those customers? What is the likelihood that those people are going to make a claim on insurance? Well, if you make a contract insurance contract that is too onerous than the other party, and you say that, well, you have to fill fill this condition in this condition in this condition in this condition , and you have to pay this high premium every month. Then you might scare away honest, good counter parties, good customers and the only people that are left are the people who are gonna claim for sure so they willing to take your contract. You can try this with another example, such as banks that charge really high interest rates or credit card companies that have really high interest rates. The people who actually take those at the end of the day are unreliable borrowers and unreliable creditors, because those are the people who are willing to take those high interest rates because they know they're going to default or they're more likely to default and have no other options. Universities that claim patents on professors discoveries those tend to attract lower quality professors. And that's why you'll see universities like M. I. T. And Stanford. They don't claim very many patents on professors discoveries. Those air usually quite open contracts that are suited towards the professor's advantage. Same with public health care, with free public health care. The's citizens that are actually under those health care plans. They tend to use a lot more health care services than they would if they weren't under free health care. And that's why free health care is often very expensive in a debates in politics. So far, we've been just looking at individuals, So maybe one specific company at a time of stock. What happens if you group a bunch of stocks together? What risks are you facing then? As different than if you were just facing the risk of an individual stock? Well, let's take a look at this. One of the more famous models that they've used over the years is called the Kappa More Capital Asset Pricing Model. And it works like this. The return that you can expect to get is based off of three factors. First of all, the return from your risk free investment or them back to buy government bonds, Treasury bills, etcetera. You have the return of the market that you are going to be pages for investing in the market, your market risk premium. And then, of course, there's the risk of the individual stock, the individual security. We call this the idiosyncratic risk, and we call this thesis systematic risk, essential ideas that if you have a lot of stocks together, a lot of different securities, the individual effects of a single security doesn't really affect the portfolio that much. It has a negligible impact as you get a larger and larger group of securities together of different types and varieties from different industries. So one of the interesting benefits of that is, if that's no longer a factor, the only thing you're left with really affecting your return is your systematic risk. And that's made up off your market risk premium. And this thing called beta, this thing called beta is essentially just the volatility of your security or portfolio in comparison to the market as a whole is just a way to measure how up and down the whole market is going as a whole. The beta is based on the idea that you have some kind of macro level change is something that affects the whole market, the whole portfolio. Well, that sounds good, and that assumes that stocks move harmoniously or that they move the market moves all together at once. If they don't move altogether once, then that Peter is a little bit less applicability. Well, it works well in some countries, like historically in China. All the stocks tended to rise and fall harmoniously, but in the U. S. In the leader 20th century, the U. S. Stocks don't seem to rise and fall so much altogether. Well, let's go back to the first example when they do rise harmoniously, why might this be? Well, let's think about this. This gives where it gets interesting. If you're in a corrupt country, CEOs can steal profits, and they can have very suspicious accounting rules to make it look like they're having a very consistent trend upwards alongside everyone else in the market. But as accounting rules get more strict in better, we've noticed that stocks tend to move less harmoniously during the year before company issues new shares. Company profits tend to suddenly increase. Perhaps poorly governed companies are just following what other companies are doing. Maybe a dumb CEO was just following a smarter CEO of another company, whereas if you're in a company that has a really smart CEO, perhaps they're doing their own thing. And so the company is completely acting indifferent to the rest of the market in companies like Egypt. Historically, it's being hard to get individual company information, so the only thing that's left is macro trends. And that could mean that perhaps since companies are only based on macro trends, the pricing that might not be too effective of the individual companies. In some countries, shorting or buying on margin is illegal, and that's gonna affect the price. And when foreigners with diverse information intermarket, we noticed that the market behaves, lest harmoniously as well. We normally think off bubbles just being in the financial market. But really, it just is referring to people acting altogether because they don't really understand the factors involved and they all acting in the same way. There's a bunch of examples of similar things. The bubbles outside of the financial markets in the Dark Ages. We had these things called witch burnings, where people in medieval ages would accuse each other of being witches, and they would have these ridiculous trials where people would be accused of being a witch and if they were condemned than they would be burned alive and you didn't want to be accused of being a witch. So one of the things you would do is you would accuse someone else of being a witch, and then you would hope that that way they won't accuse you. In the Chinese Cultural Revolution, there was a period where everyone was destroying cultural items because they didn't want to be accused of being a rightist. So what they did is they accuse other people of being a rightist and kept destroying cultural property. In Hitler's reign in Nazi Germany, there was gay bashing, racism, prosecuting Jews and one of the reasons that this kept happening and people went along with it is people didn't want to be accused themselves. So in order to avoid being accused, sometimes it was mawr convincing to accuse other people in the art community. You'll find artwork that's worth a ridiculous sum of money. And one of the reasons is that even if you don't understand the art, you don't want to be accused of being an idiot or not appreciating art. So you'll go along with it and you'll say that this must be a beautiful piece of art because everyone else says it's a beautiful piece of art universities. Sometimes you'll see these articles with complicated jargon and words from a variety of subjects that mean nothing, and it's essentially pseudoscience is not actually saying anything. It's just a large collection of words that is written in a very complicated manner, and one of the reasons is because professors sometimes don't want to be accused off being an idiot. So they'll read these long and complicated jargon. And since they don't understand it, either they'll say, Well, this is This is a very, very in depth. This is a very deep, complicated, insightful work and they don't know understand any more than the author understood. But they're able to get away with this because no one wants to be accused of being an idiot . There was an unsophisticated tribe that saw planes that were flying overhead, and since they were very, very untech, nha logically evolved. They didn't understand what these planes work as they've never seen them before. So they thought they were some kind of gods, and they started building these shrines of airplanes and worshipping them. Do economists and financial professors really understand what's going on or have any insightful ideas when it comes to efficient markets? You'll see this term efficiency talked all over the place in universities. But do they really know what efficient markets are? Or they all this patting the back of one another? If it's CEO likes a product, then management will find ways to show that the product or project has a profitable NPV. It looks like a good opportunity. On the other hand, if a CEO dislikes the project, management will put together a presentation to show that the project has a negative NPV doesn't look like it's a profitable opportunity. So one of the best practices to avoid all of these situations of jumping on the bandwagon is to use statistics to your advantage to eliminate any kind of bias. One example of doing this is a Monte Carlo simulation, and this allows you to use statistics to give you a range of possible outcomes for each of your some sins. And you can have a lot of assumptions Now. The Monte Carlo simulation isn't perfect it There's still some limits and how practical that is. But there's a bunch of models you can use. Herbert Simon points out that we don't know what most economic distributions are, so we satisfy. So we just make some assumptions. Instead of spending the time to figure out what the actual value NPV are complicated calculations that need to figure it out. John Maynard Keynes points out that often we see CEOs guts just driving capital expenditures. Whatever the CEO thinks, that's where money gets spent and enterprise decisions, they only pretend to be driven by reason. But really, they've made a decision, and then they figure out the reason after they made the decision. If this is the case, then capital budgeting analysis is kind of irrelevant. You're throwing in unknowable assumptions with unpredictable variables and CEOs. They're just making decisions based on hunches. So the investors confidence is really based on the CEO, which may or may not actually have any reason behind their decisions. It might just be their gut. So rather than doing capital expenditure calculations, sometimes CEOs just copy each other and one company