SOME THINK FAST, SOME SLOW

SIC PRESENTATION, 9/12/2013 JUST THINK!

THREE IMPORTANT IDEAS FRAMED INCORRECTLY Size of the derivatives market Disappearance on IPOs Options expensing

OMG ??

EXAMPLE I own 5,000 shares of IBM, worth about $1,000,000. Hedge drop in price, long 50 put contracts, X = 170, price of $0.27 per share (put contract = 100 shares) Long side, notional value $1,000,000 Short side, notional value $1,000,000 Short side was dealer putting a bigger deal together, buys an offsetting put, X = 170, for $0.25 per share Long side, notional value $1,000,000 Short side, notional value $1,000,000 Short side is a PE firm with a short position on 50,000 shares $200 (ignoring rest of hedge).

EXAMPLE Finally, price of IBM drops to $185 a share. I sell my 5,000 shares of IBM, for $925,000. And to eliminate my put, I entering into an offsetting put, price is now $7.00 per share (netting me $35,000). Short side, notional value $925,000 Long side, notional value $925,000 Total derivatives outstanding (notional amount) is $5,850,000. Note that $3,850,000 is perfectly offsetting (no risk to system). Remaining short is covered by short position (net no risk).

EXAMPLE 5,000 shares of IBM, worth $925,000. Total derivatives outstanding (notional amount) is $5,850,000. Appears that derivatives market is 6.32 times the size of the asset market. And none of this has anything to do with GDP!

THE ASSET APPROACH

COMMERCIAL REAL ESTATE

GDP? Again, perspective is (partially) wrong. Treat world GDP as a perpetuity – an asset! $50 trillion / 10% = $500 trillion. That is was is at play, not the annual nominal cash flows from that asset. Is it more correct to think of total derivatives positions (especially repeats) as a stock or a flow? Consumption GDP?

GDP? Again, perspective is (partially) wrong. Treat world GDP as a perpetuity – an asset! Not entirely correct, but not entirely wrong either. $50 trillion / 10% = $500 trillion. That is was is at play, not the annual nominal cash flows from that asset. Is it more correct to think of total derivatives positions (especially repeats) as a stock or a flow? Consumption GDP?

HOW DOES GDP PLAY? MLB postseason chances

WHERE HAVE IPOS GONE?

CAUSES Popular view: drop in public market valuations of tech companies, heavy-handed regulation such as Sarbanes-Oxley (SOX), and a drop in analyst coverage of small companies Jay’s view: declining profitability of small firms

IMPLICATIONS? Popular view: 10m – 20m “lost” jobs Jay’s view: (research) assume(s) that thousands of companies that didn’t go public would have grown as fast as companies such as Google if they had! This assumption, which I would tend to categorize as completely ridiculous …

IMPLICATIONS? Popular view: fix SEC, Wall Street, etc. Jay’s view: fewer investor protections can potentially result in more fraud Eg., S “Democratizing Access to Capital Act of 2011” and S “Capital Raising Online While Deterring Fraud and Unethical Non-Disclosure Act of 2011”

OPTIONS EXPENSING Short video “Stock options should be charged to earnings.”

OPTIONS EXPENSING Think about Cisco example $2.6 billion profit cut in half. Implications for the firm? Does this “expense” smell right? What do all other expenses have in common? Do options?

OPTIONS EXPENSING Scenario A: Whiz computer programmer leaves IBM for a start-up. Was making $300K (assume this is “fair”). Offered $100K plus deferred options package. B-S puts package at $500K. Scenario B: Whiz computer programmer leaves IBM for a start-up. Was making $300K (assume this is “fair”). Offered $300K. Has right at end of year to buy same options package as Scenario A.

ACCOUNTING Scenario B Salary Exp$300,000 Cash$300,000 Cash$200,000 Opt Revenue$200,000 Cont Cash$XX Cont Equity$XX Scenario A Salary Exp$100,000 Cash$100,000 Opt Expense$500,000 Cont Eq$500,000 “Fair value” is NOT a finance question. It is an HR question! And even if you disagree with that point, still ignoring Revenue!

IMPORTANT QUESTION How messed up are financial statements for firms that were forced to expense options? How can we profit from this?