In this module, Professor Shiller discusses the theory of debt and its proper role. He also covers corporate stocks.
A naïve view of what stocks are is that it is some certificate that people buy so that the price can go up. That is not what stocks are. Stocks represent people, organization, a claim on ownership on an organization.
Compound interest is another misunderstood concept.
If we have $10,000 to invest and we have two alternatives, one which gives 5% return and another gives 7% return. Does it make a lot of difference to choose between the two if we only want to invest for a year? No, it is about $200 difference which maybe we can buy a good dinner with. What about if we want to invest for forty years? If you work out based on quarterly compounding for forty years, the difference is $87,000! It’s huge.
Introduction and theory of debt
The interest rate is a percentage you earn or you pay for a certain sum. Why is most interest rate few percent a year? Why is it usually a positive number and not a negative interest rate?
Von Bohm-Bawerk wrote a book on the theory of interest rate in 1884. He came up with three explanations:
1) Technical progress
- As the economy get more economic information on how to do things, it gets more productive. Maybe the 3% or 5% of interest rate is the rate of technical progress.
2) Advantages to roundaboutness
- If we have to do something directly right now, we have to find out the fastest way but not necessarily the most efficient way to do it.
- However if we have time on our side, we can afford to go the roundabout way to produce certain things, for example, tools that make us more efficient in the long run. Maybe the interest rate is a measure of the advantage of the roundaboutness.
3) Time preference
- People just prefer the present over the future. Most people are impatient. Maybe the rate of interest is the rates of that people are willing to pay to get the money now instead of in the future.
Irving Fisher gives a theory of interest rate back in 1930 which shows that the higher the interest rate, the more money people want to put in banks to earn that interest. That is the supply curve.
The demand for the money would come from businesses and they would want to get as low of an interest as possible and that forms the demand curve.
The intersection between the supply and the demand curve is known as the interest rate.
An example of a loan instrument
- It pays a fixed amount at a future date and sells at a discount today and it pays no fixed interest.
- However, we can calculate the interest rate by using the formula below.
Equity is shares of a corporation.
Corporations are owned by shareholders and one share is usually for one vote. The idea to have shareholders is to elect the board of directors to run the company.
We choose the state which we want to list our stocks and we follow the rules there. Usually, there is an annual general meeting and one of the things we do is that we choose who to be the Chief Executive Officer (CEO). The CEO will report to the board and he or she is an employee of the company.
The value of the shares of the company is equal to the value of the company divided by the number of shares.
The market capitalization of the company is the value of share times the number of shares.
The key thing we have to know is how many shares out there and how many shares we own. This is to know our percentages of ownership of the company.
If they pay out any money to one shareholder they have to pay out the same amount of money to the remaining shareholders.
Companies pay a dividend which is also known as the distribution of profits. However, the dividend is paid at the discretion of the board of directors.
Typically young company do not pay dividends as they need to retain their earnings to grow the company.
A lot of people think we buy stocks because the price will go up, but the price will go up because we think more dividends are coming.
The price of the stock ought to be the present value of the future expected dividends.
Dilution refers to what happens when the company issues more shares. Anything that expands the number of shares decreases your interest in the company.
If the company pays a dividend, it goes through as income to the shareholders and it is taxed at the same rate as capital gains.
Dilution and repurchases of shares are neither good nor bad and it all depends on the reason for it.
Another type of shares is called preferred stock. It pays a set amount of dividend.They cannot pay a dividend to the common shareholders until the preferred shareholders are paid out. However, they typically do not have any voting rights.
Read: The whole Summary of Yale University Financial Markets Course series here.
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