of copies what the other company does, and this can lead to harmonious trends in the market. It's similar to in modern art, where the price of art is just skyrocketing up for a single type of abstract art. That doesn't actually mean anything to some people, but no one wants to look like an idiot. So they assume that the price of that art is expensive or when you go to the movies and you see some movies rack up millions or even billions of dollars in box office sales. One of the reasons is because it's already being successful has already being a bunch of sales. People don't even need to know anything more than other people have gone to see the movie, so they're going to see it as well. It's just jumping on the man wagon and same with YouTube. Video views. If you see a video has many, many millions of views, you kind of want to see why it has many millions of views and the video just gets even more . There's actually some interesting websites where you can purchase YouTube video views or Facebook likes or Soundcloud likes. It's kind of interesting is actually relatively cheap. And although YouTube doesn't like it, it's used a surprisingly a lot in the industry, especially with music videos. Milton Friedman points out that CEOs they're not stupid or they wouldn't be CEOs, so there must be some kind of value behind the intuition that is C. E. O. S. He gives an analogy of Let's say you have someone who is a pool shark. They play pool really, really well, and they don't need to know the physics behind how pool works in one ball in the angle links to one another. They don't need to know that they can still play pool without knowing So CEO is investing NPV or profitable projects without needing to know what the forces are behind them, so you can see that based on risk. There's a bunch of factors that you can take into account one hand. You can be refusing to pay anything. Mawr. If you think something is risking your man a discount, you can group a bunch of different securities together and try to diversify out some of the idiosyncratic or individual security risk. However, then you're still susceptible to the market risk, and the market actually itself might have a little bit of risk, depending on how harmonious is it? Is it all moving together, or is it moving separately individually? If the market is extremely efficient and everyone is acting on their own accord or not simply copying each other then you don't have to worry so much. But if the market is moving harmoniously as it does in some countries, then you have to consider that as well 6. Role of Government: What bold is the government play in the financial markets? First of all, let's think of a what is government. Charles T. Boat studied why cities were successful. His ideas at cities compete with one another for taxpayers and government services. So governments that have MAWR government programs that rent seekers wants will attract more taxpayers if they provide better public goods and taxpayers are willing to pay more for them. The governments can then attract higher paying taxpayers and get war taxpayers. On the other hand, if the government is giving subsidies to the wrong people and services suck thin, the taxpayers will leave and go to another city. It's an interesting idea, and we might be able to find examples to support that. But let's look at another way. What if the government wasn't competing for service is what would that look like? Well, this has happened for many years, and this is where we have this term called my Santelises. This is where one government would capture another country, and they would form a government there where the government's purposes just to extract resources and benefits for the home country, we now need to introduce another term and called rent seek when seeking, is where individuals will use organizations or the government resources to obtain some kind of economic benefit for themselves without actually making any value to the rest of the society. An example of rent seeking is when you have a company that lobbies for government alone or grants or tariff protection any of these things, they create benefit for the individual. But they don't create any benefit for society. They just merely re distributed resources to themselves. Game Baptist Colbert, a French politician, is often known as the father of her centralism, and he pointed out that a more centralism society tends to have a few distant qualities. Since the purpose of that government that's being colonized is solely to benefit the home country, there's gonna be a few factors that tend to pop up, such as complicated cat tax structures, government subsidies. There's a benefit for the home country elite, and any politicians that they install in this colonized government are now entrenched. They don't want those people to be removed. They want them to stay there. There's often a large number of monopolies that are state owned. A monopoly is just a firm. That doesn't happen to competitors. So with no competition, they're able to charge whatever they want. And the services will be taken by the consumers because there's no one else to buy from. There's incentives to create monopoly profits because you already have a monopoly. You want to milk that. So there's a lot of exports, but not too many imports. Often the elite create laws that favor them and you condone. Then purchase government positions for yourself and the family, who or anyone else who had loyal ties to you. So this government then in this my Santos instructor is organized specifically to maximise political rent seeking. So your government is revolved all around that now Scottish university professor Adam Smith . He didn't like that. He hated more centralism. He thought that rent seeking in general slows down the economy. It involves a large number of experience and contacts for specific firms to make lobbying easier, and this makes firms grow extremely large and bureaucratic, and it's very hard to stop, went seeking economies once they start. Williams, an American economist, agrees and says that if rent seeking slows down the economy and perhaps the reason the West was able to get rich so fast is that they were able to abandon more centralism, Fasher, than other colonies around the world. Olson Manker is an American economist, and he asks the question. Then why are there still so many rent seeking countries? It's easier for small, rich groups to get together than a large working class and try to lobby the government. Small, rich, organized classes are able to lobby better to get what they want. Rent seeking trade barriers, face and corruption harm the economy, but they benefit individuals. So how does rent seeking begin anyways? How do you get a rent seeking economy? George Stigler and American economists looked at the life cycle of a bureaucracy, specifically a regulator bureaucracy. So in regulation and this forms, it is this large, massive bureaucracy that nothing seems to get done. How does this start beginning? Well, it starts off with a regulator who's actually honest and committed. They want to benefit society, and that's what they wanted to install some kind of regulation that would be good for the society. After a while, bureaucrats noticed that they can advance their own personal careers if they can regulate a large industry. They then developed close ties and relationships of trust with the firms that they're regulating. The bureaucrats seek to protect and raise the profits of firms in their industry and, over time, a bureaucrat who started off as a government representative trying to influence the industry. They end up as a representative of the industry, trying to influence the government. Roger Room Rajan and Weegee's and galleys notices how entrepreneurs they start building businesses, and these are often very innovative. But when they get old, their Children tend to take over. The business is, but the Children are not entrepreneurs. However, they are now part of the elite class, and the elite class can use their lobbying power to capture government. So rather than trying to come up with innovative new businesses, what these Children do is they focus more on being more politically connected. Mara Ferruccio notices how firms that are more politically connected now have a few interesting characteristics. There tends to be a war corruption, more barriers to entry, more regulation, last press freedom. But here are the benefits. For those, there's often a higher stock share price. There's often higher subsidies or, more likely, there's more likely the probability of a bailout during crises and the probability of being bailed out multiple times, and they often have access to higher leverage and from funding. So it's easy to see how being politically connected has lots of benefits. So when seekers then will lobby for subsidies that lobby for Freeland for tax loopholes and exemptions, they want favorable regulation or favorable deregulation, and they often ask for more trade barriers. And so this is where you can see why does the government often create all of these subsidies and tax loopholes and odd regulation and trade barriers? It's probably because some politically connected firms are lobbying for these things. Also, manicure now made an interesting observation. What does the Mafia do? The Mafia collects protection money. It keep public order, enforces contract deals. They provide protection from other criminals. They run gambling joints and sell drugs to help the needy, and they support the needy. What does the government do? The government collects taxes. They keep public order. They enforce rules of law. They provide protection from criminals. They were on lotteries and sell liquor. They helped the needy, and they support the me from interesting comparison. His theory. Then comes this. The government evolved from bandits or from the Mafia, or something similar like that used to be lots of roving bandits, and these roving bandits would go all over the place and steal from everyone. And so people didn't bother to collect too much wealth because it might get stolen from them. However stationary bandits, they don't take everything. Rather, a stationary bandit is a roving band has collected so much wealth that they now need to stay in one place. They can't carry it with them, so they stay in one spot. And once you're staying there, the people are ready. Who's stealing from? They now have different incentives. He actually wants the people around him to collect wealth, become wealthy themselves and then steal it from them rather than having to costly chase all over the place. In return, he offers protection against other bandits, and slowly the government forms out of this so stationary bandits will then coordinate to leave an optimal amount so that the farmers of people he's stealing from will get rich. But they will allow them to get rich just and steal just the right amount so that this can be sustainable if you look back. Historically, you can see that many dukes and rich monarchs, their ancestors. They date back to castle cattle rustlers emerging after the Middle Ages. Often you can even see that a lot of nights. Often they got their wealth in the very beginning by stealing it from farmers of these going back through their ancestors, so they were essentially wielding bandits. There's another definition of what a government might be. Douglas Dorff has a definition off what an institution is. It goes like this. An institution is anything that constrains self interest, such as laws, regulations, contract obligations, cultural taboos, customs and religion. The purpose of institutions is to make sure that by people acting in their self interest, they're not causing harm to a larger part of society. Also known as an undesirable Nash equilibrium, the West then developed institutions faster than other countries, such as accounting standards, financial regulations, market efficiencies, laws, courts, police, prisons and so on. The West was able to develop these or at least more efficient institutions than other parts of the world, and so these economies to live faster. He can then point at historical points out how British colonies tended to do better than Spanish, French and Turkish colonies because they had better institutions. So here we are, with several different ideas of how the government might have been structured. Is it structured to compete with other governments for taxpayers? Or, rather, is a structured to encourage rent seeking so certain individuals will benefit from the government? What kind of regulations are involved? And what are the incentives behind regulation or deregulation? Also, what institutions are being created to what kind of self interests are being constrained to benefit the public? And so whose interest is the government acting for? Isn't always so simple because it changes over time as different groups gained political influence. 7. Call Options: Let's discuss long call options. It is very straightforward. It's saying that at a time in the future we have the right to buy at a price we decide today. So let's do a little example here. We have a timeline. This is your present Time Time zero. This is your time in the future. Time one. And let's say we wanted to get this right to buy in the future. So we have to purchase a long call option for, let's say, $1. And so what's gonna happen is that in the future, we're going to have the right to buy the future asset at a price that we decided today. So what's gonna happen is we're going to receive that asset in the future. In this case is $102. We're gonna have to pay the price we agreed today. This is also known as a strike price. We should account for the price we paid for the option in the first place. And so in this example, we actually end up with a profit. So we exercised our call option, used our call option, and that allowed us to purchase at the strike price we agreed today and receive the value of the asset in the future. But what happens if the asset in the future isn't actually higher? Well, it's a little different because we're not going to want to exercise. So let's walk you through this. If you were to exercise what would happen well, you would receive, let's say something that's a little bit less. You would receive the asset, but we would pay even more. So you already ending up with a negative value of profits. So that doesn't make any sense. And you're going to actually lose out more than if you had just not exercised. If you're not decided to use your rights, you would just cut your loss at your original price that you paid for the call option. So if the value of the asset goes down, you're not going to exercise your call option. You're just going to let it go. So let's take a look at this visually because I find a visual. Representation is the way you really understand how call options work. So if we were to take a look at this, we have a payoff. Diagram is the best way to see this. And it's where you have profits on the Y axis. And you just have the value of the asset, stock or bond on the X axis. And essentially, it works like this. You realise what is the price you had to pay for the call option? You figure out your strike price in this case, that was $100. And that's the time that you agreeing you can exercise your call option. So this is where you start. You realize this is your beginning point. I had to pay $1 for that call option. So this is the price that we begin it. And if he call, if the value of the asset goes down, we're not going to exercise our call option. So we're going to start off with a negative profit of $1. But if the price of the asset goes up, we're just going to make a profit. And in this case, are break even. Point will be the price of the stock or the asset, plus whatever you had to pay for your call option. So in this case, $101 of that break even number in this example, and anything greater than that is just pure profit. So this is how you can visualize what a call option is going to do with a payoff diagram. Now there are actually several different kinds off options out there. There's many types. Let's take a look at a few of them. The's simplest one is the American call option. And that's where essentially you're saying that between now and in the future, if you have a call option, you can use it. You can exercise it at any time between now and a specific future date. Let's say this is February 5th. Any time between today and February 5th, you can use your call option a European options a little different. It's saying that on Lee on that specific day in the future, you're allowed to use a call option. You're not allowed to use it on any other day. Maybe a mutant option is saying that you can use it on any of these if you selected specific dates. So that's going to depend on your contract, of course. And then on any of those days you can exercise your call option. Exotic options get a little bit crazy because you might not always have the right to buy. You might, on a certain day, have the right to sell. You can have exotic options working the other way as well, where someone else might have the right to buy from you or the right to sell. Do you call options on specific dates? An Asian option is quite a different principle. It's saying that we're looking at not thespians if IQ price of an asset on any given day. Rather, we're going to look at the average price of a asked stock of bond over time, and that average is what we're going to compare to at the end of the day. So when we were looking at our earlier example right now, we might have a strike price of $100 that we agree on today, and this average we're not looking at any specific point we don't care about. These little points will only care about the average. If the average went up to, let's say, $102 then we get to exercise and receive that value. So that's quite a different way of looking at you, looking at behavior over time, and a digital call option or option is also known as a binomial option. And if we had to have a payoff diagram again, you're able to see that a digital option is instead focusing on instead of unlimited profit . Where we earlier had our example, it just goes up forever. What were instead we're going to say is you can only make a certain amount of profit, but you make all that profit. So let's say if we were looking at our original strip electrics of 100 you're going to exercise and you immediately make a certain amount of money. But you don't make anything more. He just always make that same amount of money. So by no meal option looks a little bit like this. When you see a payoff diagram, you make a specific amount of money, but only that amount of money and you make that all or you make nothing. So these air, the different types of options that you have available, and now you understand the different, um, combinations that you can have, how you draw them and how they work 8. Long Put Option: let's discuss long put options. The idea is quite straightforward and similar to when we had long call options. Except now we have the right to sell in the future at a price decided today, instead of the right to buy, we have the right to sell. So let's do an example here. Let's say in order to get this right to buy the put option, we had to pay $1 and now we have the right to sell at $100 in the future. So when this future time comes, we get to t one and we now have the right to sell, received money for selling the asset this stock with a bond and will receive that agreed price that strike price have $100. We will now have to pay the value of the asset in the future, and we will account for the original price we paid for that put option, and in this case we end up with a profit so you can see how it's a little bit different. But it's the same basic idea yourself, the right to do something. Now what happens again if in the future we find out that the price of the asset has actually increased. Well, once again, we would not exercise output option because then we would have the right to sell at $100. We have to pay something even more. And then we'd still have to account for that. And we would end up with a negative profit again. So once again, if the price does not go the way you wanted to in this case, if you have a put option and the price increases, you would just not exercise and you would be just left with your initial upfront cost. So let's now do our overall, um, payoff diagram and see how this looks like if we had our payoff diagram. So this would look something like this. What? We have profit on the X axis on the on the Y axis and the price of the stock on the X axis . And what's gonna happen is we're going to start off with a strike price. So the strike price in this case was $100 and the price of the option the put option that we had to pay was $1. So we know that we're actually going to start off at the strike price because that's the most money we can make. If the price of the asset went all the way to zero, we would be able to sell for $100 buy it for $0 for $0. So in that case, we would make the exact price of the strike price. That's where we start, and it's just going to decrease until we get to our price that we paid for the call option . And then if it's anything higher than the price of a put option, If it's anything higher than the price of a put option, then we're just not going exercise, and we'll just kind of losses at the price of the put option. So this is how you're payoff diagram will look like when you're dealing with put options. So once again, it's the right to sell in the future. At a price you decide today, 9. Short Put Options: let's discuss short put options, realize that a short put option is just the counter party to someone's long the put option . So hey, long put option once again is when someone has the right to sell at a certain price that we agreed on in the future. And then at that amount of money in the future, they will be able to buy it back at whatever that price happens to be. So in this case, we have a premium, and they paid $1 for that right to sell. It paid for the premium, and they now have the right to sell at whatever that price is. In this case, it's $100. So they're hoping that the price of the stock will go down over time, will go down over time somewhere in this area. And when that happens, they will then be a blue cell still at $100. So let's say the price went down to $99. What's gonna happen is they're going to buy it at 99 exercise their long put option a the right to buy it. At 99 they get to sell it 100. They collect a profit. In this case, they just break even. So that was the long. But what happens with short again? Now, if you're dealing with the person who's short the put option, well, that means they have to deal with the exact opposite transactions. So they start off collecting that profit of a dollar. They collect that premium and then anywhere less, then that strike price. If that thes doc the asset goes down to well, they are going to be losing profit because that means that they have to sell something at whatever that prices. But they always have to buy it back at $100. So one thing to notice is that they gain and loss is limited to a certain extent with put options. If you are long the put option, the most amount of money that you can make is the price of the strike price. And for the person who short the put option, the most that you can lose is thestreet price again. For the person who was short, the put option the most amount of money they can make is the premium, and for the person who is long, he put option. The most of amount of money that they can lose is limited to whatever that put options. So now you know how put options work when you're long and when you're short. 10. Short Call Option: Let's take a look at short call options now shorted call options. So long is another word for by and short is another word for Cell now. Earlier, we didn't example where we had someone who's long a call option, and that meant that they had the right to buy a stock at an agreed price. Today and now we're going to look at what is the person on the other end of that transaction doing? What is the counter party doing? So we need to understand that short call options are the counter parties view to a long call option. Now that may sound a little tricky, so let's work our way through it. Someone who is long call option. What happens? They buy. They pay for premium, they have the right. They have a long call option. Now let's say the Shrek Price was $100 and let's say the price rose up to $101. That's what the stock acid went up to. So they now by at 100 they can now sell at $101 and we'll say it's in this case at the Prophet was you so what's going on with the person who gave them that call option? Who sold, um, that call option? Well, they in the very beginning they collect that premium. They collect the dollar until the call option gets exercised. And at that point they're actually starting to lose money because someone else is going to buy something for them from them for less than they can get. So anywhere in this range they're actually losing money, so they will have to buy it at 100 $1. They will then be able to sell it at $100 because that's what the strike prices. And so that means that their net profit is zero in this example. So what's going on here is that the person who is short, the call option and the person who's long call option in this case, they actually balance out at this one price, and you can see that neither party actually made any profit. They actually made your profit. However, if the price is anything other than $101 someone else is making money and someone else is losing money. What happens if the price is below be call the strike place. If the price of the stock is below the strike price, then that means that the person who was short a call option will be collecting the premium . The person who was long call option will be paying that premium, but they won't have any incentive to exercise a call option. So that means that they are actually just going to collect the premium. And that's it. They just collect whatever that profit is. And if, in a real life scenario you know that the stock is going to go down, that is one off alternative. You can eat a short, the stock or you could short a call option, and you can collect that money now. What happens if the price is higher than the strike price? Well, in that case, the person who is long the call option is going to be collecting profit, and they have unlimited potential. Upside the stock price just keeps going up infinitely, they congest Onley, pay this one price, and they can collect whatever that new price of the acid is, so they have unlimited potential gain. But the person who is short, the call option now has unlimited potential loss. It's a zero sum gain. Someone's gaining someone's losing. So this is how a short call option works. You just need to realize that it is the counter party to someone who is long a call option and that whenever someone is collecting, someone else is paying the other side. 11. Mergers and Acquisitions: mergers and acquisitions. They are generally a negotiated deal with one company's board of directors with another company. Where the buyer makes something called a tender offer and that's to purchase the shares from shareholders is a few types. Days are horizontal merger. This is the purpose is to scale, to try to get your products to reach a larger market. An example would be in pharmaceuticals. Shoppers Drug Mart have a collaboration. A merger of a whole bunch of different drug companies together on advantage of doing horizontal mergers would be collective database is Another example is you can access other markets. For example, the Inter Continental Stock Exchange bought out the New York Stock Exchange, and the reason is because the Internet Continental Stock Exchange ah wanted a derivatives exchange the way they did that was just bought out. Another exchange. It was already there. So they went and did that. Another example of ah merger would be something called a rollup, and a roll up is where you try to consolidate a bunch of fragmented pieces of different industries and put them together. This is more common in Third World countries. Another example would be Supercuts, which is a haircut salon franchise, and they just consolidated a bunch of different hair salons. And together under one brand name is another type of merger called a vertical merger. This is motivated by production technology and contracting costs. They're trying to reduce the cost, make it more efficient. An example of a vertical merger would be when GM and Fisher body Parts Fisher Body Parts was a company that created a G M's metal frame parts for the vehicles. As the man for the cars increased, GM wanted to re negotiate rates with Fisher body parts. The original contract terms was the cost of parts, plus a required return plus 10 to 12% of ghost merchants. Fisher Body Part said no to renegotiation of renegotiation of rates. So in response, GM just bought official body parts up, and then they were able to get the race they wanted. Another example is where Porsche was going to buy out Volkswagen. This was around 2007 and then the 2008 crash happens, and the banks that had been backing Porsche. They got cold feet, and they refused to provide the money to buy push. Portia is left exposed with a time of shares, but not quite enough to acquire Volkswagen. Volkswagen still wanted the merger, and so they bought out Porsche. Historically, there's a bunch of examples such as Thomas Edison. He was a corporate raider and he would buy out other companies, merge them together, and we now know the companies that he combined his General Electric. He was claiming credit for a lot of inventions, and you can see that he's known for hundreds and hundreds of inventions. But really ah, lot of them were from companies he bought out. There is something called closed end funds, and this is where investors combined shares in holding companies and the holding company. What they will do is specifically mergers and acquisitions. They will just buy out other companies so they'll take the money from the investor. They'll use that money to acquire other companies, and so they don't actually need to have any kind of products or revenue of their own. They will just use that. J. P. Morgan did a bunch of takeovers, and the way he did it was he would buy companies shares in exchange for shares of his Standard Trust shares. So he had a standard trust and he would issue shares. The's shares would be given to other companies. What did the trust hold? Trust? Whole held shares in other firms. So this was a very, very ingenious financial move to by firms using the money of other firms. He didn't actually have to put up money of his own. He could just by companies with shares of other companies. So you can see that when it comes to mergers and acquisitions, it's usually based down to negotiating some kind of haggling. But when you actually go and you want to go buy a stock on stock change, you're going to see a fixed price. You can't negotiate that very easily. Why did this come about? Why do we have fixed prices anyways? Where to fix prices come from? Why do we just not haggle for everything? Well, historically, we did. We actually had to haggle and barter for everything. If you wanted something, you had to haggle for it. And the reason that we haggle a lot less and that we have fixed prices is due to advances in communication. For example, telephones, roads for cars or what we no longer have to lie on railroads. That was a slow form of communicating prices. Radio is the easy way toe tell people what a price was. Um, the invention of the telephone was interesting because alongside it came the idea of phone catalogs and people could go and they could get this catalog of products, and then they could find the item they wanted to buy. Call a number in the catalogue and they would buy it for the price in the catalogue. And when that happens, they can now take that and say to a shop, Hey, you are selling mawr thin this pressure in the catalogue. You have to drop your price to this or I will just buy it from the magazine. So that was one way to standardize prices to a certain extent. And, of course, also movies in television. When a company announces that it's going to acquire a company, we noticed some interesting things. The acquired company stock tends to go up 40% at least in U. S. Markets, and this tends that happen immediately after lengthy announcement. It's not like this. Always nine old countries, for example, in Canada, thes stock price tends to rise gradually in the months leading up to the announcement. One of the reasons is might be is because inside trading laws are strictly enforced in the United States. But they're not so much in Canada. Very few people go to jail in Canada for insider training. This is, Ah, one of the reasons why Alibaba had their AIPO in the US rather than in China is they wanted to get the maximum value for their shirts, and they didn't want to have too much insider trading. The US has one of the most efficient equity markets in the world because they really are very diligent and hammering in prosecuting people for insider trading. If a hostile takeover occurs, stock prices rise slower than mergers or friendly takeovers. Why would this be? Perhaps shareholders believe that the acquirer will make improvements in the share price will increase why it is a stock price rise before I take over. The one theory is that the two firms, the buyer and the seller, they become closer to a monopoly because now there's less competition. You can raise the prices of your products and cellos for more, but this doesn't hold up if you drop your prices of the products afterwards. When a merger occurs, the price of other firms in the industry also tend to increase as well. But if the merger gets canceled, we noticed that the price of other stocks in the industry they don't seem to fall afterwards. So monopoly theory doesn't really hold up that much. Do monopoly profits motivate mergers and acquisitions? The U. S Federal Trade Commission uses something called a concentration ratio and a her fiddle index to measure monopoly profits. And the idea is that if we notice that monopoly profits are increasing a lot, then they might step in and say, You can't have a monopoly. You can't merge together. But what we noticed is that monopoly profits don't seem to go up that much most of the time . One of the reason for this is that acquired firms tend to be broken up and sold into smaller pieces. Joseph Schumpeter, who we mentioned a little while ago, his has a term called Creative destruction. Creative destruction is the idea that there's a industry industrial mutation that's constantly evolving over time, and the idea is that whenever you have some kind of innovative firm or products that forms in the market. It will essentially destroy the old market. It'll take over, and it will create a new market. Creative destruction. Essentially, let's innovative firms dominate and take over until a more innovative firm comes along and eats it. Monopolies can be good if it's the result of creative destruction because you're getting more innovation. Monopolies are bad if there due to some kind of artificial barrier, though for example, tariffs or something like that. This isn't quite a black and white issue, though it's hard to say whether Monopoly is good or bad. For example, is Microsoft a good or bad monopoly? It's being very difficult for companies to compete with office software, but Microsoft's products are quite innovative, so it's not always a black and white issue. All right, what happens after a merger occurs? Do layoffs increase? Not on average. Do wages fall? Not an average. We do notice that white collar layoffs occur, and a company tends to hire more blue collar employees. We also noticed that money tends to be removed from over funded pension plans. Do share prices rise on the news of layoffs? No, we noticed in general that share prices tend to fall. Do tax savings and benefits motivate mergers and acquisitions? Well, they might a little bit. But as we mentioned earlier, we tend to notice that the acquired company stock tends to go 40% after a company announces is going to be acquiring it. So is tax savings 40%? No, not that high. Contribute to a little bit, but not that much. Why do stock prices increased 40% on average? Are they undervalued? And the takeover alerts everyone that the stock is undervalued and that they should go by it. And that's the reason. Well, people might believe that people might see a take over and say, Oh, that must be a good investment. But that doesn't necessarily mean the stock was undervalued to begin with. That's given analogy to show why this might not be. Michael Spence, a Nobel Prize winning economist, wondered why people pay so much for higher education, post secondary education, university education. And here's a few reasons it signals to employers that you were good enough to get into the post secondary education to get good grades and you graduate. But if they don't really care what your major minor was. They just want to know that you were good enough to get through. It sounds quite familiar to some of you. Another example in the biology world is that biologists think that p fouls, meaning male peacocks. They spend so much time foraging just to have the energy to grow. These massive tales to indicate to females that they have food. It's like a litmus test for the females to say he's got the biggest tail. Therefore, he has food, and another analogy is Haider potlucks. Thesis was a feast that Villagers would save for. They spend years collecting enough money so that they could pay for these great big ceremonies. And in fact, they were so expensive that they would have to cut out other things in their lives just to afford these potlucks. And it's slowed down economic progress. So taking these three and allergies together postsecondary education, overpriced, um, giant peacock tales really energy. The pleading way to indicate that you have food and potlucks are extremely expensive. Just to say that you have some social status. The implication is that saying you have to take over a firm to indicate that the stock is undervalued. That seems a little bit excessive and unlikely that the firm was under price in the first place. What about the company that is buying? The other company would have their shares overpriced. If you have bad money, spend it quickly before it's gone. In 1999 a. Oh, well purchased Time Warner. At the time a Orwell's Price earnings was around 200 times, it realized that it shares were overvalued. This was at the time, the largest merger in U. S. History for $450 billion. Steve Case from a well met with Gerald Labine from Time Warner, and they made a deal where a well ended up owning 55% of Time Warner, and they paid just in a oh well shares. Why would a company give so much money toe own you at the time, the share price of a well was six times at Time Warner. Gerald Levin made the merger deal, and he didn't even discuss it with the Time Warner executives. He thought it was such a good deal of time. Then, in May 2000 the dot com bubble burst news of a wells misstated earning started leaking out . But by this time, the A O. L executives had already sold awful of their shares. But back to that idea. Are the buyers shares overpriced? What do we see? Well, we noticed that the acquirer firms they tend to be in popular industries. Whatever is hot at the time, the acquirer firm top executives, they tend to sell the shares that they own. At the time of takeovers, we noticed that the acquirer firm shares tend to fall abnormally months or years after the takeover. CEOs who own their own company's stock, they tend to pay lower premiums for acquisitions. The rationale might be perhaps when a merger successful, the CEO benefits. But when emerging fails, the CEO doesn't bear the losses. So if a CEO owns their own company shares and they have more incentive to make better decisions, and we know is that firms with stronger boards tend to make better decisions. Vinyl Course had a another idea. This was something he spend years coming up with, which is the theory off a firm. What is a firm when you have a merger, a firm buying another firm, what is what is a firm in the first place. His ideas. This affirm is an alternative toe organizing economic activity. It's saying where the cost off building things on your own is approximately equal to the course of outsourcing. So technological improvements caused the cost of production to decrease the total gains theory is the idea like this a firm acquisition? Buying into the firm is just like any other NPV calculation is just like any other financial decision. If a firm is a place where people come to contract with each other, if you're an entrepreneur and you're a single person and you want to have your own business , you would have to hire someone to come up with the product. If you don't do that itself would have to hire someone to do the supplies. Hire someone to get the supplies to trend, to transport them from one place to another. To do research and development, you have to hire someone to do sales, hire someone to do marketing all these individual things you'd have to have your own contracts, for that's really complicated. Whereas a firm is an efficient contracting house instead of everyone making individual contracts with other people. We decide collectively that we're going to contract together with a fictional concept called a firm, and this firm is a way that we don't have to come up with. Individual contracts with everyone else will all work collectively together. This firm is then owned by shareholders. It's essentially a former property. Well, what is property? What his ownership of property? Well, really. The only thing that indicates for property is is that you're preventing other people from owning it. It's your property cause other people aren't owning it. Shareholders have a residual ownership of a firm. If you buy shares for money, the company will take your money, and there's no guarantee that you'll get anything back. But you kind of own it. This is where we bring into something called an agency theory. Agency theory weren't like this. Shareholders don't run the for the managers of the firm run the firm. If the managers don't own shares, they are agents. What we mean by agents is that they don't really have an incentive to work for the shareholders. Why should an agent generate wealth for someone else? They shouldn't. They should benefit themselves This is where companies will give stock options to employees in an attempt to remove agency problems with company executives. This explains situations where the selling company benefits and the buying company loses. There's another way that companies might benefit from acquiring other firms. This is where they do so in something we like to call the price earnings game. And the purpose is just to improve their own financial statements by buying another company . It works like this. The buying company purchases a company with a lower price earnings. The hope is that the buying companies price earnings ratio will transfer over to the acquired companies. So the buying company pays a premium. They still end up increasing the share price. And the rationale is that the bond company thinks that price earnings ratio is overvalued and wants to spend the extra money. While they can note that when this happens, thebe buying companies paying in shares rather than paying in cash. Theoretically, there should be more takeovers during bad economic times, then good all kind of times. This is where a company would be struggling due to the overall economy rather than just being run poorly and so the price of their shares might be unnecessarily low undervalued, and this would be a good time to buy. But what we noticed is that the tend to be more takeovers during good economic times when the price of stocks might be overpriced. Is this just due to over optimism? Are people not bad? They're just over optimists. Why are there more emerges during booming economies? The neo classical approach is a theory is that the stock market is just a reflection of the overall economy. Maybe on alternative is that firms overvalued and they have money they shouldn't have, at least not for long. And when they have this money that they only got 1/2 possession for for a short time, they spend it quickly on mergers. This doesn't happen everywhere in the world. So, for example, in Japan, when the economy is doing well, we noticed this very few acquisitions. But during poor economies, there's a lot of acquisitions. But you'll also notice that Japan has a little bit of a different structure when it comes to how they issue shares. Japan is a lot of cross web of share ownership where one company may own another company that is also owning their shares. A lot of interconnected companies. Example. Mr Mitsubishi shares owned by companies that deal with them by suppliers have shares of the buyer, and the buyer has shares with suppliers. So everyone has aligned interests, so it's rare to have hostile takeovers. More likely, there is a merger where a strong firm is buying out a week, a firm that's not doing so long. But that's more the exception to the rule. Another reason that there might be a lot of acquisitions and mergers could be diversification benefits. A firm that specializes in one product could spread the fixed cost around. If it diversifies. You can think of the example of a factory where you're making one product in the factory. You've already got this fixed cost. You're paying for the building you're paying for the laborers. He may as well make more than one product, though you've already got that fixed. Costs may as well make several. There's something called The Winner's Curse, and this the idea that when the firm successfully acquires another firm, they paid too much. If you think about a silent auction, whoever wins a silent auction, they paid more then everyone else, and that's why they won. But the only time that they're actually able to receive that product to buy it is when they pay more than everyone else is willing to pay, so they can only win if they over pay. So a successful company acquiring another company, perhaps, is paying too much if he uses a rational Bradley de Se and Kim have a theory that if the acquisition alerts people to under valued firms, then the rise in stock price of the selling company should stay high afterwards. But what we notice is a usually false after a deal collapses. So perhaps that's not true as well. What we do know, though, is there's a lot of competition amongst bidders to drive up the price of the seller stock. On the other hand, if there's only one single bidder, then the stock returns tend to not increase very much. So why do firms acquire emerged with other firms? There might be a number of reasons it could be because that acquired company is undervalued . But it might also be because the acquiring company is trying to scale. They're trying to diversify their products they're trying to expand into other industries. Perhaps if they're paying in shares, they're trying to take advantage of a high price earnings ratio or some other ratio. And they're hoping that that will transfer into the company that they're acquiring, where they're trying to obtain a financial ratio. And the way they do that is by buying companies that have the ratio they're looking for and that that will then dilute their own ratio. So there's a number of reasons why it might be beneficial for company to purchase or merge with another company. 12. Takeovers, Leveraged Buyouts and Defense Tactics: a takeover is essentially a hostile acquisition. It's where the buying company is trying to take over a company that doesn't want to be taken over. So it was a little recap acquired company's shares. They usually tend to increase about 30 to 40% upon the announcement that a takeover is happening. But the acquiring firm shares they could go up or down. Either way, we find that cash to finance takeovers tend to increase the share price of acquiring companies. However, stock finance takeovers, those tend to decrease the share price of the acquiring company. CEOs often say that they're doing takeovers to leverage a high price earnings ratio by buying a weaker price earning company and hoping that they can apply their own price earning, toothy company being acquired. But really, what you're just doing is diluting out those financial statement. They'll just balance out between them. A dying industry sometimes tries to buy a hot tech company with the hope of jumping into a new industry. These usually flop, and the reason is probably because there's not much expertise going in. They just bought a company trying to be popular. It might make sense to give money to a tech firm before efficient markets existed because that was might have been the only way the tech firm would get money. But if inefficient market exists, and there's really no reason for this, one of the reason is CEO may try to buy hot tech company just trying to hold on to the acquiring company for a while to disguise any kind of misstating in their financial statements. They just want to hide it. The company's going down and to make a look good, they keep buying other companies. However, some takeovers are good in the sense that if you take over and you trim the fact to remove the lousy middle managers that aren't necessary, that could be good. Let's talk about leveraged buyouts. This is a way of raising funds to do an acquisition. If you don't have the funds already or you just don't want to spend your own money to understand how to do a leveraged buyout, you need to understand a little bit about how junk bonds work. There is something called an investment grade bond. This is according to Standard and Poor's, a triple B rating or higher, or according to Moody's A B A A rating or higher and prior to 1977. If your bond was below investment grade than these agencies, they wouldn't let you issue a bond. Then, in 1977 at Lehman Brothers made some exciting news when they issued a bond that was below Triple B rating. A man named Michael Milken came around, and he noted that ah, stock is theoretically riskier than even the worst bond. He also noted that there's often a big tax advantage to using debt. He took a job at a company called Drexel Burnham Lambert, and he wrote a condition into his job description that he wanted to have the right to issue junk bonds once a week with that condition, I will work for you. He then collected a commission on each of his sales, and this turns out to be a really good idea because 1985 junk bonds took off, and they ended up making up about 20% of all bonds in the market. Michael Milken and Drexel Burnham Lambert became super rich. Michael Wilson. He realized later that he could use junk bonds to do a hostile takeover of a firm. So here's the process that milk and use when he was doing a leveraged buyout. Hostile takeover. First of all, someone would come wanting to do a takeover and asking milk and for help. So then the company, Drexel, would approach a junk bond buyer at ballots, trying to convince them to buy junk bonds out of a shell company that the bitter sets up to do take over. So essentially, they make a company with no assets. That's what a shell company is, and this company is made with the specific purpose of doing this junk bond transaction. The company Drexel then gets a commitment from interested junk bond buyers and pays them a commitment fee of soup 15 to 1% of the amount that they agreed to buy. And they make the shell company. Drexel then gives the bidder a letter guaranteeing financing if the bid is successful. Drexel loans three Bitter Shell company the financing to do the takeover, and then, after the takeover, everyone gets paid back, and this might sound a little bit confusing view. So I'm going to sum this up. It's this. You can use the future junk bonds off a company that you are taking over to finance the takeover itself. You can essentially take over a company with the promise that you're going to issue Bonds. And using that promise is what you used to raise the funds to do the takeover. So where have these leverage bio? It's being done historically, If you ever watched the movie Wall Street, you will hear of this character called Gordon Gekko. And essentially, what he was doing was leveraged buyouts. The politician Mitt Romney. He was a candidate at the time, competing against Barack Obama in the election and for presidency, and how he obtained his fortune was by doing leveraged buyouts. There's also a man named Kohlberg Kravis Roberts. Roberts, who did leveraged buyouts and thes, were often extremely highly leveraged, up to 97% leveraged. And what he would do is he would bio company fire ALS the old managers and bringing new management. Private equity firms. They often do leverage buyouts as well as hedge funds. Sometimes they do something called a management buyout, and this is where you have a leveraged buyout, but you don't replace the management. In fact, the management goes to a private equity firm and gets them to do the buyout off their company, so they're trying to get someone else to buy them out. In fact, 10% of businesses selling off their assets tend to be management bios. So when a company's bought often what happens is is broken up into lots of pieces. And then the management of one of these pieces will go and try to do a management buyout to get one of the pieces back so they can keep their jobs. What are the benefits of junior leverage? Bio? Well, often, thedc companies that are bought out are usually quite productive afterwards. If drastic changes were made to improve the efficiency, that's the reason it was taken over. One of the cons of a leveraged buyout is that often these air extremely highly leveraged. So there's a high risk of bankruptcy, and sometimes this doesn't appear until of a session comes a few years later, a leveraged buyout might have 90% plus leverage. In fact, Onley banks often have ratios of leverage is high and banks are different because the government will usually bank them out, bail them out if something goes wrong. Since the government will bail. A bank out is usually incentive, actually, for banks to get as close to 100% leverage as they can because it is a tax benefit. But usually there's a minimum amount of bank reserves and a mandated by government. So takeovers can be good if they are done with the purpose of trying to improve the company by trimming the fat, removing the lousy middle managers who aren't necessary. But often when a takeover is done, hostile takeover like this, the defending company the company is being acquired doesn't want to be taken over. And there's a number of defense is that they can do to prevent their company from being taken over. There is the poison pill. This is known as the shareholder's rights plan. It's where the company that's being acquired, they issue call options that are non transferrable and out of the money and in the fine print. It says that the call options will become in the money if the company is acquired, so essentially the call option changes the strike price. If the company is being choir, this is called flipping in the poison pill, and so the shares of the company become extremely diluted, and whoever was trying to buy out that company, they suddenly find themselves owning only a small percent of the company. There's also something called a poison put. This allows bondholders to put on bonds that the company has. So the idea is that if the company is being taken over, bondholders have the rights to sell. It bonds back at a redemption value, usually above the's sold price, the par value. So this means that the acquirer will need to prepare to feel fine. It refinance the targets debt right after the takeover. And so there's an increased need for cash. Miss can raise the costs that it takes to do the acquisition. There is the defense tactic of a staggered board of directors, and this is where they have some kind of clause in there Constitution that the company directors can only be replaced so many each year. So it might take two years before you can actually get a majority off your people onto the board to control the company. You might have all the shares, but you don't have board members, so you're still not in control. Another way could be to have a restrictive voting rights where a member on the board might only be allowed to have 15 to 20% off the voting rights, even if they own more shares. So that could be a limit is. Well, you might have something like a super majority voting where you have to have a really, really high voting percent in order to do a takeover to accept it, and that can be extremely difficult to get. It might be like 80% or higher. Nets might be very, very unlikely. You could have something called a litigation defense, and the idea is that if you are trying to defend yourself, you might go to the government, complain that the rating company is forming a monopoly, and what this is going to do is this government will then trigger a whole bunch of legislation, and the government will do a bunch of investigations, and this will draw out over many months and make extremely inconvenient to continue with the takeover. There's a defense called the White Knight Defense. It's where you get a friendly company, someone you're an ally with, to buy up all the shares in your company and that way, well, the takeover company can't buy because someone else has already bought it. This is often quite expensive, so more often you'll see something called a white to Squire defense. It's where you get a friendly ally company not to buy up your whole company, but just a large chunk of shares. There is a defense called the Patriotism Defense. It's where you complain to the government that some kind of foreigners are coming in and taking over a company that is essential to your nation. And so these foreigners are no good. They're not good for our country. And usually this results in the target firm very share price falling. There's a defense called the greenmail defense, and what you can do is you can buy back the rating companies stock with a premium. So essentially they li buy stock trying to get your company, and you just buy that stock back from them. Now, this might work short term, but usually is gonna encourage other people to try and come and use the same tactic. There is a difference called the Pac Man defense, where they were trying to take over you, and in response you take over them. There is a defense called the Crown Jewels Defense, where you sell off any valuable asset that the company trying to take over you might want. So anything that might be useful to them, well, you might engage in something like 20 year contracts with suppliers and customers to make your company unprofitable. Historically, when Napoleon had his army trying to invade Russia, what Russia did is they burned all of their towns and food, and Napoleon's army essentially starved out until they had to retreat. This is essentially the same concept. There's a defense called the Golden Parachute Defense. Now this is only for a few members in the company, such as the CEO or select members of the board. And what happens is as the board gets taken over thesis, EEO will get the board to fire him with a massive payout millions and millions of dollars of bonus in the US There was a movement against this, and at the moment, anything above three times a salary of the CEO at the time is now taxed at a 20% extra. So this is often a good incentive for the CEO to leave and usually when this happens, there's news of a golden parachute that reaches the public and stock price rises. So based on that, presumably, shareholders air glad the CEO is gone and, of course, is also the tactic where you could just buy back your own shares. So a takeover companies trying to buy your shares you might just buy some shares of your own to make it difficult for them to get the majority that they need. You can also do a leveraged takeover of your own company. So remember levers takeover, essentially selling a bunch of bonds to raise funds to take over the company? Well, you could do that yourself, and that way you can buy up your own shares. So to sum up, if you're trying to take over a company, there's a few ways you could just buy out their shares using cash or trading in shares of your own. But there's also a tactic called a leverage buyout that you can do where you're raising funds by essentially selling bonds off the company you're taking over. If you are a company that's being taken over and you don't want this, there are a number of different tactics that you can use to defend yourself to prevent your company from being taken over 13. 2008 Financial Housing Collapse: in 2007 to 2008 there was a financial collapse in the United States, which resulted in US homeowners losing a cumulative $3.3 trillion in home equity and the stock market losing around $6.9 trillion. Now this is interesting because it was a result of some of the financial tools and instruments that were being used at the time, and to a certain extent, is still being used. Let's discuss how this financial collapse occurred. So the spark, of course, was the housing collapse, and this was caused by homeowners able to get mortgages that they weren't able to afford. They specifically weren't even able to afford the interest payments on the mortgage. But somehow the bank, it's still given them a massive multi $1,000,000 mortgage to people who had a measly income . Now, why would this occur in the first place? Banks were supposed to plan against this, and Onley make mortgages to people who can't afford them. Well, this is due to some of the financial instruments that were being used at the time, and what was occurring was that the bank that made the mortgage to the homeowner wasn't actually bearing the risk that the homeowner would default. They were able to give the risk toe another party so they would collect the funds, transfer the risk to someone else. And so they could just collect this commission without having to worry that the homeowner would default. The bank will engage in something called a credit derivative, and this is where they have a credit protection buyer. Make a contract with a credit protection seller who provides protection against a specific credit loss. So what we're saying is that the bank will buy insurance against the situation where the homeowner defaults. A credit default swap is where the credit defaults. What buyer makes payments to thes cellar? The seller doesn't make any payments until a credit event occurs, such as a bankruptcy or failure to make a schedule payments, and that you have the promise of compensation for credit losses from the default of 1/3 party such as the homeowner. So a credit default swap is essentially insurance, so we now have two different cash flows. We have money coming from the homeowner to the bank from the mortgage, and we now have money that the bank is giving to the credit default swaps cellar the people that they are paying to ensure the mortgages. Now, if you are the company that is ensuring the mortgages for many years, this will seem like just easy free money because you're just receiving cash flow. And as long as thehuffingtonpost don't default on their property, you don't have to pay anything. You're just collecting money whenever you have something that's essentially a series of cash flow, so you can create a financial instrument out of this. One of the things that the banks did is they transformed the payment streams using something called asset backed securities. This is where they divided the payments from the bank to the credit default swaps cellar into slices called tranches. And the whole purpose behind these tranches is that you can now have different priorities of claims where if you if you were just dealing with something like a bond mutual fund, all the investors have the same claim the same rate of return. But with an asset backed security. Some investors take priority over others over the returns, and they also have different levels of risk. Whenever there's a cash flow that has consistent returns like this. It's enticing to investors to invest in this, and you can think of this. It's essentially like a bond. They are collecting payments over time and that someday in the future they're going to have to pay back this principle. But in the meantime, there just collecting money. So what's the benefit of having a collateralized mortgage obligation? The benefit is this. You can have different levels off return and different levels of risk preference for investors realize that there is a cash flow stream going from the CMO to investors, and what they investors have done is they've purchased a specific trench in the CMO. They have said that I am going to be the by train J trains be trance, see if I buy Tranche A. I am taking the safest investment, but I'm gonna get less return. If I purchased a trance seeing contrast, I will be subject to more risk. But I'll receive a higher return. What's causing this risk? Well, let's say we have the homeowner who either refinanced the defaults. Now there's less money going into the CMO, so there's less money now for the C mo to give toothy investors. How is this money divided up? Well, everyone in Trans J gets paid first. All the investors who purchased that get paid, then we go to trans beef. Is any money left over? These people get paid a little bit more because this trance beat. If there's any money left after that, then we moved to trance seat. If there's no money left, then the people who purchase Trans see didn't get paid it at all. So this is the benefit of having these different tranches. You can invest and receive a return in proportion to how much risk you invest into, so you can see that a collateralized mortgage obligation is a really useful financial tool for the banks. They're now able to collect money from the home owners, the mortgage owners. They were able to collect that cash flow. They're now able to transfer the risk of these mortgages onto the investors. From the investor's perspective, a CMO isn't necessarily a bad thing, either. It's essentially just a form of a bond. Were they able to collect an income stream over time? If they invest in a trench? A. They're going to receive less return but it's a little bit safer. They invest in a trance, see they're going to receive a higher return. It's a little bit. Rescue, though, is the same thing. Is investing in a safer bond or rescue about No, depending on how much risk preference you have depends on how much returning gonna receive . So what occurred during the 2000 financial collapse was that the banks now had an incentive to create lots and lots of mortgages. Even if the home owners couldn't afford them because they were no longer bearing the brunt off the risk of defaults on the mortgage, they were able to transfer that risk on toothy investors. They're supposed to be rating agencies such as Moody's, who will take a look at thes asset back securities and appropriately rate, Um, but what they didn't do at the time with identify that thes collateralized mortgage obligations had become a lot riskier in years leading up to 7 4008 whole bunch of mortgages had been created with these variable interest rates where the homeowner wouldn't have to pay very much interest for a few years, maybe 0% even and then in 7 4008 they would suddenly have to pay something like 12% 20% interest. And what happened is that, of course the homeowner would default. The bank themselves that made the mortgage they're not exposed. Remember, all of the exposure is in the collateralized mortgage obligation. So who are the people who owned these? All of the investors who being collecting money for many years, such as the company A. I G. They own a whole bunch of these asset back securities, and what they suddenly discover is that these air about to implode the's trance sees of these collateralized mortgage obligations no longer going to be providing payments. And this is why I g suddenly lost billions and billions of dollars. They were expecting these asset backed securities not to collapse. And of course they did. And remember, at the end of the day, this is a credit default swap agreement, which means that when everything is good, the banks will be paying money to the credit default swaps cellar. But when the credit event occurs like a home mortgage default, then it's like an insurance policy, and the bank now gets to make a claim and say, Hey, this event occurred I want to get paid So the companies like a I G. Who had Bean ensuring who had bean selling the credit default swap agreements. All this time, they've been collecting money. They now have to pay the principle under these agreements. So this is why I, G, Lehman Brothers, Merrill Lynch and other banks lost all of these billions of dollars because all of these claims suddenly came in on these credit default swaps. And that's why a whole bunch of these banks went bankrupt. It's like when you have insurance for a car. The insurance company just collects money as long as you're not in an accident. But as soon as you're in an accident, you suddenly make a claim and the insurance company has to pay you. It's the same principle going on here with a credit default swap. In the book, The Big Short by Michael Lewis, also made into a big movie production. It discusses how several investors realized that these mortgages were about to experience a major credit event, and what they wanted to do was by a bunch of credit default swaps against specific tranches in CDO C collateralized debt obligations, essentially what they wanted to do with by insurance against the's asset backed securities . They wanted to say that if these things collapse, we want to get paid. And so they were searching for particular. Tranche is in these collateralized mortgage obligations that contained toxic mortgages. They then bought a bunch of credit default swaps against those tranches you can think of this is buying put options against them, were buying insurance against them, and then when the housing collapse occurred, they got paid big time. And that's what the movie is about. It's about these investors who identified this financial collapse before it occurred and made money off of it. So this is essentially what happened in the 74,008 collapse is that the mortgages went bad . The banks, the way they were using these financial instruments, weren't exposed to the risk and rather, the banks. Some of the investors, which in this case of a Bear Sterns and Merrill Lynch, who were exposed as well as a I G. They bore the brunt off all of these collateralized mortgage obligations. And this is because them, too go bankrupt. Jogo nearly bankrupt 14. Conclusion: Congratulations. You've reached the end of the course for financial history. In a nutshell. The foundations of modern finance. I hope you had fun in this course. I hope you learned a lot, but the one take away I was hoping you would get is that finance is really interesting. There's a lot of fascinating things that are going around that it on Lee made possible due to some of the creative and inventive ideas that come up based in finance. So keep that in the back of your mind. If you're interested in taking some more of the courses that offer or some of the products I offer, feel free to visit the website Chester's guy dot com. You can also follow me on Facebook or on Twitter, so thank you for your time. And I wish you the best of luck in your adventures. Head